The Gold Report: Many of the resource companies in Pinetree Capital’s investment portfolio are gold companies. Gold went from above $1,900/ounce (oz.) in early September to around $1,600/oz. currently. Pinetree’s share price has followed gold lower and your exposure to gold remains high. What’s Pinetree’s pitch to investors right now?
Marshall Auerback: We had a very significant run up in the gold price, so some correction is understandable. But the conditions that created the run-up to $1,900/oz. have not dissipated. If anything, they’ve become more pronounced, notably in the Eurozone, where investors must begin to seriously consider the possibility of a break-up of the European monetary union and the implications that has for gold. And if you look at the monetary overhangs in places like China and Japan, it’s hard to find stores of value there either. So we have had some significant spec liquidation, some central bank sales-a plus, as central bankers are usually a great contrary indicator-and yet the price appears to have stabilized around $1,600/oz. Gold stocks, in contrast, still reflect valuations that are substantially lower than the current gold price. It is also important to note that the capital markets, in contrast to late 2008, have not shut down. Good quality mining projects can still obtain funding, especially for projects with robust economics, which a number of our holdings possess.
Pinetree has a unique structure. We raise money from the markets, which means that our longer-term funding requirements are, to some degree, shaped by market perceptions and market enthusiasm for resource stocks. But it also means we are not subject to monthly, daily or quarterly redemption pressures, so we can hold on to some smaller names that now offer the most compelling value they have offered in years.
TGR: A few years ago, Pinetree went from being focused on technology and biotechnology stocks to resource-based equities. If you were making that decision today, would you still go in the same direction?
MA: Yes, the fundamental thesis has not changed. The developing world is likely to remain the dominant social, political and economic theme for at least the next few generations. Commodity prices have soared because the depletion of readily available resources is now finally outstripping the ingenuity of mankind to extract these resources. That is not just our view. Jeremy Grantham of GMO believes that this has changed the fundamental trend in real commodity prices, though the explosive nature of these prices in recent years has no doubt been amplified by speculation and historically unprecedented and ultimately unsustainable fixed investment in China. So you will get periodic corrections, especially during periods of global economic slowdown, but we don’t think this changes the long-term thesis. The portfolio composition has changed somewhat to reflect a changed economic environment of less base metals, more precious metals, but that is a tactical, as opposed to strategic, decision.
TGR: Did that one-month, $300-dollar drop in the gold price ruin gold’s reputation as a safe-haven investment?
MA: Not really. The price rise was, like other commodities, undoubtedly amplified by the actions of trend-following speculators. These are generally weak holders, and they tend to get shaken out when there are market gyrations of the sort that we have experienced over the past few months. But the fundamental reasons for holding gold have, if anything, grown stronger over the past few months.
TGR: Is the fear-trade gone? Is gold now trading strictly on supply and demand fundamentals?
MA: Given the way that markets have traded toward the end of the quarter, where you get maximum incentive to “paint the tape” in an upward direction, we think it is way too premature to suggest that the fear trade is over. Ultimately, though, gold is a supply/demand story. The market has been in fundamental deficit for decades and only the sales and leasing of gold by the central banks have prevented an even more acute price explosion.
TGR: The market is always about timing, but timing is even more important now given the rampant volatility in the markets. Fearing an economic collapse, many investors exited the junior sector once the volatility started in August. Many of those same investors remain on the sidelines today and some probably want to get back in. Is there something they should wait for-like a bottoming of the gold price-or is now the time to return?
MA: We think the time when you get maximum valuation is during these periods of turbulence and fear, when the baby gets thrown out with the bathwater. The good stuff is thrown out along with the bad as redemption pressures mount. Since we are in a comfortable position vis-à-vis our cash positions, we are in a good position to capitalize. Especially as Pinetree, for reasons explained before, doesn’t face comparable redemption pressures.
TGR: Our readers are primarily retail investors who like the high-risk, high-reward nature of the precious metals juniors. Pinetree is essentially a retail investor with lots of cash and a crack research team. How is Pinetree playing the current market? Have you been adding to your positions on the market dips? Have you sold off? Have you held tight? Give us the scoop.
MA: We try to “feed the ducks while they’re quacking,” in the sense that we recognize that many of these holdings are small and illiquid, and we tend to take large, strategic stakes. When our assessments are largely validated by market action, then we find that it is a good time to reduce, particularly because with these smaller, less liquid names, we are almost always going to be a bit early because we have to trim when there is good demand. This is especially the case when the company’s development has largely tracked what our analysts forecasted and with that comes the growing popularity of the shares with the broader market. Selling in those kinds of situations gives us the flexibility to take on new deals or, as is the case today, to buy from distressed sellers.
TGR: Let’s switch gears to silver. Does Pinetree believe silver is a better near-term investment than gold?
MA: No, we think gold is likely to be the better performer if a global recession becomes the predominant concern, as opposed to systemic issues. That said, there have been some fairly violent moves to the downside over the last few weeks. The bear talk on China has really been overdone. Remember, China has over $2 trillion in foreign exchange reserves, so it has ample firepower to combat the forces of recession. In the very short term, we could get these massively oversold conditions worked off if it looked like the world was not coming to an end and silver could have a nice pop. Look at the U.S. data recently:
- Since late August, the U.S. economic data has surprised somewhat to the upside.
