Are We There Yet? Finding that Elusive Bottom

Source: The Gold Report  11/14/2008

David Skarica, author of the Addicted to Profits newsletter, gives The Gold Report an exclusive preview of coming market attractions including double-digit inflation, a super pop in gold stocks, and the demise of an empire. A financial advisor who earned his reputation as a contrarian before he turned 30 by predicting the dot.com bust, Skarica was the youngest person ever to pass the Canadian Securities Course. He incorporates technical analysis, historical precedent, demographics and investor behavior into his forecasts and names some likely beneficiaries of the next market move.

The Gold Report: Have we finally hit the bottom? Are things turning around?

David Skarica: I’ve studied the panics that have occurred over the past 100 years and discovered that there’s a similar trading pattern when you reach the true bottom. A panic like we saw this September through October is typically followed by a reaction rally similar to what we have now. That rally will take the market 20% to 30% off its lows and last for about a month and then you’ll get a retest. Maybe not an all-out retest, but a repeat of that rally over the next month or two. For example, in ’87 and ’74, after a big 30% or 35% decline, you got a rally into November, then this decline into October and then the market held, the lows took off and launched a bull market for a couple of years.

Once this rally plays out, the key thing to watch is a pullback into December that could very well be “the low.” You’ll know it’s the low because you’ll see non-confirmations. You won’t get as many new lows in the market; the fear gauges like the VIX (Chicago Board Options Exchange Volatility Index) won’t hit such extremes. A lot of the industries that led us down, such as the banks or the airlines, will hold well above their lows. That will be the bottom. In a worst-case scenario like 1929 or 2001, when you had big sell offs, there were rallies for four to six months before the market rolled over and hit new lows. If the market continues rallying into January or February, that would be a very negative signal. I want to see that retest. One positive thing is that we already saw one retest in late October and now we’re seeing this secondary rallying. In 2001, there was no retest. The market sold off real bad for three or four days after 9/11 and then kept rallying.

Gold stocks are at an all-time low in terms of P/Es, and their price relative to the price of gold. The dollar rallied during all the de-leveraging but at some point, the dollar is going to roll over. If you look at the currencies that got killed— the Canadian dollar and the Australian dollar—fundamentally, those countries are still stronger. They’re not running huge deficits. Canada’s deficit will only be a couple of percentage GDP, unlike the U.S. with a deficit of nearly 10% of the GDP. The Canadian banks are fine; none of them need a bailout.

TGR: European banks and Japanese banks are bailing out their banking systems too. Why would U.S. currencies do worse against other currencies?

DS: I don’t think the dollar will totally tank in the short term because Europe —not just the Euro but also all the other European countries thrown in with Euro—have something like 70% of the dollar index. These countries have problems as well. Milton Friedman said he never thought the Euro would survive its first severe recession because you’d never get consensus among the different countries. How are you ever going to get the British, Italians, Germans, and French to agree on anything? The dollar rallied because people thought that the U.S. at least had a policy. I don’t see the dollar collapsing in the short term. Unless we’re going into a total worldwide depression—I don’t think that’s going to happen. I really believe the rest of the world will distrust the U.S. financial system.

Wall Street packaged all this fraudulent stuff and then sold it to everyone. These guys were dumb and greedy for buying it but they were defrauded. So Asian banks won’t be buying anymore Fannie and Freddie bonds; they’re going to say the heck with it and invest in China, India and other emerging nations. Capital flow will shift away from the U.S. After the crash of 1929 the world’s financial center shifted from the U.K. to the U.S. This crash will shift the financial centers from Wall Street to Singapore, Dubai, Mumbai, and Bombay. Japanese banks are pretty solid right now and so are a lot of Asian banks. They’re involved in lawsuits because they own some of these toxic assets, but, again, you’re not seeing mass bailouts over there and Australian banks are strong, too.

There will be growth going forward in emerging economies. Meanwhile, in the U.S. the baby boomers are retiring. In technical analysis we talk about overhead supply and that’s when the stock goes way up and comes way down. The problem that stocks are going to have is the people who bought at much higher levels are going to sell into any rally to cut their losses. Baby boomers are retiring, so they’re selling into any rally. In the 1970s and 1980s they were in their 30s and 40s, so they bought stocks. Over the next ten years they will be sellers.

TGR: What about the echo boomers? They’re getting out of college now. The biggest group is starting college.

DS: They’re getting out of college, but won’t reach their peak earning years until they are in their 40s and 50s.

