In today’s fast-paced market, investors sometimes forget that mining is an intricate and time-consuming science experiment. Investors who can stomach the risk and the wait are generally the ones who profit the most. Brent Cook, editor of Exploration Insights newsletter, and Quinton Hennigh, a geologist and contributor to the newsletter, believe that investments in prospect generators have yielded some of their best investments, plodding along slowly to unearth some often spectacular projects. In this exclusive interview with The Gold Report, Cook and Hennigh discuss why prospect generators are worth the wait.
The Gold Report: Brent, Quinton recently joined Exploration Insights. What does Quinton bring to the publication?
Brent Cook: Quinton is a geologist who can see the big picture. He focuses on how a mineral deposit forms and assesses if it is economic. His contributions allow us to cover a lot more ground in the same time and our discussions often refine and improve the final investment decisions. It’s a whole aspect to the business that’s going to help me make Exploration Insights better. Given the state of the junior mining sector, this is the time to be picking up the deposits and companies that are undervalued or that show potential value based on a real economic evaluation.
“Because this is such a high-risk game, we’re mostly looking for homeruns.”
Quinton came out of Newmont Mining Corp. (NEM:NYSE) and Newcrest Mining Ltd. (NCM:ASX). He knows how the big companies work and what their investment criteria are. Ultimately, our goal at Exploration Insights is to identify deposits that are going to have high enough margins and be large enough to attract a buyout or purchase from a major mining company. Quinton did that at Newmont.
TGR: You and Quinton will be in San Francisco on Friday, Nov. 16 for the San Francisco Hard Assets Conference to lead the workshop for investors, “Geo Tips for Tenbagger Investments,” sponsored by The Gold Report. What’s the name of the last tenbagger in the Exploration Insights portfolio?
BC: Well, I obviously wish there were more, however, since starting Exploration Insights in 2008 we have scored big on companies like Mirasol Resources Ltd. (MRZ:TSX.V), AuEx Ventures Inc., Fronteer Gold Inc., Kaminak Gold Corp. (KAM:TSX.V), and more recently Reservoir Minerals Inc. (RMC:TSX.V) and GoldQuest Mining Corp. (GQC:TSX.V).
TGR: Do you have a target rate of return when you invest in companies?
BC: In a sense we do. It all comes down to what a company is looking for, what that mineral deposit really looks like and, if it’s successful, what it’s worth. How much is it going to take to turn this rock into money? That takes into account the development costs, capital expenditures, and process and infrastructure costs. It all goes into determining what we need to see on a property. It’s on a property-by-property, country-by-country basis. That’s how we get a sense of what our target price might be. Then we follow the news as it goes along and judge if we should stay in it, buy more or sell.
“You cannot judge a deposit or a drill intersection based on the grade.”
Because this is such a high-risk game, we’re mostly looking for homeruns. We do own a number of prospect generators that just plod along and go up and down a little bit with the market, but that’s a different business model. I think we still have a chance for a tenbagger in those, but it’s a long-term investment.
TGR: Quinton, one of the things that you’re going to talk about at the workshop is red flags in mining company press releases. Give us some specifics that make you raise your eyebrows.
Quinton Hennigh: Let’s say there’s a news release that comes out. It mentions a killer hole—a long interval for a potentially good grade. But the company doesn’t list a cross section, making it very difficult to interpret. That’s always a little suspect. Why isn’t it showing us the full picture here?
Grade smearing is a chronic problem. Grade smearing is where a company takes a high-grade interval or two and transposes that into a much longer interval of lower grades in order to make it look like a bulk intercept.
Then there is drilling where there was a previous campaign. Maybe a major had a property and did some drilling. It got some results. Now a junior is coming back in and drilling basically on top of that and reporting results as if it’s a new discovery. The company isn’t showing the historic information and allowing investors to gauge what it actually has in its proper context.
TGR: The difference between true width and apparent drill width in drill results is also on the agenda. Why do investors need to know the difference between those two things?
QH: There’s a lot that goes into interpreting the geometry of a deposit. Drill intercepts are never a simple line. We have a one-dimensional line of data. Deposits are not one-dimensional. They’re three-dimensional. We need multiple holes to see what’s going on. You can’t say much about geometry until you have multiple intercepts.
“The advantage of Nevada is that all the infrastructure is there.”
True width is the width of an intersection or a vein that gives us one of the three dimensions we need to determine the tons of a deposit or a system. We need true width versus apparent width or drill width, which can give us an exaggerated width.
TGR: Brent, you’ve said in other interviews that a 1 gram per ton gold (g/t) deposit could be economic in Nevada whereas a 2 g/t gold deposit might be uneconomic elsewhere. Other than the fact that you have walked over most of it, why are you partial to Nevada?
BC: The real point of that statement is that you cannot judge a deposit or a drill intersection based on the grade. It has to be viewed in the context of what it costs to get the gold out of the rock. There are certain types of deposits that average 1 g/t in Nevada that you can make tons of money on because they’re so cheap to process and recover the gold. There are other deposits of 1 g/t that would not be economic anywhere; it’s all about the costs of turning that rock into money.
The advantage of Nevada is that all the infrastructure is there. A 1 g/t deposit makes money in Nevada, but the same deposit out in the middle of Burkina Faso will have infrastructure costs that are much higher. Then add in processing costs that are going to be more, plus energy costs and a host of other issues and it is clear we are not dealing with the same base case scenario. Jurisdiction and location relative to infrastructure are also key components of determining what a deposit is actual going to be worth.
TGR: Absolutely. What are some companies you are following in Nevada?
QH: The more exciting story at present is Gold Standard Ventures Corp. (GSV:TSX.V; GDVXF:OTCQX). It has a program on the south end of the Carlin Trend that’s an extension of the Rain mine, an old Newmont mine. It has been drilling blind targets based on geophysics and coming out with very good results. The system is complex—some holes hit, some holes don’t. It’s one of the more exciting stories right now. We no longer own it but it is certainly high on my radar screen.
“The system [at GSV's Railroad] is complex. It’s [an] exciting story right now.” – Qinton Hennigh
Gold Standard is not alone though. There are other projects out there. For instance, Pilot Gold Inc. (PLG:TSX) is drilling at Kinsley Mountain, which is an old gold mine that is seeing new interest due to higher gold prices. The technical team at Pilot put together the genetic model that delineated the nearby Long Canyon gold deposit and they are now developing some new concepts to test at Kinsley.
Miranda Gold Corp. (MAD:TSX.V) is a very good story. It has a lot of joint ventures and exposure to good properties. CEO Ken Cunningham is a first-rate geologist and knows how to pick projects.
NuLegacy Gold Corp. (NUG:TSX.V) is doing some very interesting work south of the new discovery that Barrick Gold Corp. (ABX:TSX; ABX:NYSE) has at Goldrush. The Goldrush project looks as if it’s going to be a substantial discovery of more than 10 million ounces. Barrick is actively drilling it right now. NuLegacy is targeting a similar zone on its project about five miles south.
TGR: There’s been a lot of development in Nevada over the years, but it seems most of these projects are proximate to other producing assets. Is that part of your investment thesis?
BC: Most of these deposits in Nevada line up along clear trends. These trends represent deep structures into the earth’s crust that are the conduit to mineralization. That’s where you go to look. We certainly want our investment thesis to make sense in the context of the basement geology throughout Nevada, or anywhere around the world for that matter.
TGR: You stay with a small number of companies for the newsletter. You have a very specific thesis. But in a recent edition, you said you were going to get into some other types of plays.
BC: Given the current currency debasement from quantitative easing, the speculative money is going to jump back into these sorts of plays very selectively. We decided it was time to get a bit more aggressive in early-stage exploration. Having said that, we bought a big company that Quinton identified but nixed two other much smaller companies that we initially had high hopes for being worthy of our clients’ money. Although we want to get aggressive, we’re not getting careless. I still feel the market is not going to buy your mistakes.
Our thesis is the same, though. I still want to keep it to 20 companies or fewer. A few stocks in the EI portfolio really don’t count as exploration stocks. Prospect generators are a different business philosophy and risk profile, for instance. If I bring something in, I want to be able to throw something out as well. That allows me to continually upgrade the portfolio. But exploration takes a bit of time. It’s a process. I’m not going to throw out a company until I’ve seen it follow through with the process and our original investment thesis has been tested. However, I am looking to upgrade the portfolio as quickly as possible.
TGR: You just have these 20 companies. How do your readers feel about that?
