Financial Sense Newshour
The BIG Picture Transcription
July 1, 2006
- Got What We Wanted -- Now What?
- Humor – Fed Open Market Committee
- Emails and Q-Calls
- Shifting with the Tide
- Other Voices: Roger Conrad, Utility Forecaster
- Dividends for the Long-Run
- Investing in Juniors: Patience & Discipline
- More Emails and Q-Calls
Got What We Wanted -- Now What?
JOHN: Well, you’ve got to admit Jim that this week has been rather interesting. If we flash back over the last couple of weeks here on the program describing what we thought the Bush Administration was going to be doing between now and the elections, and it’s been happening with rather breathtaking speed in the same directions that we pointed. The next thing, we sort of got what we wanted from the Fed, but then of course you have to ask the question, what comes after this?
JIM: It was amazing they raised interest rates as widely expected for the 17th time, and by the way, this is probably the longest running rate cycle. And everybody’s saying what’s coming next. Well, let’s talk about first why this has been a long running rate cycle. Unlike the past when the economy was less leveraged, I’m going back to let’s say 1994 when they took the Federal Funds rate from 3% to 6%, and they did it all in one year. And like 94, we had a bit of a pullback in the markets, not a real good year for the market, I think the markets were up only 3 or 4%. And then of course, they pursued this same policy back in 1999 in the year 2000, except for the last rate hike the Fed put in 50 basis points and said, “hey, we’re done.”
And why they’ve gone so long this time is they recognize that since the last recession we’ve added as of the end of last year an additional $12.7 trillion of debt; derivatives are almost twice the size of what they were 5 or 6 years ago. There’s a lot of leveraged bets, you’ve got Wall Street firms like Goldman Sachs that have gone from $20 billion in debt to over $100 billion, so there’s a lot of leverage out there. So they do not have the same leeway to respond and as a result of that you had speculation going on in the housing market; speculation going on in various financial markets especially like emerging debt, junk bonds, etc. and it was because the Fed was behind the 8-ball. When you’re only going a ¼ point at a time, and the reason that they were doing that is we realized that there are a lot of leveraged bets out there, and if we did what we did in 1994 we would sink the ship, we would really be dealing with a major financial catastrophe here – I’m talking about à la 1929 through 1933. So they didn’t want to do that, so that’s why they took their time.
The problem is that they have taken the Federal Funds rate from 1%, which was a half century low, to over 5%. And once you start going over 5% and you have the discount rate at 6%, something breaks. Now, what we’ve seen in the month of May was a break in the stock market, and now you’re starting to see a break in the economy. And so, one reason this is taking so long is bear in mind the Fed had no other choice, there is just so much leverage in the derivatives market, so much leverage on consumer balance sheets, so much leverage on the government side. In other words, their freedom of action has been limited by this, but now it has been turning into this Chinese water torture; and remember Senator Sarbanes, the last time that Bernanke was up on Capitol Hill, and by the way he’ll be back on Capitol Hill in the next three weeks, and one of the comments coming from Sarbanes was “is this going to become habit forming, every single time you guys meet you’re raising rates.” So what the Fed had to do is put some kind of language in there that “hey, we’re still concerned about inflation, but we also recognize that the economy is slowing down,” so they had to put something in there that was soothing for the market – “we realize that the economy is starting to slow down now,” and that was what the market was looking for. [4:13]
JOHN: You should see the diversity of opinion on the talkie channels, especially the cable ones. You have some people saying that we should go full bore right over the edge of the cliff, and others are saying that we’re done, and clearly giving the public the impression that they don’t know what they’re talking about.
I think that the situation looks very good. It looks very strong, and we’re confident in the Fed’s ability to read the same numbers that we’re looking at.
We do have some emerging weakness as well as slightly higher inflation to be concerned about, so I see no reason to keep going on without some pause. However, if the market gets the idea that an increase is inevitable and if the rhetoric out of the Fed supports that they’ll get themselves in a box again and won’t have much choice when the time comes.
JIM: Well, the Fed is creating that uncertainty because they’re still saying, “well, number one it is still data dependent.” In other words, if we start getting inflation numbers for the month of June that look bad and inflation numbers in the month of July that look bad, then they’re probably going to go again in August with a ¼ point, and that will be the ¼ point too far. I think they’re probably going to 5 ½and then they’ll go on pause. But what they’re basically saying is, “look, we’re watching this data.” And remember, all of this data is lagging data, it’s lagging data on inflation, it’s lagging data on economic growth. As we’ve given the analogy on the show the Fed raises interest rates, let’s say you were a home buyer a year ago last Summer, you could have got a variable rate mortgage in the 4% range, now we’re talking about 5 ½. What happened if you put money down on a piece of property, it takes 9 to 12 months to build a home, and you were counting on a 4% or a 4 ½% mortgage rate at the time you were going to purchase that house and today you’ve got 30 year mortgages at 6.8%, and you have variable rate mortgages in the upper 5% range? It takes time, so you have a lot of these deals falling through; the amount of sales activity is rolling over, and so it takes time for these rate hikes to work their way through the economy. But if you have a home equity loan, if you have some variable rate tied to the T-bill rate, what’s going to happen as a result of this month’s rate hike your interest payments are going up next month.
And we have one trillion dollars worth of mortgages that are going to be reset this year at higher interest rates, and $1.7 trillion in mortgages that are going to be reset next year. And so that is definitely going to start eating in to consumer spending, but it takes time to play itself out through the economy and there’s all this pressure on the financial markets. You have different agendas: the bond investors would love to see a recession and an economic slowdown because that takes inflationary pressures off the economy, interest rates go down, and as a bond investor you do well. On the other hand, you’ve got the people who are invested in the equity market that say, “hey, you don’t want to kill the economy because that’s going to hurt corporate profits, it’s going to hurt economic growth and that’s going to translate to lower stock market prices.” So you have these conflicting agendas from whatever perspective you’re investing in, and that’s why you create a lot of this uncertainty and the Fed –I don’t care, they can talk about transparency all they want – always give itself wiggle room in all their statements. [7:40]
JOHN: You know, you must admit the language that the Fed used was generally intended to massage and they left the door open for more rate increases in the future without trying to stir any alarm, at the same time recognizing that the growth in the economy really is slowing.
JIM: Yes, I mean one of the lines that they changed going to the May minutes, they said:
The extent and timing of any additional firming that may be needed to address these inflation risks will depend on the evolution of the outlook for both inflation and economic growth as implied by incoming information.
Now here’s where they changed one of the lines.
That replaced the line from the May 10th statement that said that:
The committee judges that some further policy firming may yet be needed. Notice that the extent and timing of any additional firming that may be needed to address inflation risk will depend on the evolution of the outlook for both inflation and economic growth as implied by incoming information versus some further policy timing may yet be needed.
“Further policy firming may yet be needed” – it says we’re still raising. Now, they’re sort of saying we’re looking at this thing now. So they’re giving themselves some wiggle room, and that’s what the market wanted to see. They wanted to take some of this pressure off where it’s: “nope full speed ahead, we’re going to drive that car off the cliff” – that’s what people are really worried about. [9:08]
JOHN: Well, at least they’re not going to drive off at the moment.
JIM: That may come in August. There was another line, they said, “some inflation risk remains.” And I think what you saw happen and this was the Open Mouth Committee that you saw throughout the month of May, and parts of June, that scared the bloomers off everybody was inflationary expectations started to increase. The last thing you want as a Federal Reserve is for those inflationary expectations to take hold because then what you have is your money velocity starts to increase. People start buying and spending their cash faster because buy now because the price is going to go up. That was what they were trying to control with the Open Mouth Committee and they were successful. They brought some of those inflationary expectations down, and that’s why they were so active. It was like, you know, three or four of these Open Mouth Committees held almost every single week, and when you do that successively week after week after week, well, they got what they accomplished: they bought the inflationary expectations down; you saw a big sell off in emerging markets; you saw a big sell off –well, I wouldn’t say a big sell off in the US – but certainly overseas when you take a look at what happened in Europe, what happened in Asia, what happened in Turkey, and other spots where all the hot money was flowing. That’s what they did, they accomplished that objective: “we’re going to be tough.” And all of a sudden they changed psychological expectations from the market’s worried about inflation to worrying about economic growth, and that the Fed’s going to go too far. And it was interesting, I printed out all the stories from CNN Money, and also CBS Marketwatch over the last month, and just from the headlines you could see how the headlines changed every time the Open Mouth Committee was out on the circuit. So that’s exactly what they were trying to do. [11:08]
JOHN: Well, let’s do what we always do here on the show and that is bring it to a conclusion, and do some prognosticating here. Where do you think this is heading?