TGR: Yes.

DS: Echo boomers probably won’t invest significant amounts of money for 10 or 15 years. This is interesting because I do a lot of cycle research and 10 to 20 year cycles are common. In the market, cycles run for 17 or 18 years. For example, we had a bull market from 1949 to 1966, but a bear market from 1966 to 1982 and then another bull market from 1982 to 2000. Now we’re in the midst of a long-term bear market. When that next generation really starts to invest heavily coincides with the time that the baby boomers will have sold out.

As I said, I think we might bottom here; we might have a one or two-year bull market like we had from 1975 to 1976 after the bad bear market in 1973 to 1974. But I think we’re still in what’s called a secular bear market, which lasts for 15 to 20 years. One of the underlying causes is the printing of all this money. I think interest rates are going way up. The next bubble to burst will be the U.S. bond market. You will see high rates in the coming years because right now the U.S. money supply is 38%. That is unbelievable. Even in Y2K, it went to only about 15%.

TGR: The big debate is are we going into a deflationary or inflationary cycle?

DS: I think hyper-inflationary—not like Weimar Republic but like the 1970s. We’ve already started that cycle. Look at the SGS (Shadow Stats – http://www.shadowstats.com), which calculates inflation the way they did in the 70s and 80s. They changed that formula in about 1990 allegedly because the old method overstated inflation. I think the current method understates inflation. When oil was $150, everyone agreed that inflation was higher than the reported 5% or 6%. Using the old method, we were at 10% to 12% this summer when resources were at their highest. So even if you split the difference between the old and the new way of calculating inflation, we were in the range of 8% to 10% this summer.

Anytime they print this much money anywhere, it always led to inflation. One of Bernanke’s big things is to avoid cutting the money supply like the Federal Reserve did from 1929 to 1932. He is doing the opposite. All that liquidity he’s introducing will result in inflation. Typically you don’t go from a period of inflation to deflation. The CPI in the 1920s was going down. They had deflation then and went to ultra deflation in the early 1930s. So usually you go from high inflation to the higher inflation. We’re on a pure fiat currency right now. There’s no gold standard; there’s nothing. Pure fiat currencies usually end in inflation, not deflation.

Take Japan in 1990s and the U.S. in the 1920s—both were creditor nations. People saved. The governments were net creditors going into those downturns, so they could afford to take on debt. Roosevelt only ran one or two deficits before World War II. Obviously, during the war he ran up big deficits. So when you’re a debtor nation, you can’t afford deflation because the amount that you owe goes up in value, right? You’ve got to inflate that away. Some would argue that the whole system is based on credit. No matter how much money the U.S. government prints, no one’s going to lend, and no one will take out loans. That will cause prices to go down. Deflation is a decrease in money supply and in the price of goods. Over the next year or two, go to the store. Is the price of your beer going to go down? Gas prices are lower now than they were in the summer, but they’re a hell of a lot higher than they were six years ago. During a deflationary cycle, you’re going to start seeing deflation on the grocery shelf. The price of your cereal is going to go down; everything’s going to go down in price but that’s not happening. Right now we have asset deflation. I don’t think we’re going to have deflation in the entire economy.

TGR: What’s going to beat the higher interest rates?

DS: Higher interest rates will be (governed by?) supply and demand. Look at the yield of the ten-year bond. The low of that yield got to about 3.2% from 2002 to 2003. The low during this ultimate panic, the worst crash we’ve seen since 1987, has only happened six or seven times in the last 100 years. In 2008, the bond yield only got down to about 3.8%. So we didn’t see this huge influx of money into the bond market. If you were really moving into deflation, the bond market would tell you. The bond market would be going down to a 1 to 2% yield and telling you, okay, everything’s going to come down. But, instead, the bond rates are around 4% right now. To get back to supply and demand, they’ve got to issue $550 billion worth of bonds this quarter to pay for the bailout and they’ll probably have big deficits over the next year or two because it’s going to be a pretty bad recession. Issuing more bonds will probably mean the buyers of those bonds are going to ask for a higher return.

TGR: How high do you think interest rates will go?