BC: They seem to be pretty happy with that. When I worked at Global Resources, the biggest problem I saw—and I still hear this from various subscribers and others out there—is that they’ve got a list of 100 companies, but they have no idea why they bought them, what they’re worth or what to expect. That’s a real problem and headache in this sector for retail investors. They hear that they should buy something for whatever reason and then they forget why they bought it and watch it slowly go down.
TGR: You’ve said that the odds of a geochemical anomaly becoming an economic deposit are roughly 10,000 to 1. Nonetheless, hundreds of millions of dollars are raised each year with those odds in place. Is the system broken? Or are enough people making money on the way up that it doesn’t matter what happens on the way down?
BC: It’s not broken, but it’s certainly inefficient. The scientific side of exploration often doesn’t understand the money side and the money side doesn’t usually understand the scientific process. A lot of money gets wasted through unrealistic expectations on both sides. It’s much easier to raise money on an old property, as Quinton mentioned, that’s got an old drill hole in it from years ago. They say, “Look, they drilled this hole. It was 100 meters at 2 g/t. We can repeat this. Maybe it gets bigger?” And, a money guy can say, “Yeah, I can see where we can repeat this hole. We get some excitement. I get off my paper in four months and I can move on.” A lot of money gets wasted with that thinking and more often than not retail investors get stuck, if they haven’t done their due diligence.
TGR: Is that wasted money coming home to roost now? Canaccord is shutting down a number of offices and the brokerage community is struggling in general.
BC: Most definitely. A lot of hedge funds that bought into these two years ago didn’t understand the long odds of success and how to evaluate early-stage concepts or the people behind them. Now they’re stuck with some stock that’s down by half, or more in some cases, with no liquidity. It’s a real problem. It’s very difficult to raise new money on anything but the very highest quality drill holes or prospects right now. I believe that’s going to last through this year at least.
TGR: The TSX Venture Exchange recently changed its regulations to allow companies to finance at less than $0.05 a share. What are your thoughts on that, Quinton?
QH: It’s like a stimulus for juniors. It’s going to amount to an excessive amount of paper being issued. Junior companies are going to have to issue a lot of it to raise anything meaningful. A first-class drill program can cost $1.5–3 million (M) in a reasonable location. That’s a lot of nickels. We’re going to be like Australian companies with a few billion shares out pretty quickly.
TGR: Are there some other companies that you want to tell us about today?
BC: The prospect generator model is a business model employed by some juniors that recognize the long and poor odds of success. It focuses on generating good conceptual ideas that can then be brought to another company with more money to spend to test the exploration thesis. It’s a very intelligent way to efficiently explore and make money, but it’s slower and not as exciting as the big go-for-broke drill hole play.
The bottom line is that we’re investing in ideas, the intellectual capital of the people in the company. If I’m an investor in a company’s intellectual capital, I want to keep my percentage of that as high as possible and dilute my interest at the project level, which is the drilling level. That way I get many more shots at potential discovery over time without excessive share dilution.
TGR: Have you ever done any quantitative analysis between prospect generator companies and the typical capital pool company method?
BC: No, but my experience has been that the prospect generators are less volatile and they last longer. Ultimately, I’ve made more money off of those than the occasional homerun because they go through a number of projects—10, 15, 20 of their projects drilled by partners that eventually fail—that is the reality of exploration. Eventually, however, they seem to come up with a project that they recognize as being special. They know that because the more work they do, the better it gets. Many of them will keep that project for themselves. Then we own a company that has 100% of a project that is recognized as special and we have not been diluted out of the discovery by previous failed exploration efforts. We’ve got something that really works.
The examples are Mirasol Resources, Kaminak Gold, Virginia Mines Inc. (VGQ:TSX) and AuEx Ventures. They have been huge homeruns, but it took time for them to get to the stage where they recognized the project was good enough to take on their own.
TGR: Do you have anything to add to that, Quinton?
QH: Project generators tend to be run by people who have a prospecting mentality. These are good geologists who can see the big picture. They can recognize the potential of a region. They can go in and pick up areas that are clearly geologically important. A lot of people that we know in the companies that Brent just mentioned know what they’re doing and know the areas that work and pick up that land. That alone tells you that they’re a pretty good bet.
TGR: Almaden Minerals Ltd. (AMM:TSX; AAU:NYSE) is a good example of a prospect generator.
BC: Almaden has been around for over a decade now. The company only has about 59M shares out. It has about $20M in the bank, which it got by selling stock in companies that ventured into its projects or selling projects to somebody else, not by issuing shares. It finally came across Ixtaca in Mexico, which was better than average and continues to be better than average. The stock has done fairly well. It’s drilling out a project that offers homerun potential and it’s doing it effectively and efficiently. That’s how the prospect generator model works.
Studying maps like this topographical mineralization map of Almaden’s Ixtaca property can help investors understand project economics.
TGR: The projects are longer-term investments, right? You have to be willing to hold these for a while.
BC: Exploration is really a long-term scientific process where we test a thesis, go back to the drawing board, test it again. It’s a process. Companies don’t just go out there, drill a hole, and say, “Bang! That was easy. Let’s go out and drill another one!”
TGR: Are you recommending to your readers that they should stay out of most of the names in the junior mining business until tax-loss selling season is over?
BC: There’s going to be a lot of pressure on these juniors coming into the end of the year. It’s been going for quite a while; we’ve seen a reprieve, but there are a lot of funds that have to get liquid and get rid of this stuff before the end of the year so they can start new and work on their bonuses for the next year. There’s going to be a lot of pressure. There’s no urgency to chase things up unless there’s an obvious drill-hole discovery in the making.
TGR: Quinton, do you have anything that you want to add?
QH: Things do seem to be picking up, but we’re going to see continued volatility. Looking back on the past two years, one thing that stands out in my memory is that companies were issuing paper in a big way when things were riding high. There’s a lot of overhang from that period. There are warrants out there. Funds are looking to liquidate certain positions just to get out of them. We’re not out of the woods yet.
TGR: Thanks for your time, gentlemen.
Brent Cook and Quinton Hennigh will be teaming up with fellow geology experts Chris Wilson and Andrew Tunningley from Exploration Alliance S.A. to present a special geology and mining education seminar called Geo Tips for Tenbagger Investments: A Streetwise Reports Seminar. It will be offered as part of the Premium Education Program at the San Francisco Hard Assets Conference on Friday, Nov. 16 from 9:00 a.m. to 1:00 p.m. In this exclusive seminar, you’ll find out how savvy investors spot the 2% of mining discoveries that can become wildly profitable, and how to spot the hidden clues inside mining company press releases. Learn how to recognize tenbagger opportunities from these experts using the most innovative geology and mining concepts. If you are registered for this event, you may submit your questions or topic suggestions here to be addressed during the seminar. This is expected to sell out, so reserve your seat now.
Brent Cook brings more than 30 years of experience to his role as a geologist, consultant and investment adviser. His knowledge spans all areas of the mining business, from the conceptual stage through detailed technical and financial modeling related to mine development and production. Cook’s weekly Exploration Insights newsletter focuses on early discovery, high-reward opportunities, primarily among junior mining and exploration companies.
Dr. Quinton Hennigh recently joined Exploration Insights where he provides geological expertise reviewing companies, projects and activity in the junior mining space. He began his career as an economic geologist with large mining companies including Newmont Mining Corp., Newcrest Mining, and Homestake Mining, where for 15 years he managed exploration projects in North America, Europe, Australia, Asia and South America. In 2007, he joined the junior gold sector where he has held executive and advisory roles at Gold Canyon Resources, Novo Resources Corp., Euromax Resources, Prosperity Goldfields and Evolving Gold Corp. He earned a Master of Science degree and a Ph.D. in geology and geochemistry from the Colorado School of Mines in 1993 and 1996, respectively.
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It is a deal with the devil: Governments churn out more and more cash for the promise of continued prosperity. But the day of reckoning is near, according to Doug Casey, chairman of Casey Research and an expert on crisis investing. As the epic battle between inflation and deflation continues, Casey discusses his predictions for the new world market in this exclusive interview with The Gold Report.
The Gold Report: There will be a Casey Research Summit on “Navigating the Politicized Economy” in Carlsbad, Calif., in September. The thesis behind the summit is that governments have made a Faustian bargain, a pact with the devil, that saves the empire with overspending, but drives it to the brink of collapse by creating fiat currencies. Doug, where in that story is the economy currently?