JIM: I think we’re heading for a recession. I think once they start going over 5%, you know we’ve got half the car hanging over the canyon right now, and probably another rate hike is what sends the car into a ditch. The Fed has a forecasting gauge that it uses to judge whether we were going in to a recession, and they use something called the yield curve. Now, there was a paper done by Marcelle Chauvet and Simon Potter, and if you google that Fed recession model you run into it, it was an abstract written in June of 2001. Whenever this model approaches the 30% probability range we have had a recession. And at the beginning of the year that probability was at 27%, now that probability stands the Fed models at 30%.
And it’s interesting if you go back let’s say over the last half a century whenever this probability whenever we had this inverted yield curve we have had a recession that follows: the recession of 59, the recession of 69, the recession of 74, the recession of 1979-1981, the recession of 1991. And of course, now we have an inverted yield curve, and the Fed’s recessionary model is now at 30% probability.
So by the time probably we get to the 4th quarter of this year, or the first part of next year, we’re going to be a recession and one of the ways I would judge that – this is just sort of an indicator that I use – I like to go to the shopping centers, the main consumer malls that we have here in San Diego and I just go up and down the malls kind of watching what people are doing. I have what I call my parking-lot indicator, and last weekend I could actually get in without having to use valet parking because there was plenty of space. Talking to the merchants, merchants are having to put stuff on sale unless it’s really marked down, they’re just not getting buyers; buyers are being more selective. So we’re already starting to see the front end as I’ve talked about, from car sales to boat sales to plane sales and retail sales are rolling over.
I have two brothers-in-law that are in the trucking business, and they’re sort of my lead indicator because that’s what these guys are doing: they’re kind of part of the Dow transports, they’re hauling merchandise. My one brother-in-law is staying with us now and he said in the last couple of months one of the things that’s changed with him is that, let’s say, he was picking up a load and San Diego and he was taking something to Boston, up until about two months ago he would drop his load off, and they’d say Ok, drive across town, pick up this load and you’ve got another load. Now, he’s waiting around for almost a day and day and a half, and his company’s talking about lowering some of their freight rates because now there’s beginning to be a lag time. And this has been consistent over the last two months. So if he’s taking something from Vegas to Seattle or Seattle to Vegas or wherever he’s taking the load he has to wait around for 24 hours and as much as 36 hours to find another load because he gets paid – in other words, if he’s taking a load to Boston, and there’s nothing waiting for him in Boston, and he gets to go home then he gets paid to go home. So the trucking company wants him to stay there until they can find something else that he can haul, that way the trucking company is not out of pocket. And I think that’s sort of a harbinger of things to come.
But I think they’ve already gone too far and the other irony of all this is the Fed is being held hostage on one of its own gauges – the CPI owner’s equivalent rent – which makes up almost 23% of the CPI gauge. So here you have a situation where you have rents going up, and housing prices going down, and I think they’re playing with fire here. [15:15]
JOHN: Well, basically, unless they find some way to start inflating something right how to give a goose to the economy, and we’re already talking about taking the interest rates up another ¼ point, we’re tipping over, we’re sliding over that cliff.
JIM: Yeah, the car is hanging over the edge of the cliff and inch by inch it is leaning over and looks like it’s going to go over. And there’s always the thing too John that Bernanke’s got the reputation as Helicopter Ben –although I call him B-52 Commander is more appropriate – but he’s got to prove his mettle and that’s what Fed governors do. Alan Greenspan did the same thing when he came on the Fed, he ratcheted up interest rates, and gave us the stock market crash of 87. And don’t forget, the Fed causes these boom and bust cycles. People forget, 1999 to 2000 they did this. What did they give us? They gave us a bear market in stocks; they also gave us a recession.
However, I think they don’t want to go there this time, so look for them to start inflating something, because they had to drive interest rates from 5 ½% all the way down to 1% to turn this thing around. And when they turned this thing around they really didn’t create manufacturing jobs in the economy, they created another asset bubble in real estate, which is where most of the jobs were created. So the Fed itself is an inflation bubble creating institution, that’s what it does, it creates inflation, and then in order to take some of the heat off inflation it creates recessions. And so the problem is if they take us into a recession this time and it gets bad, God knows how much money they’re going to have to print. If they don’t watch it this time they could take us into an inflationary depression, and they don’t want to go there.
Humor – Fed Open Market Committee
JIM:The Fed met this week and decided to raise interest rates one more time. There’s still discontent about the lack of transparency both in government and in the Fed’s Open Market meetings. To deal with that situation we actually managed an FSN exclusive by placing hidden microphones in the meeting room. Here’s what we picked up:
Ben Bernanke: Alright, alright, order everybody, meeting for the Open Market Committee of this quarter will please come to order, you’re taking minutes over hear Madame, thank you very much. The first item of business as you all know we’ve been getting some flak about not having transparency in these meetings. We’re going to take this little token photo here to release to the press that should take care of the transparency.
Fed Governor: Hey, Ben, ain’t that a little bit risky though?
Ben: Nah, we don’t think so. Ok, everybody, smile and say, “dollars."
Everybody in unison: dollars.
Ben: I heard that, that wasn’t funny.
Ben: Now on to the business of raising interest rates. Madame Pecunia, how are you doing?
Madame Pecunia: I am looking deep-deeply into the M3 money supply.
Ben: [irate whisper] We don’t talk about that anymore, it doesn’t exist.
Madame Pecunia: But I can still see the M3 aura on the economy.
Ben: Look, Madame Pecunia, just tell us. Should we raise the interest rates or lower them?
Madame Pecunia: I see interest rates going up, and I see interest rates going down.
Ben: Oh, good, that tells us a lot. So, which one is it?
Madame Pecunia: What!? Do you think I’m a psychic?
Ben: Well, keep trying.
Michael, how are you doing?
Michael: Aww, 2 snakes and a six.
Ben: why don’t you just flip a coin?
Michael: They don’t have coins anymore.
Ben: Why not?
Michael: The nail’s worth more than the coins now, besides it’s only for scrap.
Ben: Great. Does anybody else know about this?
Ben: Well, keep it that way.
Lookeverybody, I told Congress that we’re data dependent and god darn it we’re going to come up with some data.
Baby Boomer: Excuse me,
Security: How did you get in here?
Boomer: I’m a baby boomer and I was wondering if you guys could arrange it so we could stop inflating the dollar so we could retire with our Social Security and pensions at full value, and not have our golden years wrecked by your over inflated dollars.
Fed Committee: [hysterical laughter]
Fed Governor: Hey, there’s a microphone at the bottom of my coffee cup.
Second Fed Governor: Yeah, one of mine too. Security.
Ben: Look guys, we’ve got to find out what’s going on here. Why don’t we just call a ¼ point up. You know, it worked last time and it’ll work this time.
JIM: Well, it seems our microphone has gone dead, but at least you have an idea what goes on in those FOMC meetings.[19:48]
Emails and Q-Calls
JOHN: Time to go to the Q-Line now. You’re listening to the Financial Sense Newshour at www.financialsense.com. Don’t forget the new program is posted every Saturday morning at 0700 hours Greenwich Time, or Universal Coordinated Time. That work’s out to 3AM Eastern Daylight Time, and you’ll find all of the files posted there by then. And Jim, if we don’t post them by that time people are usually bashing down our doors and sending us nasty-grams from all over the world. So, you’re either making somebody’s breakfast in Europe or somebody’s dinner in Australia, it depends on where they happen to be listening. Alright, don’t forget our Q-Line is 1-800 794-6480, it is toll-free from the US and Canada. You can reach it from the rest of the world simply by dropping the ‘1’but you have to pay for the phone call. It’s only toll-free from the US and Canada. Remember to keep your calls brief, just give your name and where you are from, and your question or comment.
