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Stealthing Toward ProfitsDave Forest
This week we wade into one of the most contentious issues of our day. The inflation versus deflation debate. This is a charged conversation to say the least. I have seen discussions on this topic nearly come to fists at recent conference appearances (okay, not quite fists, but very heated). The question is a critical one to our investing future. Will asset prices continue the fall that started last summer? Or are the last few months' rally on the stock and commodities markets telling us that deflation has been banished and our homes, shares, metals and fuels are on the way back up in price? Those who get this call right will make a lot of money. I'll offer some thoughts on where I think we're heading (debt-driven deflation), and discuss one investment strategy that I think will do well regardless of what happens. We'll also take a trip into the darker side of petroleum accounting to find out why U.S. natural gas producers had an absolutely horrendous round of quarterly financials this week. (Chesapeake Energy reported a quarterly loss of $9.63 per share. The company only trades at $24!) This is an important lesson in how accounting rules can distort corporate valuations. If you're investing in the oil and gas sector, this is a must-read. But first, let's talk deflation... Deflation 101 I've said several times over the last few months that I believe North America (and much of the world) is headed for deflation. So much of global growth over the last 8 years was driven by debt. Americans in particular borrowed so heavily that they pushed the effective savings rate into negative territory. For the first time ever, consumers were borrowing more money than they were saving. This was good for the world economy. Americans bought more televisions, cars and running shoes. Many of these products were produced by Asian exporters like Japan and China. Because of increased sales, China accumulated $2 trillion in foreign exchange reserves. Chinese companies used their savings to buy capital equipment (stuff used to build factories and assembly lines) from America. Everyone prospered. Global GDP soared. Stock markets followed. Consumer debt was the foundation of this "virtuous circle". Between 2003 and 2008, U.S. commercial banks lent out $3 trillion in new credit. To put that in perspective, total lending for the previous 30 years (1973 to 2002) was $3 trillion. Americans borrowed three decades' worth of credit in just five years. These numbers aren't adjusted for inflation, of course. But the bottom line is this decade has been a period of unprecedented credit creation. Credit fueled the economic boom as more money was "put to work" buying things rather than sitting in savings accounts. That credit creation is now over. Today we are witnessing the first prolonged period of credit destruction in the last 35 years. As we discussed last week, $300 billion in outstanding loans and leases has been paid back (or defaulted on) during the last six months. A 4% contraction in credit. Total bank credit at U.S. commercial banks (a broader measure of money available for lending, including outstanding loans and other financial assets held by banks) has fallen by $450 billion since last October. A 4.5% decrease. Again, there has never been a fall in bank credit of this magnitude since we started tracking the data in 1973. Never. This past week alone, the Federal Reserve reported a drop in bank credit of $77 billion. The fourth-largest weekly drop ever. The Fed isn't the only one reporting economic news that points toward deflation. There was a very telling Q1 earnings report this week from Vale, the world's biggest iron ore producer. As we discussed last week, steel and iron ore are two commodities that give an "unblemished" view of the world economy. Unlike copper and zinc, these metals are not being stockpiled by China (that we know of!), and so these markets give a more accurate view of current industrial demand around the world. And the view is not pretty. Vale reported in its quarterly that the company expects global mining investment to fall $60 billion in 2009. The company itself saw iron ore sales drop 27% year-on-year in Q1. A large decrease. And that came even as China made record purchases of iron ore. This shows how poor industrial demand is throughout the rest of the world. And it's likely to get worse. Vale said that preliminary indications are China is slowing iron ore purchases in Q2. Brazilian analysts Brascan Corretora drew a gloomy picture for 2009 from Vale's data. "We don't believe the scenario will improve in the medium-term, in the second or third quarters of 2009," said Brascan. "There are no clear signs of recovery in world industrial activity, which would lead to increased raw materials demand." The Rule of 60/40 This is not an environment conducive to inflation. Money is being pulled "off the streets". Rather than spending, consumers and businesses are paying back loans and growing their savings. Either way, this money ends up in bank vaults (or the electronic equivalent). And banks need money in their vaults to meet capital requirements and stay solvent. They are unlikely to lend the money they are taking in from the public. My prediction is that we will see general deflation, driven by debt deflation. But I want to clarify my views on inflation. Some readers assume I believe inflation is impossible. That's