Doug Casey: It’s extremely late in the day. Since World War II, and especially since 1971 when the link between the dollar and gold was broken, governments around the world have accepted the Keynesian theory of economics, which boils down to a belief that printing money can stimulate the economy and create prosperity. The result has been to create huge amounts of individual and government debt. It’s become insupportable. All it has done is purchase a few extra years of artificial prosperity, and we’re heading deeper into a very real depression as a result.
“We have been consuming more than we have been producing and living above our means.”
Let me define the word depression. It’s a period of time when most peoples’ standard of living declines significantly. It can also be defined as a time when distortions and misallocations of capital—things usually caused by government intervention—are liquidated.
We have been consuming more than we have been producing and living above our means. This has been made possible by 1) borrowing against projected future revenues and 2) using the savings of other people. The whole thing is going to fall apart. A new monetary system of some type is going to have to necessarily rise from the ashes. That’s a major theme in the conference that’s coming up.
TGR: Will more quantitative easing (QE) give us another couple years of artificial prosperity?
DC: Most unlikely. We’re at the end of the story, not the beginning. More QE—I hate to call it that because it’s really just printing money. I hate euphemisms, words that are intended to make something sound better than it really is. Euphemisms, like exaggerations, are the realm of politicians and comedians. Anyway, the next round of money printing is going to result in radical and rapid retail price rises. There is no prosperity possible from this, rather the opposite.
TGR: Last time we spoke, you said that we are entering into a depression greater than in 1933. Can you describe how it might be different?
DC: What we experienced in the 1930s was a deflationary depression where billions of dollars were wiped out with a stock market collapse, bond defaults and bank failures. Inflationary money that was created since the formation of the Federal Reserve in 1913 was wiped out. Prices went down. This depression will be different because governments have much more power. They’ll try to keep uneconomic operations from collapse, they’ll prop them up, as we saw with Fannie Mae and General Motors. They’ll create more money to keep the dead men walking. They won’t allow the defaults of money market instruments. They will make efforts to maintain the dollar mark on money market funds. They’ll attempt to keep building the pyramid higher. It’s foolish, indeed idiotic. But that’s what they’ll do.
TGR: Which they’ve been doing by printing money. The first rounds of money printing have gone into the banking system, but the banking system has not allowed it to trickle back out into bank loans. Does that open the possibility of deflation if money is not moving out into the general economy?
DC: That’s right. The government created trillions in currency to bail out the banks. The banks have taken it in to shore up their balance sheets, but they haven’t lent it out because they’re afraid to lend and many people are afraid to borrow. That currency is basically in Treasury securities at this point. Although money has been created, it’s not circulating.
“I believe that governments have the power to create enough new currency to keep prices from going down.”
At some point, it’s going to move out. One consequence of this is that interest rates have been artificially suppressed so that retail inflation is running much higher than interest rates are compensating for it. At some point, rather than sitting on hundreds of billions of dollars that are going to be inflated from under them, the banks are going to do something with that money. It will go out into the economy. Retail prices will start rising.
TGR: Do we need to see another round of money printing to put us over the brink into a collapse? Or will it happen even if they don’t print more, because it’s currently sitting in the banks?
DC: They actually don’t have to create more money. It’s just a question of whether the banks start lending it and people start borrowing it. Another possibility is that the foreigners holding about $7 trillion outside the U.S. get panicked and start dumping them. I don’t see any way around much higher levels of inflation unless, of course, we have a catastrophic deflation, which we almost had with the real estate collapse.
TGR: How much will Europe play into this? It seems its governments are, at least according to the popular press, more exposed to bankruptcy than the U.S. government.
DC: Europe is a full cycle ahead of the U.S. Its governments and its banks are both bankrupt. It’s a couple of drunks standing on the street corner holding each other up at this point. Europe is in much worse shape than the U.S. It’s highly regulated, highly taxed and much more socially unstable.
Europe is going to be the epicenter of the coming storm. Japan is waiting in the wings, as is China. This is going to be a worldwide phenomenon. Of course, the U.S. will be in it, too. We’re going to see this all over the world.
TGR: If Europe finally does go over the brink, where it’s been headed for more than a year, would that also cause inflation in the U.S. or would you expect to get catastrophic deflation?
DC: This is an argument that’s been going on for at least 40 years. How is this all going to end: catastrophic deflation or runaway inflation? The issue is still in doubt, although I definitely lean toward the inflationary scenario. But will it start in Europe? How will it start? These things only become obvious after they happen.
TGR: When you say “lean,” are you pretty convinced it’s going to be inflationary?
DC: I think it’s going to be inflationary; in the 1930s, it was a deflationary collapse. Governments are vastly more powerful and much more involved in the economy now than they were then. I believe that they have the power to create enough new currency to keep prices from going down. Somehow, moronically, they’ve conflated higher prices with prosperity.
“Investors need to look for real, productive wealth and consistent growth.”
If we had a completely free market economy, prices would constantly be dropping. That’s a good thing, because as prices constantly drop, it means money becomes more valuable. That induces people to save money. When people save, it means that they are producing more than they are consuming—that’s a good thing. The way governments have it structured today, however, prices are always going up. That discourages people from saving because their money is constantly worth less, which encourages them to borrow. Inflation induces people to try to consume more than they produce, which is unsustainable over the long run.
TGR: You are saying that if the current value of your money is higher than the future value, that encourages borrowing.
DC: Exactly. I don’t see any possible happy ending to this. We’re approaching the hour of reckoning.
TGR: You have said that the titanic forces of inflation and deflation are fighting an epic battle that leads to extreme market volatility. But I am looking out there this summer and thinking it’s pretty calm. It seems like a very slow recovery. Gold is settling around $1,600/ounce. The S&P 500 index is testing the 1,400 mark. Is this just a pause in the epic battle?
DC: Nothing goes straight up or straight down. I just took a cross-country car trip from Florida, up the East Coast to New York, and then out to Colorado. It was actually rather shocking that many times I had trouble getting a motel room—even in the middle of nowhere. The restaurants were full. The highways were full of cars. It looked more like a boom than a depression. At the same time, our real unemployment, figured the way they used to figure it in the early 1980s, is about 16–20%. People are living off their credit cards. I believe it’s the same in Europe.
TGR: It seems as if we haven’t had much market volatility other than the technical glitch at Knight Capital this month. Do you expect market volatility to come back into play?
DC: On the one hand, some people are going to go into the stock market when inflation reasserts itself because at least it represents real value. They can invest in companies that actually produce things and have real assets. On the other hand, the stock market itself by any historic parameter is overvalued right now in terms of dividend yields, price-to-book value and price-to-earnings ratio.
I have no interest in being in the broad stock market. I feel very confident that the bond market, especially, is going to be very volatile. That’s the one place where it seems that there’s a real bubble, and it’s one of the biggest bubbles in history. It’s the worst possible place for capital right now. It’s a triple threat—higher interest rates, default risk, and currency risk.
Even reading the popular press, you can see investors in a desperate reach for yield. They’re only getting a fraction of a percent in their bank accounts. So, to get some income, they are buying all kinds of bonds, even those of low quality, just to get 2, 3, 4 or 5% in yield. The bond market is trading at insane levels as a result of the government having driven interest rates down close to zero in a vain effort to stimulate the economy.
The bond market is much bigger than the stock market. When interest rates start heading up, trillions in bond values will be wiped out, in addition to causing a lot of corporate bankruptcies—that’s why deflation isn’t completely out of the question. In addition, higher rates could really further devastate the real estate market, which has been making a mild recovery. And, of course, higher interest rates are the enemy of high stock prices.
TGR: One of the keynote speakers at the upcoming summit is Thomas Barnett, author of “The Pentagon’s New Map: War and Peace in the Twenty-First Century.” He’s going to be talking about geopolitics today and tomorrow. From your viewpoint, in today’s age of nationalism and conflicts among nations, is it important for investors to know about geopolitics in order to pick junior mining stocks?
DC: Most certainly. Very few investors are putting any money into the junior mining stocks right now, which tells me that it’s a good time to start looking at them. However, investors need to have a grip on geopolitics in order to intelligently assess which companies to buy. There are 200 nation states in the world and they all have different policies. Investors have to avoid putting money into a location where a company will never be able to develop a mine even if it’s lucky enough to find an economic deposit.
TGR: You developed the concept of the “8 Ps” for stock evaluation. Typically, you say that the people are the No. 1 thing that you look at. Is politics starting to move up in importance as a determining factor?