This is Bob, in Sacramento. I just want to thank you on your articles on inflation, apparently like counterfeiters the Federal Reserve is a thief. I was shocked to learn that the money supply has been increased over 10 times in the last 30 years. That’s the theft of about $10 trillion in today’s dollars. I think this is outrageous, our economic system depends on stealing from others but I think this is the Fed’s Achilles’ heel. Money and inflation have been redefined, not theft. I believe they could easily be shown to be thieves in a courtroom. The question I have for you is do you think a class-action lawsuit would have any chance of succeeding? Thank you for you show. [21:33]
JIM: Well, unfortunately no, I don’t think that would go anywhere because they’re an organization given certain guidelines by government and they were created by government. Although I thought the creation of the Federal Reserve was one of the downtrends of this country in the sense that we were now allowed to inflate our currency. Central banks are central planners, and their chief goal is debasing the currency because they’re always printing money, and the effects of that are what you and I are seeing. This expanded the money supply to $10 trillion over the last 30 years, it’s the main reason I think today it takes two individuals to support a family – both Mom and Dad have to work, and at the rate they’re going maybe Mom, Dad and the kids and maybe the dog.
However, I do think that if they blow it this next time around, in other words, if they throw this economy into a recession, I think they’re going to come under increasing pressure from Congress, because basically Bernanke just doesn’t have the reputation of Alan Greenspan. Greenspan had a great reputation but he was probably the greatest inflator that we’ve ever seen at the Fed. But no, in answer to your question, I doubt if a class action lawsuit would ever work. But you’re absolutely right, by printing as much money, and inflating as much as they do they’re really stealing from the people, and we’ve always argued here on the program that inflation is simply another form of taxation. [22:57]
Hi Jim and John, this is Joe from Connecticut, great show. I have a question with Jim talking about the large cap rally, where does the Index 500 Funds really fall into that, I mean that’s obviously a large cap weighted index, but will that do well or not in the coming Fall?
The S&P is considered a large cap index but you have a lot of smaller and mid-cap companies mixed up with 500. When I’m talking about large cap growth listen to the next segment, I’m more favorable to the stocks that represent the Dow, or if you want to take something similar take the top 30 stocks in the S&P by market weight. That’s where the shift that we see taking place is occurring and that’s what I’m referring to. I’m referring more to the large cap stocks – the Dow – or if you’re looking at the S&P 500 I would be looking at the top 30 to maybe 50 large cap stocks. So you’ll find some similarities for example, the number one large cap stock in the S&P is Exxon-Mobil, it’s also one of the stocks of the Dow, along with General Electric, Citigroup, Microsoft, Procter & Gamble, Johnson & Johnson. So you know you’ll find some similarities but it’s mainly in the large cap segment. And something that is bearing out as we speak because if you take a look at performance for the second quarter year to date, the Dow was up 4.04%, the S&P 500 up 1 ¾ and the NASDAQ down 1 ½%. So you’re already seeing this transition take place as we move to larger cap stocks. [24:37]
JOHN: John’s in Thomas borough, Illinois. He emails this question here:
I’m interested in investing in natural gas trusts because of the high dividend yields, and the fact that natural gas has fallen substantially off its high. Could you please explain some of the pros and cons in investing in these vehicles, and is there a good resource to research the different trusts? I’ve been listening to the show since 2000 and definitely an addict.
JIM: Oh boy, some of the cons about these is the price of these trusts –because of the dividends they pay out – are very closely related to the commodity itself. So if the price of natural gas goes from $15 down to $6, you’re probably going to see a reduction of dividends. So that’s one of the things you have to be careful of just as you would in oil. Like right now the oil and gas trusts have done much better because obviously the dividends have held up – we’re talking about $73 oil. So that’s one caveat.
Another thing you need to be aware of is can the trust replace its reserves? because remember what they’re basically doing is they’re producing oil or in the case of natural gas then they’re turning around, selling it in the marketplace, covering their expenses, and what’s left over they pay to you as an investor. So you want to make sure they have some capability of increasing their reserves or replacing their reserves otherwise you have a depleting asset. So that’s the other thing you want to look at.
And a great place to look for ideas on that, you can go to our energy page on our website and take a look at McDep.com, Kurt Wulff is a great oil analyst, and he will often talk about the royalty trusts and his favorites. He has a subscription service and he also has stuff that’s available on this website that are free. [26:19]
Shifting with the Tide
JOHN: You know, Jim, it’s important to be able to read the times in which one exists and you hear people say are you a bull are you a bear, as if this was almost a religious philosophy you’re going to adhere to. And in reality, everything goes in cycles. There’s an economic cycle, there’s a market cycle, commodity cycles and the most important thing is not to become a convinced or convicted bear or bull, but to understand what’s happening and then make appropriate moves. This isn’t a long term commitment, “I’m going to be bullish regardless of what the indicators say.”
JIM: It’s true, because one of the things that I think surprises people when I wrote The Perfect Financial Storm in the Summer of 2000 is we got a perfect financial storm. I said there were 3 things: currency; the economy; and the financial markets. Well, what did we see from 2000 to 2002. Number one, on the economy we had a recession; number 2 the dollar lost 30% of its value; and if you were in the stock market the S&P lost almost 45% of its value along with the Dow and the NASDAQ lost 75%. And like weather, John, if you’re looking at the hurricane season these things come in waves. You can get one perfect storm or you get one hurricane; sometimes, like last year, hurricane Katrina was followed by Rita back to back within a week; other times you get a long separation period between the next storm. But these things are periodic, I mean it’s not just something that just happens once. And I think a lot of people get caught in this mindset and they go into their bear bunker. If there’s a bear market in one asset there’s usually a bull market in another asset. And it was amazing because we were bullish on natural resources: going into energy and the year 2000, going into gold in 2001 when nobody was talking about it – I was bullish about that. I wasn’t bullish on particular stocks, you know, the kind of stocks I’m going to be talking about in this segment now, but these things go in cycles. And I think that’s where people get themselves caught up in a trap. [28:20]
JOHN: Let’s just follow this thought down the trail here. You made a number of calls this year. You expected the Dow’s to hit new highs. I think you made a comment last week that Dow stocks are undervalued which caused a flurry in the chatter rooms out there, and tech stocks you were talking about at the beginning of the year being very bullish on that. And so there’s a lot of controversy over that, but if you look at the record so far we’re up double digits on that whole thing.
JIM: Well, you know, at the beginning of the year I said looking at where we were going, and some of the trends that we were seeing, in other words, with the economy slowing down with Fed rate hikes, and coming to the mature side of the business cycle –I’m a big believer in the Austrian explanation of the business cycle – usually when you come to the end of a business cycle there’s a shift, a rotation that you see take place in the market. And I made a prediction in the first half of the year that we would see a new record on the Dow this year. And up until about May 16th we got within 75 points of achieving that goal. I’m going to adhere to that goal, I still think we will see that this year. Now, what does that imply, does that imply that I think that the whole market is undervalued? No, I said a select group of stocks are undervalued. There’s a big difference there. And certainly in terms of what we’re seeing in the market right now – the Dow Jones Industrial Average is up 4%, the S&P 500 is up 1 ¾, the NASDAQ’s down 1 ½%.
Sometimes there are trading opportunities. I mean we have 4 core things that we invest in, precious metals and some base metals along with that especially strategic base metals, we invest in energy, water, and food. That’s sort of our 4 core areas. But you also have room in the portfolio for what I call trading opportunities, or cycle opportunities. If we’re heading into an economic slowdown that means there’s going to be a shift, and I think you’re seeing that shift take place in the last six weeks with the Fed Open Mouth Committee scaring the bloomers off everybody. All of a sudden, risk is being repriced in the marketplace, from credit spreads to emerging market debt, to emerging markets themselves, to junk bonds. All of a sudden, people are saying, “holy cow, we could go into a recession.” If we go into a recession we could see debt default on junk bonds. We can see a slowdown in stocks because basically over the last six or seven years outside of natural resources it’s been small cap and mid cap stocks that have outperformed the big, large cap growth stocks. Well, as we know in any kind of market, nothing goes on forever. We saw gold go up to $728, that didn’t stay up there forever, we saw a pull back and correction. And I think what you’re going to see now is gold consolidate, and the natural resource area consolidate. [31:22]
JOHN: Before you go on Jim, it’s really important I think that you explain the business cycle to people so they’ve got a picture before you go into the details.