certainly not the case. We're living in a time of rapid money creation. The U.S. monetary base has grown by $1 trillion in the last six months. The story is the same worldwide. Japan's monetary base has grown by $100 billion since July 2008. Japanese money supply was up 6% year-on-year in April alone. No one knows what effect this new money will have on prices and economic growth. We can't rule out inflation. If American consumers become optimistic again and start spending more freely, newly-created money will be set loose on the streets. This would be inflationary. This threat is (rightfully) in the back of investors' minds around the world. This week the People's Bank of China warned that, "A policy mistake made by some major central bank may bring inflation risks to the whole world. As more and more economies are adopting unconventional monetary policies, such as quantitative easing, major currencies' devaluation risks may rise." I agree with the Bank. There's a chance we could see massive inflation. But as investors we have to play the odds. In poker this called "the rule of 60/40". You never know with 100% certainty what cards will be dealt. So you gauge the odds and act accordingly. You bet when the chances of being right are greater than the chances of being wrong. The more certain you are, the more you bet. If you know 90% that the next card will be in your favor (assuming you can count cards!), you might go all in. If you're 60% sure, you'll probably bet a smaller amount. The 60/40 at the moment favors deflation. Consumers (especially in the U.S.) have been too badly damaged. Consumer sentiment is at record-lows (despite having recovered slightly over the last few months). And with good reason. U.S. household wealth decreased by $11 trillion in 2008. That's a phenomenal loss of asset value, and now consumers must re-trench. As we discussed above, the public isn't borrowing. It will take a lot more than the current bounce in the stock market to get people "feeling happy" and spending money again the way they did over the past decade. A return to the "good old days" of debt creation is possible, but not likely. That said, the odds of deflation aren't good enough to go "all in". If we felt 95% sure that deflation was coming, we should all sell our homes, short the Dow and keep as much cash around as possible. But we're not 95% sure. Maybe 70% or 80%. That still leaves a considerable margin for error. We need to design investment strategies that prepare for deflation, but that won't get "hung out to dry" if inflation rears up. Winning By Not Losing What investments will do well during deflation? And not get wiped out if inflation does emerge? There's at least one: gold producers. This is counter-intuitive. We're conditioned to believe that stocks of all kinds will suffer during deflation. But let's take a closer look at what happens when assets deflate. Deflationary periods are bull markets for cash. Things like stocks and homes and commodities are all getting cheaper. People don't want to own these "falling knives". They sell assets and keep cash on hand so they can buy things back down the road, once prices have settled at lower levels. Gold is a form of cash. During deflation, some investors choose to hold their money in coins or bullion rather than in paper (or electronic) dollars. Especially if there is suspicion that the currency will lose value (which is certainly the case today with the U.S. dollar, justified or not). Demand for gold increases. Gold also benefits from "safe haven" buying during deflation. Deflationary periods tend to be unstable. As asset prices fall, businesses suffer. Unemployment rises and social tensions increase. These are time when people buy gold as a neutral and portable currency to prepare for the unknown. The net result is that gold prices stay relatively buoyant during deflation. Gold may not rise considerably, but it does maintain its value (more or less). We saw this last fall. When the financial kafuffle really broke in October, most assets plunged. Oil fell 80%. The Dow dropped 40%. Junk bonds fell 85%. How about gold? It dropped from $900 to near $700 per ounce. Only a 20% decline. And it recovered all of those losses (and more) by the end of 2008. By contrast, oil is still off 65% from its highs. The Dow is 25% below its September 2008 level. Even amid financial panic and widespread price deflation over the past year, gold has held its value. If deflation continues (or accelerates) expect more of the same from gold. The price should stay flat (plus/minus a hundred dollars or two). Events like the International Monetary Fund's planned sale of 400 tonnes of gold might cause a dip in the price (if they haven't arranged an off-market buyer, which is likely). And North Korea firing another missile over Japan might cause a spike in price. But these will be short-lived. There will be enough demand for gold that some investors will buy dips. And enough demand for cash (to pay off rising debts and margin calls) that some investors will sell the rallies. In the end it's a wash. The price stays level. Same Gold Price, Bigger Profits That makes gold a good store of value. Although not a particularly good investment for anyone looking to grow their capital. But companies that produce gold will likely be a profitable investment during deflation. The key is margins. During deflation, the gold price stays constant, so gold miners' revenues are steady. At the