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Gold and Silver Mining Shares and the Economic Mess Ahead

Tuesday January 14, 2014 12:19

Currently the mining shares are still selling at near record discounted values with the gold price in the $1220 range. At this point, even a sideways gold price could support a major rally in the gold mining shares.

North American gold shares are 43% undervalued based on the current gold price vs. the value of proven and probable reserves. Since 2001, any discount below 30% has signaled a major rally in the mining shares.  Higher gold prices will then be another important driver to force values higher. Mining companies that have strong growth patterns and lower cost production profiles will have these items also as positive drivers of their share price.

Sea Change in the Mining Industry

As investment funds flooded the industry in the 2004-2008 period, many companies made a strategic choice and became growth conscious in terms of ounces produced and not profit conscious. Therefore there was a big push towards large tonnage deposits that had lower grade (richness per tonne) gold. These massive capital intensive projects sometimes requiring $2-5 billion in starting capital became the main focus of the larger companies. As many of my articles in the past have stated, the most important item to look at in a mining deal besides the management is the grade of the ore.

Low grade deposits create an environment where if anything goes wrong the project can be in trouble. High grade deposits make even bad management look good because the rock is so rich in gold (and profitability) that cost overruns in the engineering of the mine plan and processing plants are absorbed by so much more gold being recovered per tonne. Some of these mega projects have been put on hold in various parts of the world and many are basically on stand-by until the gold price recovers.

Today it now takes 9-12 years from discovery to production of a typical large mining project. This is much longer than years ago when I can remember a 6-7 year ramp up. What this means is that a significant sea change has occurred in the precious metal industry. During a period of time when the global money supply has exploded (when compared to historical averages) and banks are more overleveraged than in any previous decade, the availability of  real money (gold and silver) is going to be curtailed dramatically in the future by a slowdown in mine supply. At the same time the forces at play that make investors and savers want to own precious metals continue to march onwards unabated.

Banking Problems

Imagine someone starting a bank and collecting $1 million in capital to open the business and then going out and leveraging that money by 40 times, placing $40 million in investments. If 3% of those investments failed, the bank would lose everything. Deutsche Bank, Credit Suisse and Societe General are three of the largest banks in the world. They are leveraged almost 40 to 1. Many of the investments being carried on their books are bond issues from insolvent EU countries that are possible default candidates. The 3rd largest bank in Italy and the world’s oldest bank, Banco Monte Paschi is again insolvent after the Italian taxpayers have spent $5.6 billion to keep it afloat.

The European banks have a funding gap of $1.7 trillion. This means they are that far behind “prudent” levels of leverage and even more vulnerable to loan losses. This leverage points toward a massive new bailout of printed money coming in the future.
Because of the international scope of the banking industry, many U.S. banks are very exposed to any monetary or economic hiccup in the EU. This means the Federal Reserve will not hesitate to break out the paper and ink if needed to help shore up the EU system since a problem overseas could also mean a problem here as well.  The banking industry borrows money and invests that money but the money they are borrowing is money that another institution has leveraged themselves to lend. This is a round robin of dangerous leveraged money lending which can backfire when an economic slowdown, higher interest rates or a credit/confidence crisis develops as in 2008. This is one of the main reasons to own precious metals and precious metal assets in the ground via mining stocks.

In a recent interview, the European Central Bank’s new banking Chairman Mario Draghi (from Italy) was asked about Italy’s gold holdings, which are substantial. He gave an outstanding reply. With no back off he told it like it is, that gold is the best monetary asset a Central Bank could have and an important part of central banking. The Chinese, Indians and Arabs all understand this as well.

Central banks that have been flooding the world with paper and ink and calling it money have just completed their tenth consecutive quarter of net purchases of gold. They have accumulated over 180 tonnes of gold so far (latest available figures) in 2013.


John Williams is a well-respected Dartmouth economist who runs a sophisticated economic website called Shadowstats.com. This website calculates the inflation rate in the United States based solely on the Bureau of Labor Statistics’ (the purveyor of the Consumer Price Index) old 1980 format before it was changed to either defy reality or hoodwink the country into thinking that inflation is really not a problem. Since 1993 – twenty years ago – the real consumer price index calculated the old way has almost tripled. Officially the CPI has “only” gone up on average 2.5% annually or compounded 64%.