JIM: The business cycle is created by expansion and contraction of the money supply. And it’s generated by the Fed. Let’s take for example, we were in a recession in 2001, what did the Fed do? Greenspan began to dramatically expand interest rates. He took interest rates down from the 5 ½ to 6% level, all the way down to 1%. And at the same time, he started flooding the banking system with money, so banks had a lot of capital to loan. What happened? Interest rates come down, people refinance their house, that brings down their payments, that increases their cash flow. People were taking equity out of their home. That gave them an additional spending power. The government cut taxes, 2 or 3 different occasions that put more money in the economy. The economy gradually began to take off, and we went from a recession to a recovery. And then Greenspan, once he got interest rates down to 1%, he kept them there for a while until the Fed was sure the economy was recovering, we were adding jobs, the economy was expanding. And then as a result of that as you bring more demand into the economy eventually pressures are put with all of this money and credit creation that creates more demand, you start seeing rising prices, then the Fed begins to raise interest rates, technically pull money out of the economy, they’re really not because they’re still expanding the money supply but they’re make it more expensive to borrow and eventually you start seeing a contraction. Eventually, typically, 90% of the time the Fed goes too far and you have a recession.
Well, in each part of that cycle ,the early expansion phase coming out of a recession, the middle expansion phase and then finally what we call the late expansion phase. Those are the 3 parts of the recovery and then there’s two parts to the recession: early contraction and late contraction.
And there are certain stocks or segments of the market that do better during each one of those phases. Like for example, right now we’re in the late expansion phase of this economic recovery working our way I believe to a recession. And what you start to see is people start reassessing risk, they’re starting to say if the economy slow down which companies are going to do better in an economic slowdown. In other words, if consumers are going to start slowing down in their spending patterns I don’t want to be investing in companies who are going to be directly impacted by that. For example, the automobile companies are consumer discretionary type companies. So what people look at is the things that are doing well in the late expansionary phase are consumer staples – people that sell toilet paper, toothpaste, detergent, diaper and things that people need to have – consumer product companies that we consume on a daily basis. Food companies, because their economic model is a lot more stable than somebody that is selling some kind of discretionary consumer item like cars, big screen TVs, electronics, luxury type goods – those things start to suffer.
Then, eventually you get a recession. And in a recession people start going towards safety, you see people shift from maybe out of stocks, you see them shift to bonds or you see them shift to utilities. In the latter part of a recession the financial stocks and consumer cyclicals start to do well because at this point the Fed is cutting interest rates and people are anticipating an economic recovery, and they start investing in those areas that really come out strongly in an economic recovery. So, I hope I explained it on that point. [35:27]
JOHN: Sounds good. Jim, let’s get back to the subject then of the controversy from last week. We were discussing the issue of undervalued stocks and you didn’t say everything is undervalued, you were picking specific stocks that were undervalued but I guess some of the chatter went in the other direction.
JIM:Getting back to the business cycle what we’ve seen since the tech bubble burst in 2000, we’ve seen value stocks over growth stocks – in other words, the type of growth stocks the Walmart’s, the GEs, the Microsofts, those type of companies that did very well in the later stages of the 90s bull market, they began to grossly underperform. People went more towards value stocks, they went more towards small cap stocks. In fact, value stocks have outperformed growth stocks by almost 52% since this Summer of 2000. But what is happening now is this area of the market the large cap growth stocks have become extremely oversold, and there’s this feeling that this is a permanent condition. In other words, whatever has existed for a period of time people think that’s what’s going to exist going forward.
However, the one thing we’re starting to see now are conditions are pointing us especially towards the late cycle of an expansion or slowdown that you’re starting to see, and you’re seeing it now reflected in the average, a flight to quality in the financial markets. You’re also seeing rising market volatility; and also a revival in the non-cyclical sector of their performance relative to other areas of the stock market. Once again, the disparity in terms of the Dow, the S&P and the NASDAQ.
The other thing that we’re starting to see right now is that as you get towards the end of this cycle as people get more defensive, in other words, a lot of the goofy stuff people were getting out of that, getting out of high risk areas, and risk is being repriced right now. So what you’re seeing when you saw the major pullback from the emerging markets is people are shedding risk in all asset classes around the globe – that you particularly saw in early May. And this has really reflected heightened concerns over monetary overkill, in other words, we’re going from worries about inflation to the Fed killing the economy. Also this global liquidity drain [because] central banks are raising interest rates. Conditions needed to reverse a loss of risk tolerance are not around right now. In other words, the Fed isn’t slashing interest rates so we’re going to begin another inflationary cycle, that’s further down the road as we start to see the economy really start to move in a downward direction. As we pointed out in the first segment, the Fed is already heading into the overshoot territory, boosting the odds of a policy mistake. And because of that risk tolerance is undergoing a sustained downshift.
And meanwhile volatility is starting to increase, the corporate sector financing gap is turning up, in other words, corporations are doing mega-mergers now, so they’re back tapping the bond market; and the risk is escalating that there’s going to be a monetary policy mistake. What that means is that you’re going to see this flight out of risky assets: as I pointed out, junk bonds, emerging markets. And if there’s going to be a shift, and I believe that shift is taking place back into the growth sector. It’s amazing when you take a look at that because if you look at the growth stocks, here’s something that’s very key, that is not being recognized. The large cap growth stocks have a 77% exposure to the global economy. So, in other words, not just what is happening in the United States, but also what is happening globally –and China is growing at 10% a year – versus only 23% exposure to the domestic market. Also, they tend to perform much better in the latter stages of a business cycle versus the early stages of a business cycle. And they tend to be more defensive. So what you’re seeing now is this dramatic shift that is being reflected in what we’ve seen in the outperformance in the Dow. [39:45]
JOHN: We did hear all this talk about people predicting a crash, and things of that nature, but you were really saying there was a select group of growth stocks that were undervalued. This wasn’t the whole thing.
JIM: Yes, and I think that’s something that was clearly misunderstood because what we did is we took a look at the Dow stocks because we think we’re in the latter stages of the business cycle, and obviously when you do that there’s going to be sector rotation. The kind of companies that do well in the early stages or mid stages of a business cycle aren’t the same group of companies that do well in the latter stages of the business cycle or the early phase of an economic contraction. So what we did is we took a look at the dividend discount model. For a lot of the technical people and the analysts out there we took the Bloomberg dividend discount model where it’s a 3 stage business model which most analysts are familiar with; and then we also did the Ford database which is probably ranked in the top 3 independent databases in the world – we took their dividend discount model; we also took a look at the Bank Credit Analyst’s discount model in terms of valuation of the market. And what we did is we looked at what these intrinsic valuations were. We didn’t look at just one method, we looked at several approaches and what we found from the Ford model to the Bloomberg model to the BCA model was the same conclusions: that these large cap growth stocks have been ignored by the market and were selling at discounts from their intrinsic value. Now intrinsic value discounts are obviously a subjective type of valuation but you know it gives you some semblance in terms of are the stocks overvalued or undervalued.
The other thing that we looked at, not only in terms of intrinsic value we took a look at earnings over a five year period. And where we took a look at where those earnings were, we took a look at average earnings; we also then looked at for example PE ratios, the 5 year average low, the 5 year average high and then discounts from those. And that’s where we came to these conclusions. Did I say every Dow stock is undervalued? No. But I believe the large cap growth stocks that have been largely ignored in the market and we talked about them: the Walmarts, the General Electrics, the Johnson & Johnsons, and some of the consumer product companies, the Coca-Colas, the Budweisers, the drug stocks. These companies were being undervalued in the market; they were selling at some of the lowest PE ratios that we’ve seen. The same thing that was occurring in the energy sector, they were pricing these energy stocks for $40 oil, and we’re still at $73. I think we’re going to have blow out earnings in the second quarter because this is the largest quarterly period in the market’s history that you’ve seen oil prices consistently spending the entire quarter above $70 a barrel. So if you’re an oil company and you’re selling oil at over $70 a barrel, that’s a lot of money. [42:54]
JOHN: To reiterate here, you’re not saying the entire market is cheap, you’re saying that select stocks are undervalued, and because of the business cycle we’re going to see a roll over, we’re going to see a rotation, which is to be expected in this. And so far what we’re picking in that are up double digits. So I guess you’re doing something right.