DC: People are still the most important because good people who are running a company will choose an intelligent jurisdiction to develop. It’s also a question of whether the world at large is becoming more stable or less stable. I think it’s becoming less stable, because all the governments in the Western world are really bankrupt and are, therefore, going to be looking for more tax revenue. Mining companies are going to be in its sights because mining companies can’t move their assets; they are the easiest thing in the world to tax. The good news is that makes mining stocks very volatile, and sometimes extremely cheap. Volatility can be your best friend.
But economically, as things get tougher in the Western world, that will hurt the developing world, too, because it depends on marketing its raw materials. If the Western world is using fewer raw materials, it’s going to put pressure on those developing countries.
TGR: Doug, you’re talking a lot about geopolitical unrest. The world is becoming less stable. In 2010, I heard a lot of discussion about gold going into a mania stage, specifically for many of the reasons we’re talking about now. As we approach 2013, will we run into that discussion of gold mania again?
DC: It’s not likely to happen until we reach much higher levels of inflation and we have something approaching financial chaos—but that’s exactly where we’re headed, and soon. The mania is likely to be fear-driven much more than greed-driven. Gold is still in the climbing-the-wall-of-worry stage. Mania is still in the future. It’s going to happen. I feel confident of that. There’s going to be a rush to gold.
TGR: One of the people you like to quote quite often is Richard Russell. There’s a specific quote I’ve heard you say a couple of times: “In a depression, everybody loses. The winner is the guy who loses the least.” In order to be that guy who loses the least, is it a viable strategy to stay out of the markets?
DC: It’s almost impossible to stay out of the markets because almost everybody has a pension program, an investment retirement account or something of that nature. You have to put the assets of that pension into something—the stock market, the bond market or cash. Most people own real estate or their home. If the real estate market gets hurt, you get hurt there. If you have wealth, what are you going to do with it? It’s not a good option to put $100 bills under your bed. Even then, you’re in the market for currency. That’s one of the biggest problems with inflation: It forces people to direct their attention to gambling in the markets, as opposed to productive business.
There has been way too much concentration on the financial markets over the last 50 years. This is shown by the fact that roughly 22% of the U.S. economy is in financial services, which is basically just moving money around. The financial services business doesn’t weave, spin or sew; it doesn’t produce anything. In a sound economy, the financial services sector would be tiny, just big enough to facilitate transactions. It wouldn’t be the mammoth that it is today. It seems as if everybody is in the business of moving money around, but the money they’re moving around is just paper currency. It’s quite non-productive.
TGR: They are producing new financial instruments. In a way, financial services companies are coming up with alternative methods to build wealth.
DC: I question that. Financial services don’t actually build wealth. Real wealth is created by the production of new technologies, food, metal or products. Financial services serve a purpose, of course, but it isn’t a real wealth creator. Today the sector is more of a moving-paper fantasy.
Even what I do, which is advising people on where to allocate their wealth, has always made me feel a little bit sheepish because I’m not actually building a bridge or creating a new engine or technology. I’m just telling people how to move things around. If the economy were sound, 90% of the people in my line of work would be doing something else. A speculator, basically, is someone who capitalizes on politically caused distortions in the market. If we had a sound economy, the government wouldn’t be causing these distortions—and it would be much harder to be a speculator.
Anyway, the whole financial sector is bloated. By the time the bottom hits, the last thing that people are going to want to hear about is the stock market, the bond market or where to put their money. They’re not going to want to read financial newsletters because they’re going to be so sick at the very thought of those things. People won’t ask how the markets are doing; they won’t even care if they exist. They’re going to get back to the basics. That is the foundation for the next boom. But that time is a good many years in the future.
TGR: But you are still in the business of helping investors move around assets. What would you say to investors now on how they can protect or grow their wealth through the next phase of volatility?
DC: First, it’s very hard to be an investor in a highly politicized environment. Investors need to look for real, productive wealth and consistent growth. Speculators, on the other hand, try to capitalize on the chaos that is caused by the myriad of destructive government regulations, taxes, and, of course, currency inflation. That’s why I look at all markets, in all countries. But right now there are very few bargains. At some point, for instance, real estate is going to be of interest again. Not right now because governments everywhere are going to raise taxes on it.
TGR: Would you put things like technology, pharmaceuticals and healthcare in the category of real wealth?
DC: Very definitely. That’s why we have a technology letter. I’ve always been kind of a boy scientist; technology interests me from an intellectual, as well as a financial, point of view. Technology is the real mainspring of human progress. No question about that.
The problem with the medical industry is that it’s being nationalized. It’s very hard to do anything with the U.S. Food and Drug Administration (FDA) as it is. It costs $1 billion to develop a new drug today. Developing medical devices can be almost as expensive. Even if something is approved by the FDA, if something goes wrong, count on being sued by the plaintiff bar. It’s a very high-risk business, which is a pity. Living longer and better physically is one of the most important things there is; medical businesses should be encouraged, not pilloried. I’ve always said that the FDA kills more people every year than the Defense Department does in the typical decade. But Boobus americanus still thinks it’s protecting him… (Editor’s note: Read more about investing in The Life Sciences Report.)
TGR: Are there other areas for real or productive wealth?
DC: I read science magazines all the time. There are more scientists and engineers alive today than in all the history of the world put together. Hopefully, with the continued blossoming of India and China—where students are generally going into science and engineering as opposed to things like gender studies, political science and English literature, which students idiotically are doing in the West—there will be even more scientists and engineers 20 years from now.
What areas are they going into? Nanotechnology, microbiology, robotics—these things will blossom the way computers have over the last few decades. The problem when it comes to investing in them is that they’re increasingly highly specialized. Investors need at least a sound layman’s knowledge in order to know if they’re barking up the right tree or not, and that’s hard. There’s just not enough time in the day to gain enough expertise for this type of thing. Of course, that’s the value of magazines and newsletters. The editors condense information for readers to give them an intelligent layman’s opinion.
TGR: Now we’re back to the importance of people. You do have to have some sense of the person who is doing that analysis for you. It needs to be someone who’s credible.
DC: Absolutely. That’s the advantage of having a newsletter over a magazine. In a magazine, you don’t always know what’s going into the sausage that that writer of an article is making. When you’re dealing with a newsletter, you can get to know the editor, what he’s thinking, how expert he really is and what is his psychology. You can learn if you can trust his opinion. Although I read both magazines and newsletters, newsletters are much more valuable.
TGR: To bring this full circle, I would imagine attending conferences where you meet these newsletter writers or analysts face to face is also beneficial.
DC: Yes, it gives you a smorgasbord of views. It’s helpful in assessing the validity of the views to be able to assess the personality of the writer and have a better understanding of whether his views are actually credible. And it’s a great opportunity to ask questions.
TGR: Doug, you’ve given us quite a bit of your time. I greatly appreciate it.
Read Doug Casey’s thoughts on the energy sector in The Energy Report exclusive, “Doug Casey Uncovers the Real Price of Peak Oil.”
Even if you can’t attend the “Navigating the Politicized Economy Summit,” you can still benefit from the information the 28 experts have to impart in the Audio Collection. Right now you can save $100 when you pre-order the 20+ hours of audio.
Doug Casey, chairman of Casey Research LLC, is the international investor personified. He’s spent substantial time in more than 175 different countries so far in his lifetime, residing in 12 of them. And Casey literally wrote the book on crisis investing. In fact, he’s done it twice. After “The International Man: The Complete Guidebook to the World’s Last Frontiers” in 1976, he came out with “Crisis Investing: Opportunities and Profits in the Coming Great Depression” in 1979. His sequel to this groundbreaking book, which anticipated the collapse of the savings-and-loan industry and rewarded readers who followed his recommendations with spectacular returns, came in 1993, with “Crisis Investing for the Rest of the Nineties.” In between, Casey’s “Strategic Investing: How to Profit from the Coming Inflationary Depression” broke records for the largest advance ever paid for a financial book.
Casey has appeared on NBC News, CNN and National Public Radio. He’s been a guest of David Letterman, Larry King, Merv Griffin, Charlie Rose, Phil Donahue, Regis Philbin and Maury Povich. He’s been featured in periodicals such as Time, Forbes, People, US, Barron’s and the Washington Post—not to mention countless articles he’s written for his own websites, publications and subscribers. Casey Research currently produces 11 publications on a variety of investment sectors and maintains two websites.
by Viral Shah.
The Reserve Bank of India has stepped in to regulate the pricing for debit card transactions. The rationale behind this regulatory change seems to be that lower transaction processing fees paid by merchants will lead to an increase in the adoption of retail electronic payments overall. Issuing banks will have to give up interchange revenue in the short run, but increased transactions will make up for lower fees in the long run. An unintended consequence could be that transaction processing gets adversely affected, and the current growth rate of retail electronic payments slows down. The RBI circular was released on June 28, 2012, and the industry is expected to comply from July 1, 2012.