Milk costing $2.00 going up to $2.05 next year is not the end of the world. But when this is compounded year after year it creates a lot of lost purchasing power for everyone. The media rarely report that people’s take home pay has not kept up with the rise in the cost of living because of the creation of paper money robbing them of purchasing power. They do report of the income inequality and blame it on capitalism or low tax rates but never the real culprit – paper money. These reports create incentive for politicians to do something to help people. This always involves creating or borrowing even more paper money. This slow motion increase of the CPI allows the establishment monetary players (the Fed and the Congress) to continue to print money and run huge deficits. They have now stepped up the printing and eventually one of the great inflations will show up in the United States.

Economic Problems for the Wage Earner

The loss of purchasing power for the average wage earner creates a political problem and that problem is solved by doing whatever the politicians can concoct to placate voters. The solutions to the lower standard of living for the wage earner is too somehow give him more of something else. There are now 47 million Americans on food stamps. It is irrelevant whether this issue is good or bad for the country. If there are people starving or families going hungry at a higher rate than anytime since the Great Depression it means more printed money and more debt. The food stamp issue relates to gold ownership. It is an economic indicator (see chart below) that people are much worse off than 10-20 years ago. Politicians both on the right and left will try and fix this by more deficits and printed paper.

Because of the loss of purchasing power of the lower and middle income earners more and more people are going to require food stamps. This will require even more government assistance and become another reason to print money or raise taxes that will slow the economy down and create more unemployment and even more food stamp recipients.
Unemployment continues to plague the U.S. Much of this is a direct result of two things: 1) Small business owners (who employ 65% of the work force) not hiring. If you own a small business and the economy slows down and your costs and taxes keep going up you have to cut back on your payroll. 2) The U.S. is overemployed to begin with. In the good old days from 1950 to 1975, the economy did well with only 31% of Americans working. Unemployment averaged less than 4% most of those years.


Now with a peak of 45% of the population wanting a job, there is just no room. Hence the government solution of printing even more money to try in vain to get this unemployment rate down. If the government would stop trying to over-regulate the economy and over taxing businesses, the economy and employment would improve dramatically. When you read about the thousands of bills (new potential laws) that are circulating in Washington you are reading about more control of people, businesses and the economy by lawmakers that are collectively unfit to govern.

Most businesses would hire more people if tax rates were reduced. It is an economic fact denied by the NY Times and Washington that when you lower taxes you increase government revenue because more business takes place as more people employed contribute to the tax base. Lower taxes means small businesses hire more people. If you give millions of people a real job a multiplying effect takes place. These people pay taxes but they also spend their income and other businesses make more revenues and pay taxes on those profits. This is a positive spiral. Raising taxes causes a negative spiral. We are now in a negative spiral and that will be matched by three bad policies, higher taxes, more debt and more printed money. The price of gold assets will not ignore the obvious for too much longer.

The U.S. Economy

The U.S. economy is chugging along. With all the money creation it would be hard to see a recession coming any time soon. The stock market is strong with the Dow around the 16,400 level. This is actually a positive economic indicator as well as the copper price above $3.00. But the market is richly valued and deserves careful watching as a top may be in the works. As long as the “official” inflation rate stays below 3% all may be well for awhile. But the usual suspects always eventually show up and change things. The usual suspects show up in the following order: 

  1. Inflation starts to increase and persists higher and higher month after month and quarter after quarter.
  2. Interest rates then follow the inflation rate.
  3. As interest rate rise higher and higher, businesses curtail capital spending and expansion plans that are usually financed with loans get shelved.
  4. Employment hiring slows down dramatically and then stops. Lay-offs increase.
  5. The slow-down in the economy is now in full swing coupled with higher inflation rates and since productivity is also lowered one has a classic situation of plenty of money floating around chasing less goods, contributing to even more inflation.
  6. As inflation expands so does the interest rate level and a vicious cycle is now in play. It is 1973-75 and 1979-81 all over again.
  7. A major recession ensues and the stock market retreats.

Normally investing in precious metals and mining stocks is a good idea when inflation is a persistent and perceived problem by the crowd on Wall Street. This is not the case presently but I expect the near term future to see the above scenario start occurring. But there is an even more important factor today at play in the owning gold rationale.