same time, most other commodities are falling in price. Things like oil, chemicals and labor all get cheaper. This means lower costs for miners as they pay less for diesel, sodium cyanide and mine workers. A steady sale price plus lower costs equals higher margins. This is a "stealth" improvement in business performance for the gold miners. Most investors expect gold stocks will soar to profitability when the gold price rises. But falling costs will put more earnings into miners' pockets, even if the gold price fails to rise above the current $900/oz. And earnings are ultimately what drives share price. The effects of deflation on gold producers are already showing up in the statistics. Notela Resource Advisors (www.notela.com) produces a custom index of costs for the U.S. gold mining sector. The index tracks prices for fuel, electricity, industrial chemicals and mine labor. The cost index peaked in Q3 2008, indicating that gold miners were paying a lot to produce an ounce of gold. Since then, the index has fallen 20% (as of Q1 2009) in just six months. In the same period, the average quarterly gold price has actually risen 4%. This represents a large improvement in profits for gold producers. The decline in the cost index is likely to continue. Mine labor accounts for 40% of the index, and labor costs are falling as mines around the world close down. Just this week U.S.-based North Shore Mining announced 280 layoffs at its Silver Bay iron ore mine in Minnesota. The Australian Mines and Metal Association estimates that 12,500 mining jobs have been lost across Australia in just the last three months. That means a big increase in the supply of available mine workers. Which will push down labor prices. This will take some time to work its way through the system as many mine workers are paid on longer-term contracts. But as contracts roll over during the coming months, there will be steady downward pressure on labor costs. This creates greater profits for producers. The chart below shows a ratio of the quarterly average gold price to Notela's gold mining cost index. A rising trend shows that the gold price is increasing faster than costs (or decreasing slower), leading to higher margins. During this past quarter, the ratio pushed above 2 for only the third time in the last 40 years. The other two "plus-2" quarters were Q1 and Q4 1980, when the gold price was rising quickly. The current strength in the ratio is notable because it's come without any significant appreciation in the gold price.  The "word on the street" tells the same story. Profit margins for U.S. gold miners were near 15-year highs in Q4 2008. Q1 financials released this week were also encouraging. Yamana Gold's cash cost of production fell from $383 per ounce in Q4 2008 to $379 this past quarter. Kinross Gold reported record margins of $478 per ounce. Kinross' cost of production was $419. The company says 2009 average production costs could be as low as $390. Goldcorp's cash costs fell from $323 to $288 for Q1. Of course, there will be ups and downs in costs over the coming quarters as things like grade control and operating conditions affect output. But on the whole, the industry appears to be trending toward greater profitability. This is the kind of thing investors notice, sooner or later. The Stealth Bull Market Interestingly, even as gold producers' profit margins are near record levels, share prices are suffering. True, the S&P/TSX Gold Index has recovered most of the losses it took last October. Yet the index is 20% below the record levels seen in late 2007 and early 2006. Profit margins now are as good or better than during either of those periods. Fundamentally, gold stocks should be trading higher than they are. The gold sector also looks underpriced on a P/E basis. The average P/E ratio for the S&P Gold Index has rebounded from 10 to 20 over the last few months. But 20 is still the lowest level seen in the last 15 years. Up until late 2007, P/E ratios for the gold mining sector had generally been above 30 since 1995. Reaching as high as 50. The current level is low on a historical basis. Especially at a time when companies are seeing record profits. Why is this happening? As I mentioned above, reduced costs are creating a stealth bull market for gold producers. Most investors aren't used to the idea of margins improving through declining costs. They expect that gold companies won't do well until the gold price rises considerably. Analysts fall into the same trap. As of April, analysts were forecasting a consensus 3.3% growth in earnings for the gold mining sector. This is fairly meager. In early 2008, analysts were predicting 54% growth in gold miners' earnings. In 2006, the forecast was 74% growth. Yet, as we saw above, the gold price/mining cost ratio is currently higher (producers are more profitable) than at either of those times. It will take time for analysts to catch on to falling costs and rising margins in the gold sector. Eventually they will. And where analysts and brokers go, the public usually follows. This will be the real "coming out party" for gold producers. To read the rest of this article, click on the hyperlink below: http://www.piercepoints.com/print_letter.php?newsletter=2009_05_08_Pierce_Points.html May 8, 2009 Copyright ©2009-2010 Resource Publishers Inc. Note: To subscribe to Pierce Points please click here: www.piercepoints.com Pierce Points
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