DS: That’s really difficult. There’s no reason you can’t get back to at least 7 to 9% on the ten-year bond, which is where we were in the late 1990s. It’s not exactly a heady level, but we could reach low double digits. Here’s the thing no one’s talking about. If you read about the decline and the fall of the Roman Empire or the U.K., the U.S. has made all the same mistakes they made. They tried to police the world with an overly aggressive foreign policy and they spent all your money on war. They went to a pure fiat currency. The U.S. is a super power in decline. It could take a generation, but I think it will happen. In 1913 the U.K. ruled the world. Thirty-five years later after two world wars, the U.S. had to bail them out. These things can change quite quickly. Ultimately people will demand higher returns on that debt, so I see interest rates reaching 10% or higher and I’m being conservative. At the secular top you might get back to where you were in the late 1970s.

TGR: Where would you expect the inflation rate to go once hyperinflation kicks in?

DS: It will be 10 to 15%. Gas was up 10% today; oil’s up 10%. I’m an inflationary guy. Watch someone like Jim Rogers. He’ll talk about how it’s not just a demand thing with China and India or the U.S. dollar going down. His point is that there’s no oil supply coming on the market and alternatives like solar and wind will take a long time to replace fossil fuels. So, I expect double-digit inflation. Now they may only report it as 7% or 8%, but it’ll probably be 15% to 16%, maybe even 18% or 19% higher than that. Look at the way they calculated inflation in 1980. Using that formula, inflation actually got up to 10% to 12% this summer. Now it’s probably down to about half of that because of the drop in commodity prices.

But here’s an interesting note. Commodity prices started falling apart in September during de-leveraging when people were dumping everything. The PPI, the producer price index, in September still went up. Even with huge commodity price declines, you still had an increase in the PPI. I think that’s due to the fiat currency effect. It’s very difficult to get inflation. Remember, even from 1980 to 1982 when they upped rates to 20% to kill inflation, inflation slowed down from 20% to 4% or 5%, but we never went into deflation. People just get mixed up because they think that when stocks go down or real estate goes down that’s deflation. In fact, that’s asset deflation. Deflation is actually a decrease in money supply and decrease in the price of goods. Look at your electricity bill. You won’t see it going down that much.

TGR: As you said, oil was up 10% today.

DS: Oil is $70 now. Oil never hit $70 until a few years ago. People act like, oh, it’s gone down from $140 to $70. But remember, oil was only $25 to $30 when the Iraq war began in 2003. People act like this is deflationary, but oil is just pulling back. To Jim Rogers ‘This is the fourth decline of 40% or greater in the price of oil since the bull market began in 1998.’ I think we’re in a big commodity secular bull market that started in 2001. Commodities are very volatile. They can fall 50% and still be in a bull market. In 1975 to 1976 gold went from $200 to $110 after it went from $35 to $200. Everyone thought the gold market was over and then in the next four years it jumped to $800. Gold can go to $600 and still be in a bull market. People just don’t get that because they don’t think long term.

TGR: So if you’re saying the commodity bull market started in 2001 and that these cycles take 15 to 18 years, we are about half way through this then.

DS: Yes.

TGR: Commodities are volatile, but will the last two-thirds of this bull market grow exponentially faster? Or will it grow fast then drop off?

DS: The two biggest moves are always the one at the beginning and the one at the end. For example, the HUI, the Gold Index, went from $35 to $200 within a couple of years after reaching bottom. That’s a great 6:1 gain. So usually you have a huge launch off the bottom. The Dow went from 800 to 1,500 in its first year or two of the bull market. The first move up will be big and then in the middle you’ll go up more gradually. At the end you’ll have the bubble blow-off. And you’ll see another double or triple gain.

The only comparison I can use is the CRB Index, which is more of a commodity. It went from $100 to around $170 or $200 in the mid-1970s and then had a final blow-off to $350 to $360 in 1980. So the CRB Index went up 250% in the 1970s. It started this bull market at $180 and went to $470. But, again, if you go up 250% from $180, you’re talking about the CRB being about $600 to $650, which would be more than a doubling of its current level. This commodities bull market is going to be bigger because of what’s going to happen when it turns into a bubble. It’s like the growth of the Internet – all of that got priced into the tech stocks from 1999 and 2000. Even though the Internet’s a lot bigger and faster now than it was ten years ago, and there’s more commerce being conducted over it, the stock prices all peaked in 2000. Five to ten years from now, you’ll see these commodities pricing in global economic growth to perfection. So people won’t get it after that if they invest in commodities in 2018. In 2025 commodities will be down 40 to 70% from their highs, but the global economy still growing.