JIM: Yes, I mean remember just like the seasons of nature you get these cycles of Summer, Winter, there are seasons in the market that are associated with seasons in the economy, and the business cycle, and when the business cycle changes the seasons in the market change with that business cycle. [43:34]
Other Voices: Roger Conrad, Utility Forecaster
JIM: Well, last week Anadarko Petroleum stunned the market with a $21 billion takeover of Kerr-McGee and Western Gas Resources. Is this the beginning of a new trend? Joining me for Other Voices this week is Roger Conrad, he’s editor of the Utility Forecaster and Canadian Edge.
Roger, why don’t we talk about the Anadarko purchase. Some people are saying this is signaling the end of a bull market when companies start paying up for reserves, or is this telling us something totally different?
ROGER CONRAD: Well, my view is it’s telling us something totally different. I don’t think this type of energy bull market – you know, a real entrenched one, a multi-year one – ends unless you see a lot more conservation, switch to alternatives, some major new discoveries of conventional reserves – and that doesn’t include oil sands and non-conventional reserves, which are only economic when prices are high – and then probably some sort of big demand crunch and slowdown. Those are the four things that really brought down the energy bull market of the 70s, and I think they’re going to be needed before this one comes to an end.
You know, we heard a lot of the same kind of talk about the end of the bull market and so forth when Conoco-Phillips purchased Burlington Resources last year, and that was a very big deal, people were looking at the price paid, and saying, “well, they way overpaid for it,” but you know Conoco-Phillips was looking ahead to the fact that there’s not a whole lot of fresh new reserves out there ready to be exploited. So, they made that move and suffered for it in their share price. In fact, right now, it’s only trading at about 8 or 9 times the very lowest Wall Street estimate out there.
So, a lot of pessimism on these stocks – in particular on the companies that do make acquisitions, and I’m sure Anadarko will fall into that as well, but there again you have to sort of think about who might have a little more knowledge about the industry, what’s out there, the supply and demand situation. Is it people on Wall Street who are thinking that they paid too much, sure it isn’t these guys in the sector themselves that are maybe locking down reserves at a time when some are not aggressive enough to take them? [45:54]
JIM: There was an article, I think it was about 2 or 3 weeks ago on the front cover of BusinessWeek – Why You Should Be Worried About Big Oil – and Roger they talked about big oil companies today only represent about 15 or 16% of world oil output versus 30 years ago that was probably double or triple that. They also said that if you take a look at where the existing oil reserves in the world 85% of the world’s oil reserves are unavailable to companies. That leaves a very small margin for all of these companies to go after and replace the reserves that they’re producing each year. So, maybe this is what this message is also telling us.
ROGER: Yes, I think that’s also true. Another sector that I look at are the Canadian royalty and income trusts, and they’re basically oil and gas producers producing from wells that have been developed for some time, so they’re somewhat depleted, and by their tax structure they’re able to exploit them very effectively. What we’ve seen with these trusts is a lot of acquisitions and of course their reserves are depleting all the time but they’re making a lot of acquisitions and trying to grow their business which will allow them to produce more. So companies bulk up for several reasons I think mainly to – but as you point out – replacing reserves but also to grow them in an environment again where everybody knows that there really hasn’t been a major new conventional reserves discovery since the North Sea which was over 30 years ago.
And with so much of the production now being replaced by oil sands which is again much more expensive, and is only economic when prices are high. So, yes, I think we’re going to see more of this type of activity. I think the companies that eventually make the acquisitions will be rewarded nice multiples. Chevron, which I guess was one of the first in the trend when they purchased Unocal last year, and the stock was definitely punished for it, and it has been trading at a discount to other Big Oil. I think it’s finally starting to get a little recognition at least in the market that what they did has helped them grow their reserves, and grow their output, which again, with such a shrinking part of the pie going to Big Oils and US oil producers, and that’s a pretty strong seat for a large company to be able to increase reserves and increase production. [48:17]
JIM: You know, it almost seems right now Roger that either we’ve got this whole situation on oil wrong or the market is really mispricing oil, because one thing that you didn’t see despite these robust earnings, despite the price of oil going from $20 a barrel to almost $74 a barrel on the day we’re speaking, was these PE multiples expansions like we saw for example in the bull market of the 70s. In fact, many of these stocks, as you pointed out, whether it’s Conoco-Phillips or Chevron, or even Exxon-Mobil are selling at some of the lowest PE ratios that we’ve seen.
ROGER: Yeah, they’re clearly pricing in a drop of oil to the $40 range, and I think people have become concerned in a macro sense that the Federal Reserve will go too far raising interest rates trying to slow inflation in the economy. Admittedly, they do have a tough job because this is oil-push inflation rather than labor-push, so their control is certainly much less, but people are concerned that they will go too far, crash everything and oil and gas prices come down. So that’s where you’re pricing in from an investor point of view if you’ve been holding these things for a while that’s kind of frustrating because again you’re looking at a lot of point A to point B to point C to point D to get there. I certainly think there’s a lot more upside but on the other hand your downside risk is also much, much lower again because people are pricing in these very negative scenarios and very, very negative earnings projections, and they’re even trading off very low multiples even to those projections, so it’s a very low risk environment I think for those types of companies. And again, if oil continues to hold up and eventually psychology will change and these things can just blast off. I don’t think we’ve seen anything close to what we’re going to see here again.
I think we have to see use of more conservation and alternatives. Again, the same things that brought down the bull market of the 70s, we haven’t seen any of it. In fact, Ford today announced that they cancelled their hybrid vehicle program for lack of interest basically. So we’re using lots of oil here, using lots more around the world and even if there is some sort of economic collapse brought on by an aggressive central bank, the underlying supply-demand situation here is going to remain in effect. Again, until we see some of these things that permanently destroy demand, or permanently increase supply. [50:53]
JIM: Roger, I want to move on to another sector which is the utility sector, and I wonder if you might just share with our listeners the passage last year – removal of a 1935 Great Depression bill that prevented utilities from organizing or merging.
ROGER: Yes, this was called The Public Utility Holding Company Act, and it was passed in 1935 in large part because Franklin Roosevelt, the President at the time, wanted to break up the empire that JP Morgan had accumulated by basically buying out all the holding companies around the country. So he had established basically what was an AT&T of power around the country, again to consolidate that, and this bill helped to break that up. Morgan of course was a banker, so that of course was one of the provisions of the TPUHCA was to forbade companies outside the utility business from owning other utilities. So, that’s been bent a little bit here with some of the purchases made by Warren Buffet and Berkshire Hathaway in the last few years.
But I think going forward you’re going to start seeing more deals outside the utility business, there’s some management buyouts being talked about – one actually underway in the pipeline business which is outside the TPUHCA scope. I think [there will be] a lot more creative types of consolidation, and it sort of hasn’t picked up speed at this point. Yet for the 2 years ended last July it was an historic run in the utilities so valuations had gotten pretty high. I think now you know we’ve had earnings growth, and some stagnation in the prices so prices are coming down. And again, I think we’ll see more of that type of activity going forward but this is a fairly bullish thing for at least utility shareholders going forward. Utility bondholders I think have to be a little careful because some of the deals are not going to be productive for credit quality, particularly if they’re management buyouts; and I think we will see more merger activity going forward. [52:52]
JIM: Well, Roger, you are the editor of two newsletters, given what you see in the marketplace today with the price of energy and what’s going on in the utility industry how would you play this?
ROGER: Well, I think you first of all want to play quality companies, and what I mean by that are companies that are growing businesses, healthy businesses and so I look at pretty much everything from the bottom up and that’s what I want to see with companies. I also think big dividends are also a big plus, that’s the reason I like so many of the trusts, and one of the reasons why I’ve liked the utilities for a very long time, and also many of the energy companies. I think that’s really the way to go about it, you want companies that are growing their earnings, growing their businesses and have healthy balance sheets and that’s how you’re going to ride out the rockiness that maybe coming down the pike. I mean yesterday, you had a huge up-day in the market, but you had more new lows than you had new highs which was fairly astounding. And there’s certainly been a lot of chop. I think another up-day in certainly many of those stocks today –many of the utilities – but again lots of ups and downs. So the way you ride out these things again is with quality stocks and preferably that are growing their businesses and growing their distributions. [54:05]
JIM: What about on the energy sector would you be buying oil stocks in this kind of market?