- Initial unemployment claims rose less than expected; September chain store sales look stronger than expected; Ford Motor Company’s sales for September were up 9%.
- It looks as though GDP growth may come in better than 2% annually in both the third and fourth quarters, surpassing recent pessimistic expectations.
As far as China itself goes, suddenly all the analysts, economists and portfolio managers that were all bulled up on China two years ago, a year ago and even six months ago have become all beared up on China. We are hearing about an imminent hard landing in China from everyone. So why the sudden bearishness about China?
It is claimed that China’s informal credit market is out of control. Property developers and businesses are starved for credit; business investment and real estate will fall. A hard landing is at hand. Let’s put this informal credit market into perspective.
This informal credit market is estimated at 3-4 trillion yuan RMB. The Chinese economy is now estimated at something north of 40 trillion yuan. According to Fitch, the formal credit market plus the shadow banking system totals about 70 trillion yuan.
When one looks at these numbers one can see that the growth of informal lending and the extremely high interest rates on informal lending represent a problem in China. But it does not impact a significant share of aggregate expenditures.
The real problem lies with the banking system and the shadow banking system.
TGR: Is this important credit market now poised to take Chinese aggregate demand down?
MA: We doubt it. Interest rates in the banking system are negative in real terms. The banking system is still expanding at a double-digit annual rate. Interest rates in the shadow banking system are much higher; they are no doubt positive in real terms, but it appears they are not usurious. In any case, this credit is still being allowed to expand at a very rapid rate. Will the authorities be able to deal with problems in the banking system or shadow banking systems, which are the credit markets that matter?
The answer is probably yes. The biggest credit excesses and the biggest white elephant fixed investments in this cycle lie with the local authorities. The Chinese government in one fell swoop removed half a trillion dollars of such loans off the backs of these local authorities. A half a trillion dollars! That is as large as the entire alleged informal credit market that everyone is getting so beared up about.
Longer term, the Chinese economy is an out-of-control Ponzi economy. Labor force growth will go negative. Surplus labor in agriculture is depleting. Fixed investment is impossibly high relative to a falling warranted rate of growth. Very bad things will eventually happen. However, the Chinese economy is also an extreme command economy. Extraordinary measures will be taken to avert these very negative outcomes.
The Chinese economy is highly indebted. The Chinese central government is not. Before the proverbial you-know-what hits the fan, the Chinese government will use its balance sheet to keep the white-elephant over-investment juggernaut going. Do not underestimate the fiscal capacity of the Chinese government and its willingness to use it. We do not think the excesses today in the Chinese informal credit market are a reason to get very beared up on China all of a sudden. The Chinese bear story will unfold progressively over a long time.
The real threat in China is inflation. China’s fixed investment has become increasingly credit dependent. To keep the fixed-investment juggernaut going and avert a hard landing, there must be sustained rapid money and credit expansion. There is already a large monetary overhang. The combination of these flow and stock dynamics threaten a very high inflation down the road. Which again makes the long-term case for gold very bullish.
TGR: What are some investment themes that you expect to play out in the coming months?
MA: We think that the markets could surprise again to the upside as we have apparently discounted a double dip recession, whereas a slowdown might be more accurate. This period might end up being closer to 1998 than 2008.
The trouble with the view that we are heading for another 2008 is that all crises are different. But they do share one common element: the inability of markets to perceive that when a market discontinuity is fresh in the minds of investors (e.g., 2008); it seldom repeats until that institutional memory is dissipated. Now, I believe that European banks are insolvent conditional upon the PIIGS collectively being insolvent. Clearly, this is the case for Greece (although the European Central Bank (ECB) could easily forestall this if it keeps buying Greek debt), but for the others, this is unclear-and, particularly in the case of Spain and Italy, a function of the rates at which they can borrow. So while the ECB provides a liquidity backstop, they have the room to adjust. Of course, the missing ingredient is growth. Europe already looks as though it has slid into recession. I would argue that recession, as opposed to systemic risk and bank runs, is already priced into European stock markets. But nothing is certain.
While the current crisis in Europe is worse than the 1998 crisis with LTCM and Russia, in 1998 it was thought that the entire system would collapse. Remember in 1998 Fed funds were 5%, not zero; 10-year notes, above 4%, not 2%+; 2-year notes were 5%; SPX was 30x earnings, not 15x. We had not gone through a 1974-style liquidation in reverse parabola terms except for the one day 1987 sell-off, as we did in 2008-2009. Real estate (houses) was not selling for prices yielding 10%-15% on lower-end real estate, but that is where the focus of foreclosures is felt. The story will be told in the next eight trading days.
TGR: Thank you for your insights.
As Pinetree Capital’s corporate spokesperson, Marshall Auerback is a member of Pinetree’s board of directors and has some 28 years of global experience in financial markets worldwide. He plays a key role in the formulation and articulation of Pinetree’s investment strategy. Auerback is a research associate for the Levy Institute and a fellow for the Economists for Peace and Security.
Article published courtesy of The Gold Report – www.theaureport.com