Three things drive commodities: money supply, the U.S. dollar, and supply-demand. In the 1970s the economy was a shambles, but commodity prices went nuts because you had terrible economic policies. The government was printing tons of money, and the U.S. dollar was declining. There was no investment during the 1980s and1990s in big new commodity funds and now a lot of them have been shut down because of this pull back. Commodity prices will rebound by 2010. That will introduce a five to ten year period of high prices where people will aggressively look for stuff and bring supply to the market.

TGR: Where will gold be in the next 12 to 18 months?

DS: That’s a tough call. Right now it’s really interesting because the U.S. dollar has been trading opposite to the market since September. We’ve seen the rally in the dollar; we saw the decline in other currencies because of the flight to the dollar. When we talk about the redemption of hedge funds, most of the people who own those funds are actually outside of the U.S. When you speculate all over the world, you’ve got to buy U.S. dollars just to pay people back their redemption, right? That was part of what was going on. If we get this retest to the market in December after the short term decline in the dollar, you might see another rally out which can hit gold maybe back to around this low $700 area. But if I’m right and the market rallies next year, and this fourth quarter is really the bottom, gold will reach $1,000, even $1,100. The opportunity right now is not in gold; it’s in the gold stocks. Even with this rally that we’ve seen in the gold stocks – for example, the XAU to gold ratio, which is the percentage of the XAU’s trading of the price of gold—it’s usually 22%, which means, for example, gold – let’s make it easy – is $1,000, the XAU is $220—even with today’s rally, the XAU is about $90 and gold is about $750, right?

TGR: Right.

DS: When you do the math that’s about 12%— almost half of the historical ratio. So if gold were to go to $1,000, the gold stocks can more than double. There’s a time to buy gold instead of stocks and there’s a time to buy stocks. I’d be looking at the smaller, lower-cost producers like Agnico-Eagle Mines Ltd. (TSX:AEM). That company will return to its regular valuation. Gold could go to $600 and if the XAU went back to that 22%, it’d be trading at like $130. So the XAU could go up 40% if gold went down over $100 to get back to its normal valuation. That’s not the gold stock saying that gold’s going to go down, they’re feeling it or whatever. That was just like the hedge funds were all in the gold stock. The gold stock market is a smaller market than the equity market. They all had to sell everything and that was it.

TGR: What about buying seniors who have just been battered versus juniors that have a potentially higher upside?

DS: For the average investor, I’d be looking at seniors because they are so cheap. When I say juniors, I’m talking about junior producers with lower levels of production because they have cash flow. And, again, it’s the whole leveraging thing. Hedge funds own them, too, and they’re even more liquid than seniors. So instead of the seniors, which all went down, say, 60 to 70%, the juniors, in many instances, went down 70 to 80% or even 90%.

Look at a stock like El Dorado Gold Corp. (TSX:ELD) (AMEX:EGO) (ELD.TO), a junior producer in the late 1990s when all the gold stocks went down 70 or 80%. Eldorado was a 40 to 50 cent penny stock and, because it was a junior producer, it had more leverage when gold went up and ultimately it got as high as $8 or $9. A lot of these little penny stock gold and silver producers with cash flow, could become the next Eldorado. They could bring a lot of 10 or 20:1 deals over the next three to five years.

Another thing that’s going to be really positive for gold and resources going forward, has to do with the behavior of 15 to 20 year bear markets. Usually the big busts come in the first half of that secular trend. If you look at 1929 to 1948, the two worst parts of that bear market were 1929 to 1932, with a 90% decline in the Dow, and 1937 to 1938, with a 50% decline. After that most of the climbs were muted, like 30% down and 25% up. The same thing happened in the 1970s. The 1970 bear market was 36% off and the 1974 bear market was 48% off. From 1975 to 1976 to 1982 at the bottom, the climbs are more gradual. So we had a bad bear market when the tech stocks blew up, which was over 40%. This bear market is over 40%, assuming we hit the bottom a few weeks ago. What you’re going to see now— as volatile as it’s been, it sounds crazy to say this – but, say, we get a one or two year bull market after this bear, you’re going to see volatility dry up. By the way, that’s how you start bull markets. When you start, when the sellers are all out, you usually get everybody giving up, not in a panic, but when the market hasn’t done everything for years. During those times when the market is doing nothing, that’s where resources and gold usually do well.

TGR: So, David, do you have some stock ideas for our readers?