ROGER: I think the big oil stocks have very, very low valuations. We mentioned a minute ago they are pricing in much lower energy prices so I think your risk is fairly low there. I think you’ve also got some real opportunities coming up in the gas area as well. So, look at gas prices that have come off so heavily, they came pretty much off because of the weather, because we had a very mild Winter. Well, weather has a way of reversing itself with a vengeance and we get some storms, we may get some very hot temperatures which are happening right now in many parts of the country and I think it doesn’t take much imagination to see prices shooting back up again and gas companies really benefiting because they really have had kind of a bloodbath in a lot of these including very, very healthy companies that were former darlings and are very strong takeover targets in the wake of the Anadarko move: companies like EOG resources for example, or Chesapeake Energy – both of which I wrote up in a recent Utility Forecaster. So, again, I certainly think that’s a sector of the market that looks very good from a valuation standpoint. I think you have to be ready for some chop and volatility like with everything else, but that’s a good sector for buying and holding in this type of market. If there is anything you can buy and hold I think that’s a trend that looks like it will remain in place for a while. [55:29]
JIM: You know, the other thing too on some of these energy stocks, whether you’re looking at Canadian oil trusts, or even some of the big blue chips they pay some attractive dividends, so at least you’re getting some kind of return while you wait for the valuation to play out. Roger, as we close, why don’t you tell people about the two newsletters that you’re editor of and your website.
ROGER: Ok, well, the Utility Forecaster covers the waterfront in terms of energy, communications and water. It’s been around since 1989 and the website for that is www.utilityforecaster.com, it’s also in print so you can get a copy of that if you call (800) 832-2330. And the Canadian Edge is an all-electronic product and it comes out once a month also. It has a quote service and a number of other features that are attached to it. And the website there is www.CanadianEdge.com. You know, if you’re interested in receiving something that I write that’s complimentary to sort of get an idea of what sort of ideas I have and how I write and so forth I have a publication that comes out every week, it’s called utilityandincome.com, and it’s just basically a weekly e-zine that people can sign up for, and again that’s just utilityandincome.com. that would be one if you want to get an idea of the kind of things we look at. [56:57]
JIM: You also write editorials for our Financial Sense website, so if you want to see what Roger said in the past he’s up on our website. Well, Roger, as always, I want to thank you for joining us here on the program. Please come back again and talk to us.
ROGER: Thank you very much for having me.
Dividends for the Long-Run
JOHN: Well, Jim, to go back to one of those analogies that you love, you’re a sailor and here we are, the market is in the doldrums except for a couple of those blue chip stocks which seem to be self-propelled. Other than that ain’t nobody got no wind. How’s that? And I know you’ve always talked about the advantages of what is called dividend investing, and this is particularly appropriate for people who are retired and need to have a steady stream of income. If the stocks aren’t moving and you’re not making anything on the differential of upping and downing there’s always a good old investment for good old dividends.
JIM: One of the nice things about the stock market is if you look at stock market returns over longer periods of time, over decades, even over a century one of the keys to compounding wealth is compounding interest and dividends. If you look at stock market returns excluding dividends, let’s say you own stocks but you spent the dividends, so the only return you would have got is just the growth appreciation from the stock versus if you owned a stock that paid a dividend and you reinvested the dividends, the enormous difference in terms of compounding wealth over a period of time is absolutely astounding.
And we’ve had one of the key things that I think dividend investing is going to become very important is your Dad, John, and my Dad, came from that generation where one spouse worked and supported the family because we basically didn’t have an inflationary policy as we have in this country today when we went off the Bretton Woods system. So, you know, when I grew up we had 10 kids in the family and my Dad supported the family just by one person working. And people from that generation after World War II when the American economy was booming, when we had a very strong manufacturing base, Mom or Dad, or Dad went to work for a company, spent 30 years, had a defined benefits pension plan, retired after 30 years with the company, got the pension, the gold watch, and maybe a Timex watch and had a fairly comfortable retirement, had a pension, Social Security. You get to the reshaping of the American economy that took place especially after we went off the gold standard and we began to inflate our way you saw inflation go up, it took two couples to support a family, and the downsizing of America’s manufacturing base – moving from a manufacturing economy to a service economy and now to a financial economy – it’s rare outside the military or government, at least in the private sector, you just don’t see people working for a company for 30 years and getting a defined benefit pension plan. You know, most boomers today have had 3 or 4 career moves, they’ve had 4 or 5 job changes by the time they get to retirement so the only thing that they’ve got is defined benefits pension plans that have been basically done away with by major corporations. So what you have towards retirement is whatever you’ve saved in your 401K plan. And now the first batch of boomers hit retirement in 2008, and they’re going to have a need for income and they’re no longer in the envious position that let’s say our parents were where they had these defined benefit pension plans and Social Security and a lower inflation rate. We’re back in an era of inflation. [1:00:53]
JOHN: Jim, can we just do a 1-2-3 type bullet itemization here of the advantages of dividend investing, and then take that over into looking at the factors that we should be looking for if we’re going to do that.
JIM: Well, number one, I think you’ll find that dividend paying stocks tend to be less volatile, especially if you’re getting a good dividend relative to the market. Let’s face it, if you own a stock that pays no dividend you’re getting no compensation, and so they tend to be more volatile in the market, people tend to trade out of them when they sense that growth is slowing down, or when there’s trouble in the market. On the other hand, you have a nice blue chip stock with a nice dividend paying, you tend to keep those, they tend to hold up much better in a market downturn. And the best example I can give you is the out performance of the Dow stocks – all of them paying dividends today, versus let’s say some of the other major indexes. I think also when planning for retirement if you have a pension plan or a 401K plan, IRA or something, the nice thing about dividends is you can compound your wealth, you can reinvest those dividends, so you can compound your returns and earn a higher return over a period of time which adds up to more wealth when you get ready to retire.
I think another advantage is dividends are real. Unlike a company’s earnings and we can all remember how dividends or the earnings scandals that we saw in the early century, you know, the Enrons and the WorldComs, unlike a company’s earnings, dividends can’t be manipulated. You either have the cash in the bank to pay them, you either earn the money to earn that cash, or you can’t pay the dividends so they’re less subject to being manipulated as earnings are. And then I think probably from an individual point of view outside of pension plans, dividends are taxed twice. They’re taxed once when they’re earned at the corporate level then they’re taxed again when they’re distributed to you at the individual level being a shareholder. However, we had a favorable tax law change right now, and dividends can be taxed as little as 5-10% or no more than 15%. And by the way, Congress extended that I believe to the year 2010. So, if you get a dollar of dividends today, and this is dividends held outside a pension plan I want to point out, you only pay tax on 15% of that dividend, so there’s a favorable tax point of view to owning dividend paying stocks.
And I guess maybe a final thing if I was to sum this up: dividend paying stocks are not only less volatile as I pointed out but they also tend to represent higher quality companies. [1:03:34]
JOHN: But remember Jim now, the factors to watch and also some warnings and things to watch out for.
JIM: Yes, one of the things you don’t want to do if you’re looking for dividend stocks, don’t just go out and chase the highest dividend yielding stocks that you can find because the fact that the stock was paying a high dividend may alert you to potential problems down the road. For example, the company may not be earning enough to pay that dividend and they’re going to end up cutting it – there’s really some question on that. But the first thing you would want to do is look at dividend yields when you find something that looks attractive take a look at the dividend yield of that particular company and compare it to the industry as a whole, so that tells you is there something wrong with this company or is it within the range for this particular industry, for example, utilities are known for paying higher dividends.
The other thing that you want to do is take a look at price earnings ratios. If a stock has a high PE ratio you may be overpaying. But more importantly I like to take a look at the dividend payout ratio, I don’t like to see – with the exception of utilities, which generally pay out more of their dividends – I don’t like to see the payout ratio on dividends exceed 50%. The other thing I want to look at is cash flow. I want to see how much is the company earning in terms of cash bringing into the business versus what they pay. The cash flow should be at least 3 times the dividend payment, so you’ve got plenty of cash in the business to grow that business. So payout ratio is important as I mentioned, no more than 5% unless it’s a select industry; cash flow per share.