House of Cards

The banking and monetary system is a house of cards. The overextension and massive leverage of the intertwined global banking system was not prevalent in the ’73-75 or ’79-81 high inflation periods. Therefore this coming storm will have an even more upsetting result. It will not be a disaster. It will not be the end of the world economy nor will it be another Great Depression. It will be a high inflation period that could last a decade and a recession that could linger for 2-3 years. Coca cola, Big Macs and your favorite toothpaste and television shows will all be available – at a higher price of course. The world will move along. The system will not break down but asset classes will be volatile. The poor will get poorer and the rich will actually give plenty back as the credit and leverage problems backfire for many investments. Gold asset ownership will be the great lifeboat.

Monetary Leverage

Because of the banking system being corrupted by leverage, the money will be suspect because it is a leveraged paper asset with zero backing. A banking crisis can wipe out people’s bank accounts despite what the government may promise. Gold cannot be wiped out. Bank accounts can.

The current situation in the United States is as follows (and just as bad in most countries). There is only $1.2 trillion of currency in circulation but the U.S. money supply is almost $11 trillion. Where’s the beef? The answer is that no one knows what the future will bring but owning precious metal assets including the mining shares is good insurance and is a solid place to patiently wait for the inflation that is coming or the panic out of paper assets into something more tangible.


The Shanghai Gold Exchange is now in full gear and in just the first six months of 2013 physically delivered more gold than all the U.S Commodity markets combined. The amount equaled almost 40% of the entire world’s mine supply!

This is a sign of growing Asian demand that is expected to continue.

Bullion Dealers Hustling For Gold

Another major underlying fundamental to the gold supply and demand equation is something called the Gold Forward Offered Rate.

This is not understood by many but it is an essential part of the trillion dollar gold industry. In simple terms it means the following: If someone wants to borrow $1 million from a bullion bank, the bank lending the person money will charge interest on the loan as is customary. But in this loan scenario if the borrower would put up gold as collateral for the loan the bullion bank will actually pay the person some small interest rate (sort of like a rebate) on his/her gold. This interest rate is called the Gold Forward Offered Rate or GOFO. This means the bullion banks need current gold to satisfy obligations they have to deliver to the physical market. The last two times this happened GOFO rate was positive (2000 and 2008) a major rally occurred in the gold price and the mining shares. So look for this when you are online. It is a reliable indicator of a gold rally.

Global gold production is about 2400 tonnes annually. The London Bullion Market Association Precious Metals Clearing Company reports that every day, 9,020 tonnes of gold is traded. That’s about a trillion dollars every three days. The gold market is a robust and vibrant global market and most of the players are all circling around the same thought process regarding money. “Paper and ink under the control of governments or a gold bar?”

Portfolio Watch

Mining shares are extremely undervalued. What is commonplace on Wall Street when extremes are pervasive is a counter-trend materializes. The counter trend is usually a powerful reversal.

This reversal is primarily because of two reasons: 1) there are few if any sellers left and most of the shares are now in strong hands that realize that their downside is limited but their upside is well above average. This makes these investors continue to add to their position as well when the reverse trend starts; 2) Value and momentum investors are a large part of Wall Street. Value players are constantly searching for situations that show lots of value at a discount and eventually will find industries that may not have been on their radar screens in the past but are now flashing a green light. Mining shares are certainly in this category. Momentum players understand that the longer momentum cycles return the most rewards. Extremely discounted sectors on Wall Street usually last a long time since the natural return to normal values from such a steep discount would logically happen over an extended period of time.

There is also a third aspect to the above as well. Since we live in a world of economic uncertainty and a world where debt outweighs the money supply by a wide margin, there will always be a period in the future when gold and the mining stocks become once again front and center as an important part of an investment portfolio.

Market Vane is an important Wall Street sentiment research group. Regarding the gold mining shares the per cent of bulls to bears is at an extreme. The level is at 45% bullish. For gold, this is at the lowest end of bullishness. The last time the bullish consensus was this low was mid-2001, the beginning of the major seven year bull market in mining stocks.

There are enough indicators to allow one to feel confident that the mining stocks are going to move significantly higher in the future.

Kenneth J. Gerbino

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
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