Back for another thought-provoking conversation with The Gold Report, John Embry sees both good and bad news in the weeks, months and years ahead. For example, John— Sprott Asset Management's chief investment strategist—is braced for "an ugly summer," with "another significant test in the equity market." Before year-end, he anticipates $1,500 gold—but also the beginning of worldwide hyperinflation that may take many Americans by surprise. And while John is bearish on world economies for the next few years, within that same time he looks toward "numerous 5- and 10-baggers" among small-cap gold producers and junior explorers with solid projects.
The Gold Report: Quite a bit's happened since the last time we spoke with you back in September of '08. Gold was $874 at that point, and then dropped considerably in Q4. It has come back in '09, trading in the range of $850 to $950. Is gold still tethered to the dollar?
John Embry: I don't know that it's tethered to the dollar per se. Basically, there's a major problem with the dollar. I believe it is absolutely fated to fall dramatically against everything, but more against real assets than against other currencies. When I look at the other currencies, they don't look very good either, particularly the Euro and the Japanese yen.
They're trying to create the impression that paper currency is still good; so they go out of their way to try to pound gold at every opportunity. A week ago, clearly gold was tethered to the dollar on the downside, but on the other hand, for the prior few weeks when the dollar was under enormous pressure, there was still restraint in the gold price. It went up, but it should have gone up a lot more. They put pressure on to keep it from going up too much, and with an opportunity for a stronger dollar, they knock gold down. It's been the same format for a long time. But we're getting close to the end of that.
TGR: Why's that? What's going to push it over?
JE: There's no question what's going to push it—the realization that the U.S. is broke.
TGR: Who doesn't realize that already?
JE: Well, 90% of the people don't. Ask the average citizen. They don't have a clue what's going on.
TGR: So we need the public to figure this out.
JE: Absolutely. The U.S. budget deficit is going to be 13% of GDP. That's unheard of for the world’s reserve currency. There's no way you get out of that easily.
TGR: But most people aren't in the market anyway, so why would their realization affect the price of gold?
JE: Oh, it's not them; it's the people with the money—the people in the Far East and the Middle East. They will just want out of currency and as quickly as possible.
TGR: Why aren't they buying gold now?
JE: They are. They've already started.
TGR: So why hasn't the price gone up?
JE: It has gone up. But the fact is that, with the paper gold market, if you look at the short positions that the commercials, that the bullion banks, which are the agents of the U.S. government are running, it's a complete fraud.
TGR: How so?
JE: Because they couldn't possibly deliver on their paper promises if they were called by the people on the other side of the trade. The gold isn't there to deliver. They've cleaned out most of the western central banks. So we're real close. I think gold will be $1,500 before the end of the year.
TGR: When we had the last spike in gold back in 1979 and 1980, was that predominately U.S. individuals or were people buying it globally?
JE: It was more U.S. then because, at that point, the U.S. was still the richest nation in the world. Now, the money has gone primarily to the East. They're the ones that own all the dollars and the ones becoming more and more concerned about it. This charade with Geithner over in China, what a joke that was. He spoke to a bunch of students, who broke out laughing when he said the Chinese assets in the U.S. were safe. He couldn't even fool the kids.
TGR: But as you point out, so many American people—the clerks at the checkout stands, the butcher, the teachers—don't know what's going on.
JE: They don't. What will inform them is the inflationary impact that will really start chewing into their standard of living if the dollar falls the way I believe it's going to. That hasn't happened yet.
TGR: But U.S. unemployment hit its highest level in 25 years last month. Isn't that chewing into their standard of living?
JE: Yes, for people who have lost their jobs. However, 9 people out of 10 still have their jobs and are pretty much maintaining their standard of living. That will change if the dollar falls to the extent that I expect, which will be fairly precipitous.
TGR: If you project gold going to $1,500 by the end of the year, are you projecting that the inflationary period will begin before the end of this year too?
JE: Not in a dramatic way. It will be in the early stages. This obviously presupposes that the dollar will fall in that environment, but yes, as the dollar falls, you'll start to see more inflationary implications in my opinion. There will still be a lot of people out of work and it will start affecting those who are working. I think that will have a rather negative impact on the overall U.S. economy as well.
TGR: What are the implications of all of this on investments, be they in gold or whatever else?
JE: Personally, I have a significant proportion of my own wealth in gold and gold shares. I like most hard assets. What I wouldn't own are financial assets, such as bonds or bank deposits—and certainly not banks and financial institutions. If what I foresee comes to pass, there will be rewards for being in hard assets. That will protect you.
TGR: Will any particular catalyst make the populace wake up and realize that the jig's up?