DS: I like Agnico-Eagle Mines Ltd. (TSX:AEM) and Royal Gold Inc. (RGLD), which is a royalty company. The two juniors I really like are Fortuna Silver Mines Inc. (FVI) and Silverstone Resources Corp. (TSX.V:SST). They are both smaller silver producers. Actually, Fortuna was up quite nicely today from about 55 to 70 cents but it had been over $2. Fortuna also fell from $4 to 50 cents. It’s back up to around 60 or 70 cents right now. Right now you’re still getting in at a good level. On a totally different sector, if you’re looking at the major market, you can get stuff that’s really beat up. If we get this retest in December, I’d be looking at – and a lot of people will think I’m nuts saying given the state of the economy —some of the casinos. MGM fell over 90% from its high and I usually find that unless the company is going bankrupt, you’re really safe buying something that’s down 90% from its high. For example, this summer I wrote an article in Investor’s Digest of Canada telling people to buy the airlines because the airline index in the States had gone from an all time high of $200 down to $14, which is 90+%. Now the airlines are one of the only sectors that have gone up since July. A lot of the airlines went up 50 to 100% since then. Even with the higher oil prices, airlines are very cheap, for example, WestJet (WJA.TO).

TGR: What’s that one?

DS: It’s a Canadian discount airline. I put WestJet in my newsletter at about $9.50. Now it’s $10.50. The nice thing about it is a lot of airlines are forward selling oil prices to $80. But a lot of them expired this quarter, so now they’re going to be able to go to $60, $70, and $80 oil and it won’t kill them. I also like some of the emerging markets. I like the India Fund (IFN) and the South Korean Fund (EWY) or the Templeton Russia Fund (TRF). They are more leveraged. They usually fall 80% in U.S. dollar terms in a decline and they’ll go up hundreds of percent in a bull market. But I would wait for that retest before going into the emerging markets. I’m kind of all over the place in terms of the types of sectors I like because of the valuation of some of these things. I look for the really beat up sectors—obviously all the precious metal stuff—because they are very, very cheap.

TGR: Dave, Are there any exploration companies that are catching your eye?

DS: Yes, there are a few. The problem with exploration at the moment is cash flow or lack thereof. These companies have no revenues; money is difficult to come by at the moment. They have burn rates. That is why if you are going to buy a smaller junior, you have to look at the producers first. Therefore, I think you have to look at companies who have cash on hand. One such company is Rimfire Minerals Corp. (TSX.V:RFM). In the past they were criticized for being too conservative, much of their budget has their joint venture partners (which include majors) so they will not burn through their cash. They have about C$0.25 (per share) in cash on hand, and the stock trades at C$0.15 (per share) so you are getting the company at a 40% discount to cash. Basically, you are buying at .60 on the dollar to cash and getting all the properties thrown in for free. Also at their burn rate it will probably take them three years to go through their cash position and by then the credit markets will be back.

There are also companies I have on my list that have heaps of cash, large resources and are going into production next year, like ATW Gold Corp. (TSX.V:ATW) and Avion Resources Corp. (TSX.V:AVR). Again, I do not mind if a company is going into production, as it should get cash flow sooner rather than later. Avion is trading at cash.

I also like Full Metal Minerals Corp. (TSX.V:FMM) . The company has had strong results as of late; they are raising money to put their Lucky Shot mine into production. This will be a high grade mine, low cost. It will only have a few years of production, but again that will give them cash flow to survive. The financing they are doing is small and I think they will get it down, even in these markets.

In the case of Rimfire and Full Metal these were C$2.00 per share companies not too long ago, it will take them a bit to base, but it could still happen.

Finally, for a shot in the dark I like Cityview Corporation (CTVWF) (ASX:CVI). This is a very interesting little deal that has collapsed. They were doing a gigantic financing for offshore oil production in Angola, which fell through when the credit markets collapsed. They are now doubling the float of the company to raise capital to put a diamond mine into production in Angola, they are also looking at an oil refinery. This offering should allow them to survive and they will get production from the diamond mine. They will have a huge float (over 900 million shares), but they have the former Angolan Mines Minister as chairman and are positioned to be a leading company in Angola, Right now the stock has a market cap of about 8 million of the new offering. It is something that could turn around huge when this is finished or tank if they can’t get the funds. It is worth a small roll of the dice at $0.01.

Dave’s first book “Stock Market Panic! How to Prosper in the Coming Bear Market” published in January 1999 provided thought provoking arguments on why this great bull market will end in the most vicious bear market of all history. He is also the author of “The Contrarian Who Saved the World,” which explains how markets work. Dave has also been a contributing editor to Canadian MoneySaver and Investors Digest of Canada