Card payments background
Electronic payments are an outcome of the delicate combination of technology and incentives. A card scheme (Mastercard, Visa, etc.) brings four stakeholders together. Issuing banks issue payment cards to their customers, who become cardholders, whereas acquiring banks sign up merchants to accept card payments. The card scheme provides the interconnect between issuing and acquiring banks, so that a merchant can accept a payment from any cardholder. The diagram below shows the relationships between all participants in a payments transaction.
The service fee that merchants pays to the acquiring bank for processing transactions is called the merchant discount rate (MDR). The acquiring bank collects the MDR from the merchant and pays an interchange (I) fee to the issuing bank and a network fee (N) to the card scheme. The interchange is usually enabled by the card scheme, which guarantees revenue for the issuing bank. This incentivises the issuing bank to keep issuing more cards, and to spend on marketing and loyalty programs so that cardholders activate the cards and use card payments frequently. The MDR necessarily has to be higher than the interchange and includes the acquirer’s processing fee (A), which is used to operate the card processing infrastructure. It is traditionally market determined, and is a contract between the acquiring bank and the merchant, based on the merchant’s volumes, risk, chargebacks, infrastructure needs, etc.
We thus have the equation:
MDR (Merchant Discount Rate) = I (Interchange) + N (Network fee) + A (Acquirer’s processing fee)
Debit card transaction volumes are growing much faster than credit card transactions, and if one extrapolates the trend from the RBI electronic payments data, it is expected that debit card transactions will have overtaken credit card transactions by volume.
Different methods of payments
||Value (Rs. Trillion)
||Extrapolated from NPCI 2012 data
||Merchant / Biller
||Merchant / Biller
||Rs.50 (average txn of Rs.3000)
||Merchant / Biller
||Rs.25 (average txn of Rs.1500)
||Merchant / Biller
We have a topsy-turvy world, where banks are willing to bear the cost of transactions for cheques and cash, but expect fees when transactions are processed electronically. Given that electronic payments often lead to customers keeping higher balances in their accounts, and savings on cheque processing and cash withdrawal, it would be rational for banks to incentivise electronic payments for customers and merchants alike.
Should credit card and debit card transactions have the same pricing?
Credit cards are really instruments for lending, whereas debit cards are instruments for making payments. The card transaction model evolved first in the case of credit cards, and was subsequently adopted for debit cards. In the case of credit cards, the interchange fee is used by the issuing bank to fund the cost of credit offered to the customer, and the risk of default, between the time of purchase and the time the customer pays the credit card bill. As a result, in case of a debit card transaction, one would expect (I) to be lower due to absence of credit, (A) to be similar since it is already market determined, and hence, (MDR) to be lower.
Large merchants are often able to negotiate a lower (MDR) with acquirers, even lower than (I), implying that (A) is negative. The acquiring bank offers this service to the merchant if the merchant maintains their current account with the acquirer. Clearly, this model is not scalable and does not work for the long tail of small merchants.
Should point-of-sale (POS) and e-commerce pricing be different?
Today, both credit and debit card transactions have the same MDR – roughly 1.6% for POS transactions, and 2% for e-commerce transactions. E-commerce transactions were once considered riskier with higher rates of fraud, and hence justified higher pricing. Now that two factor authentication is mandatory for internet and mobile transactions, there should be no difference in (I) and (A), and hence in (MDR) for POS vs. e-commerce transactions.
Why do regulators step in?
The card business is a two-sided platform, where the card issuing and merchant acquiring incentives are managed by card schemes. Consider the case of a new entrant in the card scheme business. The new entrant may want to lower prices to establish market share. However, if the entrant offers a lower (MDR) to merchants by lowering (I), issuers find the proposition unattractive. If the new entrant offers issuers a higher (I), merchants face a higher (MDR), and will be unwilling to accept the product. (A) is already market-decided and offers little opportunity for differentiated pricing. A new entrant can at best, charge a lower (N). These are the kinds of challenges faced by the Government backed National Payments Corporation of India (NPCI) in launching the domestic card scheme, RuPay. The issue of debit card transaction pricing was first highlighted in the public domain in the Report of the Task Force on Aadhaar-enabled unified payment infrastructure. Due to such high barriers to entry, card schemes are routinely examined by Governments, and regulators have stepped in to regulate debit interchange pricing. Regulators have typically capped (I), but in India, RBI has decided to cap (MDR). This is likely to have interesting consequences that are not easy to predict.
What will happen on July 1, 2012, when the new pricing kicks in?
On July 1, 2012, the MDR cannot exceed 0.75% for transactions up to Rs.2,000, and 1% for other tansactions. If existing contracts remain in place, then issuers are guaranteed to receive (I) (usually 1.1% or higher) and the card scheme is guaranteed to receve (N) (roughly 0.15%). In such a case, (A) becomes negative, and acquirers will lose money on every transaction they process. However, this announcement by RBI is likely to be considered a material adverse change, one expects contracts to be renegotiated. As per the data above, if debit card volumes are Rs.40,000 crore, MDR paid by merchants at 2% is roughly Rs.800 crore. The new regulation effectively means that the merchants are as a group better off by Rs.400 crore on a notional basis on July 1. The acquirers are likely to be inelastic on pricing, which means that it is issuers and card schemes that will have to largely absorb the notional loss – (I) and (N) will have to be reduced in the new regime. Much of this will be absorbed by five large issuers. Over time, as more transactions are processed electronically, banks will save on processing cheques and cash, and instead earn fees from processing electronic transactions.
Will the lower pricing due to regulation lead to higher acceptance of debit cards overall?
It is clear that merchants who were on the margin, are going to be more likely to accept card payments. It is even likely that merchants will now start demanding debit cards from customers instead of credit cards. At the same time, it is also worth noting that cards are largely accepted by merchants in metros and by e-commerce merchants. India has a network of only 600,000 POS devices and 100,000 ATMs, which is grossly inadequate for a country of our size. (A) is now likely to get fixed due to MDR being capped, and the acquiring business could start seeing stable revenues. This is also likely to lead to an interesting opportunity for the low cost merchant acquiring technologies similar to Square, a number of which are getting ready to launch in India. It could also create an opportunity for NPCI to differentiate itself from established competitors. Overall, the best case scenario is an increased demand for electronic payments with debit cards by merchants and consumers, savings for issuers due to reduced cash and cheque usage, greater acquiring revenues, and more banks entering the acquiring business (PSU Banks are notably absent in the acquiring business). At the very least, one hopes that the oil marketing companies will no longer charge a petrol surcharge fee of 2.5% when paying with a debit card.
What are the possible negative consequences of this regulation?
If (A) is set too low by the card schemes, the acquiring business will be affected. With no further bargaining power, acquirers may have to focus on cost cutting and holding back new investments. Issuing is unlikely to be affected much given the existing base of 300 Million debit cards, and that banks will continue to issue debit cards for ATM usage. One does expect cash-back schemes, loyalty programs, and various other cardholder incentives for debit products to effecively stop, and cardholder fees to increase. Even with ATM interoperability and pricing, RBI has continues to refine its policy (making interoperability mandatory at first, then free interoperable transactions, then restricting the number of free interoperable transactions to five, white labelled ATM policy, etc.). Similarly, this is likely to be the beginning and not the last word on the matter from the regulator. The policy should be stabilized quickly, since it is consumers who suffer during the experimentation phase.
The technological opportunity in payments
In the old days, the field of payments was inextricably interlinked with banking. Money was only held in bank accounts; the only way to move money around was through banks.
Advances in computer technology coupled with financial innovation have changed all this. Banks are no longer the only game in town for the business of holding money. An array of innovators are now in the payments game. A few interesting examples are:
- Paypal is a pure-play Internet company, which rides on top of bank accounts, and gives users a payments solution.
- Western Union moves money from person to person across the globe without referencing a bank.
- M-pesa, in Kenya, does payments over mobile phones. Money is fed into a phone as with topping up a pre-paid card. Money is then transferred to another person using an SMS.
These developments have far reaching ramifications. We can now think of payments as a distinct industry, one that is not joined at the hip with banking. Banking is primarily a risk management business, of coping with callable deposits which have an assured rate of return, even though the assets are opaque and risky. In contrast, payments is primarily a computer technology business, closer to the working of a depository or an exchange.