And then also, I’d like to look at dividend coverage should be a minimum of 120%, and then I also look at short term debt coverage. And I have 2 other proprietary indicators that I’m not going to mention but look at dividend yield, price earnings ratio. For the sustainability [look at the] cash flow, the pay out ratio, the coverage ratio, short term debt. These are very important, and this substantiates basically that the dividend is well secured, because once again, the caveat here is if you just go out and try to find the highest paying thing that you can find and in many cases the company could be a cyclical company that does very poorly, that loses money in an economic downturn. And the best example I can give you are the automobile companies where they’re going to end up cutting their dividends because they have to, they’re losing a ton of money. There’s no way they’re going to be able to support that dividend. So always check what the company’s against what they’re earning, what the cash flow is coming in, so you know at least that dividend is secure. [1:06:08]
Investing in Juniors: Patience & Discipline
JOHN: You know Jim last week we talked about the concept of investing in juniors and formulas for doing that. In other words, if you’re actually going to take that seriously we got a lot of response from people about that little segment, and one of the things that it really requires when you’re investing in juniors is patience, and a real lot of self-discipline.
JIM: Absolutely, John, and in fact I’m glad we’re bringing this up again because we did get a lot of email response. You know, the one thing if you’re investing in a junior you have to remember is you’re not investing in a typical producer. So you can look at it and say, “Ok, how much did they earn this quarter, how much did they produce, what was their margins on their production, are they replacing their reserves etc?”
Basically, when you’re investing in a junior you are investing in number one, management. You better hope the geologist that is doing the work is experienced, has a track record, and has a real feel for it, because there’s a bit of an art to this in terms of learning where to put the drill, looking at the land surface and all the geology that goes into this. I mean there’s quite a bit of an art, just like it is in investing.
And you also have to remember that the way a junior works is they tap the equity markets, they do an offering, they raise money to pay for the expenses. When they get the money that’s what pays for the drill crews, that’s what pays for the geologist. Then they’re going to go out and poke a bunch of holes in the ground. Now, depending on which stage you buy a junior in, in other words if it’s just an early exploration what they’re doing is they’re just tapping the ground, they want to know where is this gold located, and you hope that they discover it. And then at some point in time they’re going to have to get into development. Ok, let’s start poking our holes closer together to see what we have here, so we start defining the deposit because you’re eventually going to need that if you’re going to go into production. That takes time.
And the other thing that you have is a lot of times what we get is the drill results. OK, they’ve poked a bunch of holes, this was so many grams of gold, or silver or copper, or whatever it is that they’re finding. And eventually when they get enough of these drill holes done they’re going to come out with a resource estimate. It may be inferred, or it may be measured and indicated which gives you a lot more higher probability that you have what you have, and then if you do enough drilling and get the drills closer together you’re going to go towards prefeasibility which is going to bump those ounces in to reserve category which are highly valued – reserve ounces go for over $100 in the ground.
And I think the mistake with juniors is a lot of times, let’s say the gold market goes up and you’re in a junior and it’s going nowhere, or it could be going in the opposite direction. So we get these emails, “what’s wrong with this stock, how come it isn’t going up?” You know what? That’s just the way the market is. The market is like a 3 year old child, it has a very short term attention span. One day they’re focusing on ‘A’, the next day or next week they could be focusing on ‘B’. And that’s just the nature of the market, but if you understand what it is that you own, if you understand people that are running the company, you know that they’re in a prolific gold belt, and the people are doing a good job then what you do is you hold your course.
I’m going to give an example, it’s in the public domain but one of the companies that we were in on a financing was a company called Aurelian, and Aurelian’s stock in 2003 just before the big junior bust was in the 2.50 range. And from the time it hit 2.50 basically towards the end of 2003 it started drifting down and then of course we had the big corrective cycle that came into the market beginning in April of 2004. From April 2004 to basically May of last year the junior gold market was dead, and even when the market hit bottom in May of 2005, the large cap mid-tier companies outperformed the juniors till the beginning of this year. And what happened is Aurelian’s stock went from like 2.68 all the way down to a low of about 45 cents. And I was having a conversation with an individual, “why did you keep it?” Well, number one, Keith Barron is a friend of mine, I know him, he’s very credible, he’s probably one of the best geologists I think in the world today and has a very successful track record. Number two, they were in a very prolific gold belt. When you see other majors surround you and they’re mining gold and they’re finding gold it gives you an idea that they’re in the right area. And then what happened? They continued their drill program, the problem is they had a large land mass, they own a lot of land in the country and of course a junior just doesn’t have a budget, like for example a Newmont, where they can go in there with $150 million, and have 10 drill crews. So, juniors, you know, they raise 10 to $20 million at time, they’re running one or two drills, sometimes three, and it takes time to explore what it is that you have, and then develop what it is that you have. They had their first resource estimate and then they found that rich gold belt, and it went literally over night from somewhere in the neighborhood of around 50 cents a share to $3 and then of course all the way to its high of $23.40. That is the nature of the junior mining index. The market totally ignored this company for almost an 18 month period of time. I mean they had some great drill results in 2003 that captured the market’s attention, they did a financing in the fall in which we participated, and then we had the correction in the gold market.
And this is the thing you have to be careful with in a junior is you never know what the next drill results are going to be like; you’re never going to know when you get that one drill hole that has the whole industry talking about what it is that you found. I’m involved in two other juniors right now. One junior which has been getting spectacular drill results has been totally ignored by the market, but I know when you have those kind of spectacular drill results even though the market is ignoring it, eventually those kind of drill results are going to be turned into resources, and especially into reserves once they get into a prefeasibility, or a feasibility study. That is the nature of the market and there’s always this tendency I think that people have, “gosh, gold was up 10% and my stock’s going nowhere.” You know what, that is just the nature of the market. You can take a look at some very successful stories that were totally ignored by the market and then voila one day you get noticed. It’s like each day you go to the same restaurant or same café for lunch and a pretty girl walks by each day, and you never notice, and then one day you look up from your plate and say, “hey, there’s a pretty girl.” You know, it is the same thing in the market, and people think gosh my stock is not going up, there’s something wrong with it. And you get the bashers that will try to short the stock, or get you discouraged. If you know you have good management, if you know you have a good geologist and you know they’re producing resources and they’re adding ounces, they’re doing drilling on a project, then you don’t panic. If anything, you add to your position.
I mean I just discovered another undervalued play that once again I’m scratching my head saying, “why hasn’t everybody noticed this?” And that’s the kind of thing we try to look for, so the next thing I’m going to be doing now is I’m going to be sending my geologist out there to take a look at this project and I’m excited about it because it is a great gold play, they’ve got over a million ounces of reserves and they’re going to add another million here in the next 12 months and nobody is noticing the stock. That’s the kind of opportunity you look for and if you do find those opportunities you keep adding to your position. So John, I think the most important thing here when you’re investing in juniors is discipline and patience. That’s the hardest thing to do in investing - not just investing with juniors but investing in general because there’s a tendency to outguess the market, outguess the company and you end up many times outsmarting yourself. [1:15:08]
JOHN: Plus a gallon sized Maalox isn’t a bad investment either.
JIM: If you’re investing in juniors there’s definitely some Maalox moments.
JOHN: Well, no pain, no gain, right?
More Emails and Q-Calls
JOHN: Alright Jim, before we sign off today, let’s do a few more emails. Gary’s in West Helena, Arkansas, and he says:
Your 3 hours are my favorite listening for the week – be truthful and the world will be at your feet.
To Gary we say, “get a life.”…but in reality, thanks!
JIM: I really appreciate those, Gary, thanks.
JOHN: Rich is in San Diego – that’s in California, by the way, in case you didn’t know that, Jim - and he says:
Last week, Jim said that housing is overvalued as a tangible asset it will do OK in the coming inflation, but while housing may be a tangible asset it is purchased with paper assets which is to say the money to buy houses comes from purchasers of mortgage backed securities. In the type of dramatic inflationary environment you guys are forecasting wouldn’t bonds, CMOs etc prices decline in a big way and wouldn’t that decline undermine the ability to pay for housing at anywhere near current prices, regardless of whether replacement costs had risen?
JIM: Remember, you’re going to have trouble with people whose income can’t keep up with their mortgage payments. These are the marginal buyers and that’s going to bring some softness to the market which is what you’re seeing right now as you see real estate roll over. But you also have to remember there are going to be people that are going to be sitting there waiting in the wings with cash that are going to be looking for that pullback, looking for that downturn to buy and if you can keep interest rates artificially below the inflation rates – as they are today – there’s a margin of spread between what you actually pay for borrowing money today which is much less than what the actual inflation rate is, and then also what you can possibly earn on an asset. And I’d be very careful about expecting the bust that everybody is talking about, especially at a time when central bankers around the world may be talking tough but the money supply globally continues to expand. And remember, this is the first time, at least in my lifetime, in history where you have the world based on a total fiat money system. There is nothing backing the currencies, and all central banks are inflating. It’s just a matter of who’s inflating against the other. [1:17:39]
JOHN: Also from San Diego, Gary says:
Mr. Puplava, I very much enjoy your weekly podcast, especially the Big Picture. I actually listen to it 2 or 3 times to try to understand everything you and John discuss
He really needs a life.
