Source: JT Long of The Gold Report (4/14/14)
An overinflated equities market could be good news for metals and mining stocks. In this interview with The Gold Report, Morning Notes Publisher Michael Berry shares two scenarios that could follow an imminent crash and tells us how to ride the coming gold wave to portfolio success.
The Gold Report: Mike, you've been watching the stock market and, by extension, the precious metals markets very closely for signs of a larger equity market blow-off that could send gold higher. What makes you think the Dow Jones Industrial Average and the NASDAQ are in a bubble? What are the signs that a crash might be imminent?
Michael Berry: I have been watching bubbles since 1987. In September of that year I correctly predicted the 25% crash of October 19. We have been blowing through mini and maxi bubbles for 30 years; this one is nothing new.
The solution to our macroeconomic issues has been to inflate new bubbles, to inflate asset values to soften the blow from the last bubble, all the while creating the conditions for the next one. That is how we ended up with the current equity market bubble. It is driven solely by the Federal Reserve's liquidity. Always remember that liquidity begets liquidity. I also see a debt market that I consider to be a bubble. These markets are just not sustainable. I can't say when, but we have an equity market decline coming, maybe a severe decline.
TGR: The housing bubble and the tech bubble were, by definition, confined to certain niches initially and then the impact reverberated to other sectors. Are you predicting a market-wide crash where everything falls or will it be confined to certain sectors?
MB: The correction will impact everything. As of April 8 I'm measuring the Dow technically, fundamentally and behaviorally, and I see a clear top by all three measurements. The top is not quite as clear for the Standard & Poor's 500, but it's certainly there. A major event could cause this bubble to burst and the markets turn down. I think it's imminent, probably this year. With the Federal Reserve pulling back on its quantitative easing, I can't see the equity market being able to sustain itself.
TGR: Are there any specific indicators that might tell when a crash is about to happen or will we only know after it happens?
MB: The money multiplier, M1, which is a measure of how well the banking system is working, is at its lowest level ever—0.69, according to the St. Louis Federal Reserve. (It usually has been above 1.0). It has continued to decline for the last five and a half years. That is the sign of a disabled banking system, a coming bear market and a severe recession or worse. There's no doubt about that. The velocity of money has been in a decline for quite some time. These indicators mean our banking system is not working properly. These conditions were last this serious during the Great Depression. Even Milton Freidman acknowledged this when he suggested the Fed's problem will be dealing with its own drastically expanded portfolio. Freidman claimed that the Great Depression was the result of a falling multiplier and the failure to increase the money supply. That has not been the case this time but we are still in serious trouble.
Europeans are now concerned about deflation, the slowing of the economy and the falling of prices. The "D" word is actually spoken. The International Monetary Fund is particularly concerned. We've certainly seen falling prices in the metals markets over the last year and a half. China's tightening and slowing along with the U.S. tapering its quantitative easing mean the economic winds are in our face, not at our back. Those are the things I am concerned about.
TGR: So when this bubble does burst, how might the different metals—gold, silver, copper—respond differently to a market crisis?
MB: That is a good question. The answer is it depends. If we don't fix the broken credit cycle and deal with exploding government debt, we will probably begin to see disinflation and deflation. Then prices will fall. Gold, copper, silver, tin, lead and zinc will decline, but probably less than the valuations in the macroeconomic economy. That will be the time to buy metals because we will recover once we see a new credit cycle. However, it could be a three- to five-year hiatus. The Fed and others will have to deleverage. Only then will the economy be able to recover and break out of it torpor. We'll see a new bull market in the commodities then.
On the other hand, if we were to inflate out of the crisis, which the Fed would prefer, we will see gold achieve very high prices. I wish I could give you a very clear answer. Personally I think deflation is much more likely.
TGR: If we experience inflation, and the gold price goes up, will the equity prices follow?
MB: Absolutely. When we have inflation—and we will as soon as a new credit cycle is in place—then we are going to see gold miners take off. Right now, there isn't a bottom on the price of these stocks because if gold goes much below $1,250 an ounce ($1,250/oz), then the cost of producing gold is going to be a problem for the big gold producers. These stocks have been punished and are close to their bottoms now. People interested in precious metals and who are patient ought to be buying these on any declines in their current share prices.
TGR: Are some mining stocks going to come back faster than others?
MB: Yes. A lot of the big-cap miners are highly leveraged with debt. They need to deleverage, and that's difficult to do in this environment, so investors want to be buying the big stocks that are not highly leveraged.
The midtier producers have a real problem because they're really not big enough to go to the next level in this kind of a capital market environment. We are going to see that quite a few of them will be taken out.
The juniors and explorers have been decimated. It's a bloodbath. There's no other word for it right now. These stocks are trading anywhere from $0.07 to $0.40/share. They are worth a lot more, but not in this environment. I have a number that I follow that have good management and good assets, and the ability to sustain themselves over the next year or two until we see a recovery. Sustainability will be very important.
TGR: The silver market is more volatile than gold. Are there reasons for investors to get involved in the space?
MB: I love silver. I'm on the board of a couple of companies that have big silver plays. But the silver market is volatile; it's a much smaller market and an industrial, as well as a precious metals, market. Gold is down 27%, but silver is down almost 45% from its October 2012 top. We produce about 800 million ounces (800 Moz)/year silver globally, and we basically use it all for everything from electronics to medical technology. The price can't stay at $20/oz for very long because new silver mines are going to be required.
Silver investors must be believers today. They must live with the volatility of the market and believe the price of silver will appreciate eventually. If you believe in silver and you believe in the ultimate limited supply/excess demand dynamic, then I think you ought to own a portfolio of these companies, put them away and let silver do its thing, because it will over time.
TGR: Would that same advice go for the other metals?
MB: Not exactly. Copper is a totally different market. I like copper a lot, but it is becoming increasingly difficult for companies to bring big mines on line. The Indonesians have done some things that hurt some big names by disallowing them to ship ore overseas. The Chileans and other South Americans have had some problems. There are problems in Mongolia with a big copper facility there. That makes North American copper plays in Arizona, Nevada, Canada and, to a lesser degree, Mexico, a great place to be right now. Copper could go below $3/pound, but with the rest of the world growing a new middle class of consumers, we're going to need more copper and that means more copper mines. It takes a long time to bring a copper mine into production, so I think copper is also very cheap today and should be considered selectively.
TGR: So these are long-term investments?
MB: Certainly. We are seeing a lot of private equity players now that are picking up properties for cents on the dollar. The private equity players can afford to sit with a property for two or three years until the commodity prices improve. Most junior mining management teams cannot do the same thing. Juniors are going to have to be able to survive over the next couple of years, so look for companies that can conserve resources. Some developers have stopped drilling. A few marginal producers have stopped producing. Everyone is, or should be, reining in costs, cutting costs. The Vancouver model of financing is broken right now. The capital market is telling us that nobody cares. If nobody cares, then it's time to tread carefully in the exploration space.
TGR: Thank you for your insights.
Michael Berry served as a professor of investments at the Colgate Darden Graduate School of Business Administration at the University of Virginia from 1982 to 1990, during which time he published a book, Managing Investments: A Case Approach. He was the Wheat First Professor of Investments at James Madison University. He has managed small- and mid-cap value portfolios for Heartland Advisors and Kemper Scudder. His publication, Morning Notes, analyzes emerging geopolitical, technological and economic trends. He travels the world with his son, Chris, looking for discovery opportunities for his readers.