As Merton Miller said, banking is a disaster-prone 19th century industry. If a critical function like payments can be increasingly decoupled from banking, it would make the world safer.
There are two distinct problems in payments. The first is the systemically important payment system which is the core utility of the currency. In India, it is the RTGS. This is an entirely separate issue. The present discussion is about the second component of the field of payments: the non-systemically important payments systems which are used by households and firms. This is an ordinary financial technology business.
When person X wishes to transfer Rs.100 to person Y, if the banking channel is used, the steps are as follows:
- Person X lends this money to the bank by putting it into a deposit account.
- He instructs the bank to send this to person Y.
- At the other end, it shows up as a demandable loan from person Y to the bank.
The balance sheet of the bank is inextricably tied into the payments transaction. Through this, all the problems of banking flow into the field of payments. Banks have opaque assets with 20x leverage or worse. It seems odd to place a mission-critical function such as payments in the hands of such entities.
In the old world, it was not possible to enjoy the benefits of payments without suffering the credit risk of a bank. One solution that was mooted was for payments to get done in central bank funds. You can do this for a few special situations like the securities clearing corporation, but probably not for most other situations.
The same problem arises with a mobile phone company:
- When you feed money, by topping up a pre-paid account, this goes into the balance sheet of the mobile phone company.
- Now you have to hope that when the time comes for you to spend this money, the mobile phone company is still solvent.
Faced with this situation, conservative financial regulators have proposed a few solutions:
- Mobile phone companies cannot do payments; payments is the exclusive preserve of banks. (This is the state of affairs in India).
- Mobile phone companies must become limited purpose banks.
- Mobile phone companies must come under full banking regulation.
All these three solutions are unsatisfactory, because they are rooted in the old paradigm, where payments was inextricably intertwined with banking, and it was felt that this is the only way it could be. We need to look beyond this.
An alternative solution: Segregation of client funds
A remarkably clean solution has been invented in the field of asset management: Segregation of client funds.
Consider a money manager such as an asset management company (AMC). At a legal level, the AMC is a mere advisor. Client money never goes onto the AMC balance sheet. Customer money sits completely separate. If the AMC goes bust, this has zero implications for clients. In the entire history of such arrangements, there has been only one episode (MF Global) where segregation of client funds did not work, in protecting customer moneys. This is in contrast with the history of banking, where failures have been taking place across the centuries, across all countries, with a high frequency.
Under such an arrangement, client funds would always sit separately, segregated from the balance sheet of the payments provider.
Segregation of client funds requires a corresponding supervisory capacity – and MF Global shows us that this supervision can possibly fail. But it would involve a much lower failure rate when compared with the problems of banking.
Implication 1: Mobile phone company as payments provider
Suppose Vodafone is my mobile phone company. When I supply Rs.1000 into my mobile wallet, this would go sit separately in a customer trust. This would not go into the balance sheet of Vodafone. If Vodafone were to go bust, this money would be returned to me. This solves the problem of the credit risk of the payments provider.
If we could do this, it would open up an array of payments innovations. The only regulatory burden placed upon the provider would be: Never ever keep customer money on your own balance sheet. We would then need some small resolution capability to kick in when the payments firm goes bust, to take money out of the customer trust and give it back to the customer.
Implication 2: This can be done with banks also
Bank accounts can be broken up into two kinds: illiquid and liquid. (From a customer perspective, this is analogous to the Tier 1 and Tier 2 of the New Pension System; the former is illiquid and the latter is demandable). Illiquid accounts would be loans from customers to the bank (as all bank deposits today are) and have greater restrictions against convertibility. Liquid accounts would not belong to the bank. They would be segregated client funds, used for payments activities.
This would derisk customers from the problems associated with bank failure. It would greatly reduce the complexities of banking regulation and supervision. It would put banks on a level playing field when compared with other technological strategies in the field of payments.
When banks do not capture the interest income on the liquid accounts, this will force a healthy unbundling of payments and banking. Banks who engage in the payments business would have to explicitly charge for payments services. This would help ensure a level playing field between bank and non-bank players in payments.
Implication 3: How to store segregated client funds
Payment vendors could place client funds into current accounts with the central bank for riskless safekeeping. Or, they could place them into NAV-based money market mutual funds, so as to earn some return.
In this framework, there would be N money market mutual fund accounts belonging to M entities. The payments system would be a technologically diverse array of alternative competing mechanisms through which money flows from account i to account j, which generates a fee income for the payments provider.
The idea of segregated client funds, which is very well established in some areas of finance such as money management, brokerage, etc., can be usefully applied in the field of payments, to cut through the gordian knot of banks and payments.
The Hunger Games – book and movie
I have no excuse – no teenage daughter or son around the house to lure me into Suzanne Collins’ trilogy that starts with The Hunger Games. I read all three just for the fun of it. And now there is an interesting tie-in between the book/movie and economics; specifically how some countries prosper and others don’t.
Matthew Yglesias writes in Slate:
At first glance, the economic landscape depicted in Suzanne Collins’ best-selling Hunger Games trilogy doesn’t make much sense. Despite its post-apocalyptic condition, the fictional nation of Panem is quite technologically advanced. It has high-speed trains, hovercrafts, extraordinary genetic engineering capabilities, and the ability to create extremely advanced weapons. And yet Panem is also a society of tremendous economic inequality, with clear examples of absolute economic deprivation and even famine.
Most importantly, Yglesias refers to a much-quoted book, Why Nations Fail, by Daron Acemoglu and James Robinson. These authors have some plain sense observations about how and why nations grow and prosper. We’ll look at those observations in more depth later.
Meanwhile, the Slate article is a good start, and an interesting connection to this weekend’s blockbuster movie.
Parlier earns about $13 an hour. She’d like to become one of the better-paid workers in the plant, but, in today’s factories, that requires an enormous leap in skills. It feels cruel, Davidson writes, to mention all the things Parlier would have to learn to move up. She doesn’t know the computer language that runs the machines. “She doesn’t know trigonometry or calculus, and she’s never studied the properties of cutting tools or metals. She doesn’t know how to maintain a tolerance of 0.25 microns, or what tolerance means in this context, or what a micron is.”
A good attitude and hustle have taken Parlier as far as they can. It’s hard, given her situation, to acquire the skills she needs to realize the American dream.
But skills aren’t always necessary. A dumbed-down UI can serve as a substitute for knowledge, particularly if a firm can hire a technician to know the technical aspects of the technology in use so other workers don’t have to. In fact, the trend of technology has generally been to serve as a substitute for knowledge and ability. Why learn Trig if you can run a fairly simple program on a computer?
Anyhow, this story is evidence of my claim of a technology gap. If labor were allowed to compete freely in a deregulated economy, technological growth would be slower and technological innovations implemented less frequently. This in turn ensures that labor is not stagnant or regressive, and also gives less intelligent laborers a chance to remain on the market longer as technology remains relatively expensive. In order to make technology more appealing, then, technological innovators will find it useful to dumb down the UI to make the device more readily accessible by lower-intelligence labor.
The point in all this, then, is that the government has basically set policies in place that pulls demand for technology forward, leaving less-intelligent laborers in the lurch. And since less-intelligent laborers tend to also be poor, it can be said that the government hates poor people.
Amid a chorus of gold mining pundits yelling for investors to snap up cheap gold equities is Ian McAvity, a 50-year veteran of the markets, telling investors to wait. In this exclusive interview with The Gold Report, McAvity, who produces Deliberations on World Markets, explains why historical cycles lead him to believe the market is in for some new lows and what that means for the gold price and the juniors seeking out that shiny metal.
The Gold Report: Ian, you have been involved in the markets for 50 years. How much of today’s market is a repeat of a cycle you’ve seen before and how much is unique?
Ian McAvity: Cyclical and secular trends haven’t really changed, but each one has slightly different characteristics. From 1982 to 2000, there was a powerful secular uptrend in the S&P 500. Since 2000, there’s been a secular bear trend, sideways or downtrend not dissimilar to 1966–1982 or 1932–1949 that may run through 2016 or 2018.
The big change has been the utter corruption of Wall Street and that nearly 80% of the trading on the New York Stock Exchange now is being done by high-velocity computers. When an investor puts in an order, it’s basically one computer versus another computer operating in nanoseconds. That’s why all of a sudden the volume is up or down 10 to 1 and you get a couple of hundred points added on or taken off the Dow in minutes. To me that’s a corruption of the process. “Ethics” and “Wall Street” are words you never use in the same sentence.