If you get a chance would you please explain exactly what you mean when you refer to monetizing debt
This is a good question, Jim. It keeps coming up on a regular basis.
I think I understand the concept but your explanation would be appreciated.
And it’s an important one but it’s not hard to understand.
JIM: Alright, let’s say the government is running a budget deficit meaning that they’re taking in less revenues than they are spending money. So how do they finance that difference? Well, they can go into the bond market and raise money through the bond market, by issuing new bonds from the Treasury to the bond market – in other words, they’re tapping the capital market – that’s one way of financing it. Another way of financing it is simply that the government will issue a bond and the Fed will buy that bond from the government. So, in other words, the Fed will create new money. That’s what you call monetizing the debt. When you hear the term “the Fed printing money” actually what they’re doing is the government issues a bond to the Fed, and the Fed just issues digits to the government’s bank account, or checking account. [1:18:59]
JOHN: Then I’m assuming that money that the Fed gives to the Federal government goes into circulation when the Fed spends it on whatever it is they spend it on.
JIM: Well, when the government spends it goes into circulation. That’s what’s called monetizing the debt.
JOHN: And that’s it?
JIM: Yes, that’s exactly when the Fed is buying the government’s debt rather than the government issuing bonds to the capital markets which is existing savings. Also, another misconception about the dollar decline etc. is a lot of times you’ll say, “well, what if central banks start selling their Treasuries?” You’ve got to remember that central banks are printing money to buy our Treasuries too. They’re doing the same thing. They’re sort of monetizing our debt when you see for example the first quarter of 2003 to the end of the first quarter 2004 when the Bank of Japan buys $325 billion of our Treasury debt. They didn’t earn that from let’s say exports to the United States, they just simply printed the money to buy that debt. So they’re doing the same thing our Fed does sometimes. [1:20:03]
JOHN: Yeah, but most importantly I think to understand about here is when the government sells those bonds to the Fed the Fed simply creates that money out of thin air. It didn’t exist one moment, the next moment it does.
Dear Jim, I’ve been a long time FSN listener, going on 4 years now. I appreciate the job you and John do educating and keeping us informed. My family and I have been able to profit from the advice given on your show and I sincerely thank you for that. The fact that you don’t charge for this still amazes me.
I want to bring to your attention, however, in a certain chat room an individual has been saying defamatory things about you. You have been called a crook –
That doesn’t match your photo.
Unethical, a pump and dumper, and other libelous comments and profiteering at other’s expense. Having listened to you for 4 years now nothing could be further from the truth. I know you don’t go to chat rooms but perhaps you should entertain doing so. At least to this one.
And we won’t say what room it is.
And see what the individual is saying about you. Appreciate all that you do, don’t appreciate people who defame you.
JIM: Wow. Yeah, somebody else brought this to my attention and what has been said has been libelous and defamatory and I’ll just leave it at this: we’ve turned it over to a law firm and this individual is going to be taken care of. But I’ve heard good things said about me, bad things said about me. You know, John, you and I talk about the nasty-grams, we now have categories for them actually. We have 3 categories: one are four-letter words; two is body parts; and then three, is family members. And we’ve actually thought of charting them and using them as a contrary indicator. You know, one of the things about being in the public arena is people are going to take shots at you. But you’re absolutely right, a couple of other people have pointed this out to me and what this person has said is libelous, and last week we hired a law firm so we’re going to deal with this individual. [1:21:56]
JOHN: Just so people understand from a concept of libel or slander one being spoken the other being written that two things are required and it’s much harder to libel or slander a public figure because obviously you appear on radio or TV or whatever, but it has to be malicious and it has to be untrue. Those are the two basic tests in a court of law.
JIM: Yeah, if it’s libelous or defamatory which is what’s going on in this case, one of the things with the internet is it’s a great social medium, but a lot of people think they can do these kind of things and hide behind anonymity. You’ve got to be careful when you do things like that or spread rumors. That’s one of the things about the internet I don’t go to chat rooms, that’s just something I don’t do if I’m going to do research on a stock or something like that, I’m going to go directly to the company website or I’m going to try to get research but the last thing I’m going to do is go to chat rooms. So, we have a forum on our website because people asked for it, and so we put it up, but anyway, when you’re in the public arena that’s just par for the course.
I remember when it first happened, John, and I think about 5 or 6 years ago, when I first wrote my Perfect Storm when I said we’re going to have a stock market crash, dollar downturn, recession etc, etc, and people started sending me all of these nasty-rams. Financial sense originally started for my clients and so why are these people saying these things, but 5 years you get thick skin and it’s just par for the course. Like I said, we have them categorized now in terms of, Ok, that’s a four-letter, this is a body part, or this is a family member one. So, we get them every week. [1:23:31]
JOHN: Maybe you should add another category: defects in your genetic code or something like that.
JIM: Between the three we’ve got most of them.
JOHN: You’ve got most of the bases covered, right?
JIM: Yeah, it’s just part of being in the public arena. When we called the top of the gold market in December, it was a mistake, we came on in the first part of the year and we told everybody, “hey, we made a mistake.” And then I started talking about juniors, and then when I started talking about they’re going to hammer the market, then people got upset and I got the nasty-grams. They go down, it gets hammered and we get nasty-grams for that. So it doesn’t matter if the market goes up, or goes down, the nasty-grams are pretty consistent, although sometimes when they talk about family members or especially my wife of something that sometimes gets to you, but we’ve learned to take it in stride. [1:24:14]
JOHN: The interesting ones and I’ve never minded them are ones that challenge me but say, “well, I respect your opinion but I disagree with it here blah, blah, blah, explain to me how you could say that.” That’s a mature approach. The other is immature, and shows the mindset of the people. Anyway, for everybody listening in Canada this weekend, Happy Canada Day, and of course, Fourth of July is coming up for people in the United States, so it’s basically a Fourth of July weekend, and are you going sailing?
JIM: Not going sailing. We have Mary’s family – a couple brothers and sisters – have come down, so we’re going to head down to the beach, do a little motor-boating in the bay, and then just relax. It’s so beautiful this time of year and I hope at least at the beach it’s not going to be as hot as it’s been inland. We’ve been suffering from global warming, John, here in San Diego.
Well, listen, coming up in the weeks ahead, a couple of things. We’ve got next week Jeremy Leggett – you know, we haven’t touched upon peak oil in a long time, and as I mentioned I have a reading list on peak oil. I have something like I think 60-something books, I’m now over 70 books I’ve read on the subject matter, so we’re going to be interviewing some of the authors of some recent books, because I think this is going to be one of the defining issues of our generation in the world over the next decade or so. So, Jeremy Leggett will be my guest next week, he’s written a book called The Empty Tank. July 15th, Ike Iossif will be joining us, and also coming up Jeff Christian of CPM Group – he’s got a new book called Commodities Rising. So we’ve got Jeff, George Orwel – Black Gold and Leonardo Maugeri – The Age of Oil. Leonardo Maugeri is a head oil executive with the Italian oil company ENI. A lot of these are going to go into August. Let me see, I forgot somebody here. Oh yes, this is the one that I think I’m going to send the CD to Bill O’Reilly, I want him to listen to this one. We’re going to have Valerie Marcel, she’s written a new book called The Oil Titans, and this is about the national oil companies which really control the oil markets today. And that will be coming up, we’ll be having a double header on July 15th, so a lot of great stuff coming up as we head into Summer recess. As everybody knows we take the month of August off, and that’s coming up, I’m looking forward to doing some serious sailing and just kind of relaxing. I’ve got a whole reading list of books that I’ve already compiled for my Summer vacation and looking forward to that.
In the meantime, on behalf of John Loeffler and myself, we’d like to thank you for joining us here on the Financial Sense Newshour, until you and I talk again we hope you have a wonderful holiday weekend.