How Long Will This Cycle for Mining Stocks Last?
Heinrich Leopold
So why is it not possible to find the basic laws or rules for investing? I just take as an example the US dollar. Why is the US dollar falling just now? The reason cannot be the trade deficit as this deficit has been around for years even through the strongest period of the US dollar and it is actually improving. So, the dollar should not fall. I had checked the US dollar in 92/93 as this has been a similar period as we experience now. The stunning result has been that the dollar has been weak despite huge improvements in the US current account and US trade deficits. Of course a lower US dollar favours the improvement, but there must be another force which drives currencies. And my result has been that the major driver for currencies today is the interest spread between currencies. This drives the US dollar, the Yen and the Euro... All other facts have just minor importance. Also politicians cannot influence this trend as it is widely assumed. These findings are in huge contrast to what we hear from the media, and also- more disappointing - from the experts of the central banks.
I have just mentioned this example as this meets the basic question for an investment strategy today: Should we act as trend followers and ask no questions about the basic mechanism of this trend or can we find out some basic rules for the constantly changing environment for investing ?
Basically the task to find the basic rules for investing comes down to find the major drivers for a trend and eliminate the unimportant factors. If the major drivers for a trend are recognised it is important to stick to the strategy as such trends can go over decades (the Warren Buffet way of investing). Jesse Livermore, one of the most successful investors said once when asked for his investment strategy : ' being right and sitting tight'.
There are very efficient statistical methods to find fundamental parameters for a trend. The challenge here is nevertheless to cope with a changing environment. So, globalisation is today a much stronger force than it has been twenty years ago. As a consequence some rules can change over time. Just as an example: at the current debt level of the US which stands around 300 % of GDP and which is higher than during the Great Depression in 1930, the world should be already in deep depression. Nevertheless, as developed countries still find countries to which they can sell their debt in exchange for imported goods, the current asset bubble can still grow. In any case, the rules are still in place, but over time some trends can get very extended.
I have made a lot of statistical work and the result for the major driver for investments is actually the money supply. If money supply grows, the economy will grow as companies and consumers have more money to spend. Consequently the stock market will go up as companies make more revenue and profits. If money supply falls, the economy will contract and on average share prices will decline as well as profits.
It is as simple as that. So, why are countries not just simply increasing money supply to make their consumers, citizens and voters happy? The answer is inflation. If M1 money supply (or cash) increases too fast and without compensation from higher productivity, inflation will rise and curb future money supply as higher inflation increases interest rates and diminishes investors appetite for bond purchases.
So the art for central bankers is to increase money supply without igniting inflation. They can do so by encouraging M3 growth (long term investments). The only backdraw for increasing M3 is that a high long term indebtedness (asset bubble) slows down the economy, which can go as far as a depression, as it is the case currently in Japan in a mild form and as it has been during the Great Depression in 1930.
US M3 Money supply has been slowing down extremely fast in the last few months and is at its lowest point since a decade. For the US this represents just the same monetary situation than in Japan 1992 when money supply came downvirtually overnight. So the US is in great danger to follow Japan into deflation.
For this reason, the outlook for higher profits in the US economy is very slim, therefore also the chances for substantial stock market gains.
In my view central bankers are aware of this situation, hence the extreme sanguinity about a falling dollar (which represents monetary easing) and future inflation as well as low interest rates. Over twenty years now long bond interests have been falling and the trend is very likely to become stronger, which means much lower interest rates.
Luckily, the current US monetary situation opens a huge opportunity for mining stocks as they respond very favourable to low interest rates and are a much better alternative than cash.
Metals - and especially precious metals - are primarily driven by lease rates spreads. Today, many projects are financed through forward sales of the future metals. This is very attractive when metal lease rates are high. Thus companies are investing in new capacities when lease rates are high - and they are not investing when lease rates are low. Forget supply and demand. Silver has been in short supply for nearly a decade by 100 mill oz per year, yet the silver price constantly moved downward - up to now.
First some definitions. What many people talk about (when they mention lease rates ) is actually the forward rate or lending rate. Here is how the lease rate is composed:
Libor - forward rate = lease rate
You can see from this equation that if the Libor is very high (as it has been during the nineties) the lease rate is also high. The lease rate is the rate bullion banks get when they borrow gold from central banks at a low forward rate and invest them in the cash market.
Currently the Libor is very low due to the dramatic lowering of interest rates around the world. As now the Libor goes below forward rate, the bullion banks have actually to pay more to lend gold from central banks than for cash. So they could rather borrow cheap cash and
invest it in the gold market - and make money. So now just the opposite mechanism of the gold carry trade of the nineties starts working.
At the same time all gold and silver shorts get really hurt as they actually have to pay for being short on gold. Now every day it hurts of being short on gold and the pressure to buy back the short positions is becoming higher and higher. As there are now incredibly many shorts out in the world (inflation is anywhere very low - so why buying gold ?) an huge short squeeze can develop over the next few months.
The correlation between Libor, forward rates and lease rates also explains the function of gold as an inflation indicator. If gold yields more than cash, a lot of cash is generated worldwide. At some point this will create inflation in the next two to three years, but actually not now. The longer the inverse spread of gold lease rates persists, the higher the gold price will go and the higher the future inflation will be. So this makes gold a very special investment as it is important to buy gold as long as the inflation is low and sell the gold if inflation is high (and the masses go into it). As soon as inflation goes up, the Libor will also go up and with it the lease rate, starting the game once again in the opposite direction.
As lease rates are very low and are trending lower and demand is quite high - due demand in developing countries - and supply is actually shrinking through underinvestment, we see an unique investment opportunity in metals. As the lease rates are very closely related to the Fed Funds it is advisable to stay in the metals as long as the FED Funds are low. If the FED raises interest rates it is time to go out of metals and metal mining stocks.
So this year gold will go up despite very low inflation. Yet the smart investors are already invested in gold, silver and mining companies. But gold will go down just when the panic about inflation - in two or three years - is the highest.
So, how long will the current mining cycle last? In my research I have the impression that the gold cycles have been quite short - even in the seventies. Low Fed Funds increased very quickly money supply and the economy started to recover, which then brought the precious metals down again through higher lease rates.
Nevertheless, what is interesting in the current cycle is that the substantial lowering of interest rates did not bring up money supply. In the contrary - money supply declined very rapidly in the last few months. It is widely assumed that lower interest rates increase money supply, which then feeds into the economy and brings up profits and stock prices. This has been the case in nearly all previous economic cycles.
As this time money supply decreased, it is very likely that we see a further fall in US inflation and interest rates rather than the widely assumed increase. Central banks are now exactly in the situation which I have described three years ago in my article 'Be Careful What You Wish For'. So yes, indeed we could see now a much longer period for low interests and high precious metal prices than many people can even think about and wish for.
I look forward to receiving your comments -
19 February 2004
Heinrich Leopold
Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.
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