The trading mechanism is broken down. Leveraged exchange-traded funds (ETFs) are designed to consume the client’s capital in leveraging and rebalancing premiums. The high velocity traders literally get the opportunity to “front-run” public orders as the order flow to “the market” is available to them for a fee. It’s outrageous in the sense that they’ve legalized front running for those who pay up for the high-speed data feed. And then there’s the initial public offering (IPO) business. Anytime the public can get shares in an IPO, they don’t want it. If they can get some, it’s only because it’s not going to be that good a deal.
TGR: Is it the corruption of Wall Street or the development of Wall Street through technology?
IMcA: It’s the culture of greed coming out of the banking system. The Street always wanted to make money. That’s never gone away. But there was a time when good clients were actually respected by a firm. A firm wanted to do well for a good client because it wanted to keep the family assets in the firm. These days a client is considered to be a mark. The system is designed to convert the client’s capital into their fees and income as quickly as possible. The public is being chased out. There have been persistent outflows from domestic equity mutual funds since 2007. A lot of people justifiably don’t trust it.
TGR: Or perhaps the public just doesn’t have the tools and the speed to become an influential member of the market?
IMcA: Let me give you an example. The average daily turnover for one gold mining junior ETF is $100 million (M). Probably $80M is day trading where there is no net investment. To call moment-by-moment trading “investment” to me is a sacrilege. There’s no way that people are making a rational investment decision in that sense. I’d rather go to Vegas where they’ve got pretty girls serving you a drink while you gamble.
TGR: Aren’t day traders just playing nagainst each other? Someone bets it goes up. Someone else bets it goes down. They wait a very short period. Ultimately, it just evens out.
IMcA: In theory it works itself out, but it creates an illusion of growth that distorts trends because it injects volatility. The majority of the billions of dollars that are trading every day is intraday noise. All the computers scalping each other for as little as a tenth of a cent.
TGR: The market was up the other day in reaction to the debt plan that came out of Europe. Is this a real increase or just more intraday noise?
IMcA: One batch of traders shorted at the opening burst, but that afternoon it didn’t sell back. All the guys that shorted in the morning got their clocks cleaned and had to cover in the afternoon. That’s why there was a second rush into the close. That trading activity is symptomatic of what’s wrong with this market. Markets are being driven by headlines. Plus, the headlines are being misinterpreted most of the time. At first, it appeared that Europe had a perfect solution for everything. Then, by the end of the day, we were discovering that there were a lot of details missing and it was unclear how many parliaments have to approve the plan. Every day there’s a leak of some unsubstantiated “plan” and later it’s denied but the cheerleaders at CNBC seem to take every wiggle as gospel.
TGR: Is it driven by headlines or the 24/7 news cycle?
IMcA: I wish the news cycle was as slow as 24/7. When people are trading on one-minute and five-minute charts, a 24/7 news cycle can’t keep up with it. It’s not healthy to have this much liquidity. What it reflects is that the bailout of the banks has flooded the system with liquidity, but none of that is trickling down to Main Street or out into the real world. It’s just sloshing around in the financial markets. The velocity of trading reflects that the system is swimming in liquidity and nobody is feeling sufficiently brave to take any risk home overnight. We’ll churn the daylights out of it, but flatten the position before lunch or the close.
TGR: How does an individual investor operate in this environment?
IMcA: Basically hide. A number of people have told me that they’ve become day traders and I ask them how they’re doing and they say, “Well, I’m not quite there yet. I know I can make money doing it.” I tell them not to blow all of their capital while they try to learn. It’s an exploitable game for somebody that has the self-discipline. But it requires a degree of self-discipline that 90% of the people that try it will never acquire.
TGR: At The New Orleans Investment Conference where you spoke in late October, many speakers talked about how junior gold stocks are essentially on sale, inferring that this is the time to buy. Should investors run and hide from a corrupt and frothy market, or go out and buy?
IMcA: You’ve got to watch the inter-market relationships. The gold stocks have been very poor performers relative to the gold price. In the last 12 months, the junior gold stocks have been particularly bad even relative to the senior gold stocks. That is creating an undervalued situation. But undervalued doesn’t mean go out and buy it tomorrow morning. Yes, there was a marvelous October rally after five down months in the S&P. However, I believe that the S&P is going to go back down and at least probe the last lows, if not break them by year end or March. The junior gold mining shares will test their recent lows and then start to show relative performance where they’re not falling as much as the stock market. I’m watching for that type of relative strength and that’s when I would be looking to buy them. I wouldn’t be surprised if the gold price came back down to $1,650 an ounce (oz) as well.
I’m looking for a point where I want to buy, where for several months I was saying I wouldn’t even think about it. A lot of the excesses have been wound out, but the best buying opportunity still lies ahead. Year-end tax loss selling and a sharp down turn in the S&P where everyone is looking for a year-end rally could provide a great buying opportunity for the juniors soon.
TGR: You’re a technical analyst who relies on a lot of charts. What are you seeing in charts that make you believe that the S&P is going to pull back to its lows?
IMcA: I’m basing that on cyclical analysis within secular trends of the Dow Jones Industrial Average. I believe the top this year goes back to February as the cyclical top of the rebound off the 2009 lows, while the S&P made its actual peak in May. On a secular basis, I view this as the second half of the bear market that started in 2007. The first half of the financial bubble was undone from 2007 to 2009. The second half will run through 2012. There could also be a final low that may be as far out as 2016.
The undoing of the debt bubble over the last three decades is not a short-term affair. It’s going to take a long time to work off. The housing market has not seen its bottom. Job numbers are going to get worse. Everything that they are doing in Washington just says that they are looking for new ways to screw it up.
TGR: You’re expecting a double-dip recession.
IMcA: It will be called a double-dip only because they’ve engineered what appeared to be a recovery, but there hasn’t really been a recovery that restored many lost jobs or did much more than temporarily slow the pace of decline in the housing market. All of the money and the liquidity that they threw into the market tweaked a few of the numbers in the gross domestic product to create the appearance of a recovery, but barely a penny of it ever got to Main Street.
TGR: Main Street is starting to spend a bit more.
IMcA: That’s like saying there is a housing recovery because housing starts went up from 420,000 to 425,000. Housing starts used to be 1 million.
TGR: When will the economy get through this mess and start on a real recovery?
IMcA: It’s going to take several years. It might start to show some signs of recovery in 2013 or 2014, or perhaps as late as 2016.
If the S&P is below 1,258 on Dec. 31, 2011, it will be the first down pre-election year since 1939. Election years don’t have as bullish a record as pre-election years. But how much fun has this year been so far? The market’s going to find a bottom for bear market rally bounces. Ned Davis Research Group created a model that I’ve modified that projects a decline in the Dow to a prospective cyclical bottom between 8,200 and 8,400 in August or September 2012 if we experience only an “average” bear market. I fear that it could be a lot worse than “average” given the geopolitical uncertainties as a backdrop.
TGR: Wow, that’s a claim.
IMcA: It’s interesting to see a cyclical decline projected through an election year. It’s not unprecedented, but it’s quite unusual.
TGR: You said earlier that you expect the gold price to pull back again. Do you expect it to pull back below its 200-day moving average?
IMcA: No. The market has come back and tested the $1,600/oz level twice. The last bounce off the $1,600/oz level was pretty credible. I’d be surprised if $1,600/oz is broken now.
TGR: You don’t believe that gold is a bubble then?
IMcA: Whenever somebody talks about gold being in a bubble, I tell them to look at the credit and stock markets. If the gold price is at $1,900/oz, it’s 2.2 times the high in 1980. However, debt in the U.S. is 12 times its early 1980 level. The S&P is trading at 10 times its 1980 level. The credit market and the stock market are about five times ahead of the gold price. I don’t forecast that the gold price will reach five times its 1980 highs, but it might. If it gets there then you can start talking about a bubble.
TGR: Do you believe that gold will replace fiat currency?
IMcA: I don’t know that it will ever replace fiat currency. The leadership of the G13, China, Brazil, and India, are probably going to push the old world to go back to some sort of a central discipline, such as indexing to a basket of commodities. It’s too cumbersome in the modern world to return to a gold standard. But I can envision an international governing body being proposed to push for some discipline such as the Bretton Woods Agreement after World War Two.
TGR: What’s in the basket?
IMcA: Gold, silver, oil, copper and conventional food.
The problem is no central banker ever wants to surrender sovereignty to some other body. The U.S. government is always going to want to call all the shots. But the U.S. government isn’t what it once was. The rest of the world is increasingly going to communicate that message. At some stage, the world needs a globally accepted common denominator. China, Brazil, India and the G13 have nearly $7 trillion worth of the debt of the old world. There comes a point where the creditor will dictate the rules.
TGR: That’s how the U.S. got to the position it’s in.
IMcA: Exactly, exactly.
My biggest concern is increasing geopolitical risk for those that are exploring all over the world, the most recent example being the Argentinean government putting in a new set of rules. The same thing could happen in African countries. If the gold price gets much higher, the South African government will be talking about nationalizing. Too many of those countries will love you while you are bringing money in, but once cash flow begins to flow out, the politics of greed and envy takes over, typically under the guise of economic nationalism.
Politically stable jurisdictions are my preference. I am most attracted to seeking deposits in conventional mining districts in Canada or the U.S. where mining laws and practices are understood and respected. Even South Carolina is coming back again. I remember the previous go-around on it.
TGR: What happened then?
IMcA: It didn’t work out because the gold price went down, as best I recall.
TGR: Any other last thoughts you’d like to leave our readers?
IMcA: The big contrast with this gold cycle and that of the ’80s and ’90s is that we haven’t really seen a big discovery that excites the world. In that last cycle there were about a half-dozen companies built on new deposits that are already mined out and gone now. Names like Echo Bay, Hemlo, Amax Gold, FMC Gold, Pegasus and several others were launched and became the darlings of the last cycle, and they have already gone from the scene by the time gold got above $1,000/oz this time around.
At some stage somebody’s going to make a discovery that’s going to turn the lights on to get the speculative juices flowing, one good, exciting discovery in a prospective new camp. It looked like that might be taking place in the Yukon with the takeover of Underworld Resources Inc. (UNDWF:OTCQB). Will there be a sequel discovery up there? One solid drill hole can transform a junior explorer, but it does need to deliver follow-up success pretty quickly to build on it.
That’s the nature of the drilling beast and discovery cycles. Others will remind you what the odds are. It’s a very high-risk and capital intensive business. That’s why I’m more attracted to the companies that are in that process of creating value out of the ground as opposed to having the political experience of dealing with environmental permitting and other regulatory impediments to getting a new mine into production. My idea is if you can make a discovery then God bless you and let somebody else have those future political and bureaucratic joys for the right price.
TGR: Ian, thank you for your time.
Ian McAvity has been involved in the world of finance for more than 50 years as a banker, broker, independent advisor and consultant. He has produced his Deliberations on World Markets newsletter since 1972. He specializes in the technical analysis of international equity, foreign exchange and precious metals markets, and has been a featured speaker at investment conferences and technical analyst society gatherings in the U.S., Canada and Europe over the past 40 years.
Chuck has good idea for reforming education:
Sometimes you hear lamentation over the fact that teachers aren’t regarded with proper levels of esteem. That we have star athletes but no star teachers even when most students would benefit more from the latter. A possible solution to that problem with a keener eye for improving the cost/benefit equation of education at all levels would be to pay the best teachers a lot of money. And pay the really good really well through syndicated teaching.
To reform the cost structure of the education system –college, high school, junior high – cut out the redundancy. Let the best instructors instruct the whole nation of students. Each school would pay a subscription fee to each of these syndicated teachers, or each student would pay tuition directly to a superior teacher. Or, hell, each student would just go on Youtube at the tiny cost of whatever time use would be contributed to the computer or the internet subscription. I would have literally saved thousands of dollars and would have a better baseline knowledge of philosophy and a few other subjects.
I suppose that if this hasn’t been already, it’s unlikely to occur. The problem, at this point, is not technology or money. This would have been feasible shortly after the invention of subscription television; all you would need on-site would be technology facilitators to ensure that equipment functions properly and someone to collect and grade homework, enter grades, and ensure classroom discipline. Alternatively, at this point, one needn’t even go to school; one could receive instruction at home. I would imagine that this proposed system would be cheaper to operate than the system currently in use.
The reason why Chuck’s proposal will never be implemented, then, is not due to logistics, cost, or the limitations of technology. The failure is ultimately due to a lack of political will.
As a child of two public school teachers, I can say with are asonable degree of certainty that the vast majority of school teachers would be opposed to merit pay. Because most of them suck at teaching. I’ve observed plenty of my parents’ coworkers (it’s easy to volunteer at public schools when you’re homeschooled), and I also spent a couple years in public high school under the tutelage of a large number of stupid and incompetent teachers. Very few teachers have a reasonable degree of mastery of their subject. Of those who do, few are able to teach effectively.
Now, most teachers belong to a union, and simple probability suggests that most of the teachers belonging to the union are either stupid or incompetent. The union’s job is to protect teachers’ jobs,not reward good work. So, the main opposition to merit pay and “star teachers” is…the teachers themselves. Why? Because a meritocracy would cause many teachers to be worse off financially.
Ironically, it is the teachers themselves that complain how they’re underpaid relative to, say, sports stars. I suspect that this lamentation is borne of nothing more than envy. In essence,teachers are complaining how they can’t earn millions of dollars for doing what they already do. They want to be rich,but they don’t want to work hard for it or make serious sacrifices for it. (Seriously, how many teachers would spend hours a day practicing teaching during their years in Jr. High? How many would hire personal teaching trainers? Etc.) Ultimately, teachers who complain about being underpaid are often nothing more than socialists, trying to prove that they are noble people, well-deserving of society’s riches.
Beyond that, then, it should be clear that the very thing preventing teachers from being stars is…teachers themselves. The government, at the behest of the teachers unions, heavily distorts the education market. Attendance is mandatory until the age of eighteen (at least in my state). Students have a limited selection of schools. The whole teacher-classroom setup is maintained only at the behest of the government. Alternative forms of schooling often arise from private schools and homeschoolers. Innovation within government schools is low and costly.
What teachers need in order to become stars is the ability to compete in multiple markets simultaneously. This can easily be accomplished in this time of (relatively) low-cost technology. A teacher could record a lesson every day and have broadcast to various schools, customized for class period length, local class meeting times, etc. But the government, at the behest of the teachers’ union, refuses to allow this because many teachers would be out of a job.
Ultimately, the current education is organized around one central purpose: to make sure that the current number of teaching jobs remains the same. One good teacher, by the “magic’ of modern technology, would be eliminate the need for dozens of bad teachers. One great teacher would eliminate the need for hundreds of bad teachers. Betteryet, economies of scale would reduce systemic costs, making education simultaneouslyboth cheaper and higher-quality. The main thing preventing this from happeningis the government (quelle surprise, non?).
Consumers are watching as many – if not more – films than ever for less money and time than ever, for a third of the cost. The money that had been spent on (now unneeded) overheads can go on other things. Be sure to avoid the broken window fallacy – the saved money will go into other productive things that people want. As Blockbuster falls, something else people want will rise. And, at the margin, lower costs mean that there should be more movies made per dollar spent.
I think this pattern might hold elsewhere, too. Since getting a Kindle e-reader in June, I’ve read more books than I did in the entire year up to that point.
Although costs aren’t falling yet – it’s a proprietary Amazon device, and they’re keeping the costs high while subsidising the cost of the device itself – the shift to e-readers means that authors will eventually be able to bypass publishers and significantly increase their profit-per-purchase. Like the rise of Netflix, this will probably mean less money spent on overheads and more spent on actual content.
Recall that those who defend copyright laws on utilitarian grounds argue essentially that the purpose of granting creators a temporary monopoly license is to ensure that people have an incentive to create. This being the case, one reasonable proposal to be offered to the utilitarian sect of copyright defenders is to decrease creators’ state-granted monopoly powers as technological innovation increases.*
Technological growth reduces publication and distribution costs for creators, enabling them to not only sell directly, but to increase their profit margins while decreasing prices. As such, monopoly protections are less necessary (if not altogether unnecessary) in the face of technological growth because technology makes it easier for creators to turn a profit, which, it should be remembered, is the whole point of having copyright laws in the first place. Thus, if creators can make a profit without doing much to protect their product, then it seems obvious to conclude that copyright is largely unnecessary, and certainly does not draconian enforcement.
Note: Software is a nebulous entity that is somewhere between copyrightable and patentable in terms of classification. As such, it is not covered under this proposal because it would drive this proposal. If it absolutely must be given IP status, it should be considered its own entity with longer terms than patents but shorter terms than copyright. Furthermore, it should also have the novelty prerequisite of patents. Given the complexity of this subject, though, this discussion is best reserved for another post.