JE: It's more an issue of the confidence of the people who have to buy the dollar to keep everything afloat. That's the Chinese, the Japanese and various entities around the world. The U.S. budget deficit is so huge that if this plays out, more people are going to start to realize that when the U.S. is forced to monetize the debt, they’re printing money and creating the backdrop for considerable inflation.
TGR: It's like the ultimate negative amortization loan. The balance just keeps getting bigger and bigger and bigger.
JE: I know. I debate with people who are deflationists; we talk about it all the time. I could see the thing going to deflation, if this all fails and the whole thing just kind of collapses. But I am from the school that if you have a total fiat monetary system, which we have today—there's nothing backing anything anywhere—you can create as much as you want out of thin air. The U.S. has done a pretty good job recently, trying to fight off the financial issues over the last 12 months. The amount of money created is really something.
TGR: Isn't that true of practically every other country on the planet?
JE: Yes. Other countries don't want their currencies to go up sharply against the dollar, so they're forced to print their own currency to try and support the dollar a bit. That leads to sort of a global inflation, which I think is the ultimate outcome. That's why I love gold.
TGR: Jim Dines' newsletter recently had a chart of all the global markets, and they're all up like the Dow and the S&P—everything across the board. And people like Ian McAvity, Rick Rule and others are talking about this as a suckers' rally, and saying that we're going to have another big drop.
JE: I think it is a suckers' rally. One of the things driving it up is obviously excess liquidity being put into the system. But on the other hand, a lot of people think this rally is for real and that because the market's up, the economy is going to recover. I think the economy will have a minor recovery, but not nearly enough to support the levels equities have already achieved. So I agree with as Ian McAvity and Rick Rule and that gang that we will see another significant test in the equity market. This could be an ugly summer.
I don't see any easy way out of this employment (or unemployment) problem that we're confronting, either. I think that's going to be ongoing, and again, more and more people out of work isn't particularly bullish for the overall economy.
TGR: What do you see the economies doing globally?
JE: I see some sort of minor recovery. But if a recovery were to have any robustness, interest rates would rise sharply, and with debt levels still excessive, higher interest rates would put a very quick end to it. Consequently, I don't think we can have sustainable growth any time soon. Instead, I think we'll see periodic rallies followed by further downdrafts. So I am not bullish on the economies for the next few years.
TGR: Not even China?
JE: They're pumping it up so badly that they may have an inflation problem sooner rather than later.
TGR: What will come first—the market braking or the dollar falling? Or will it be simultaneous? Is there any correlation there?
JE: Well, it's interesting. Right now, it almost looks like the whole system's trading on an algorithm because when the dollar goes up, equities go down and bonds go up. In the fullness of time, conceivably the market may brake first, and the dollar may come afterward.
TGR: When the market brakes again, will it be different from last fall?
JE: That perfect storm of negativity will not happen again. That was about as bad as it gets. I had an interesting anecdotal experience last week. I saw a wealthy acquaintance for the first time since the depths of the market decline. At that point, he was morose. Now he's absolutely ebullient, thinking the higher market is just great, nothing but blue skies ahead. I think that's a bit of a theme out there. Later that same day, I ran into a good friend, one of the better proprietary traders in Canada. He was making the same points that I am. He thinks this summer is going to be extremely ugly and that the public has it all wrong. Before long, we will see who's right.
TGR: So it could get ugly but you think not quite as ugly as last fall?
JE: Not that ugly. In terms of gold and gold shares, particularly, that was the cleanout that got rid of everybody who didn't really know the reason for owning them in the first place. I'd never seen anything like it, to be quite honest. I was dumbfounded. The fundamentals hadn't changed much, but perceptions did. And people threw the baby out with the bathwater.
I actually bought a lot of gold at that point. I bought some shares, too, and already have a couple of five-baggers.
TGR: On that note, what stocks you would have our readers look at today?
JE: I don't do a lot in stocks any more, but I wouldn't change many of the ones I picked last time. Wesdome Gold Mines (TSX:WDO), for example, has done well. It was driven down to as low as 40 cents in the doldrums last fall, and it's traded up to $2 recently. In the gold market I see, Wesdome will make an awful lot of money. It made 8 cents per share in the first quarter, and that's what I want. I want something in production and in a safe geopolitical environment. If I'm right on the gold price, there are so few good vehicles that they will attract a lot of money.
The larger ones—such as Barrick Gold Corporation (NYSE:ABX), Goldcorp (TSX:G) (NYSE:GG), Agnico-Eagle Mines (TSX:AEM), etc.—are all expensive. You have to own them if you have a large portfolio because you can't get enough into the smaller ones. That's why they will become even more remarkably overpriced.
TGR: Are there any other smaller production companies in safe geopolitical environments that you like besides Wesdome?
JE: I like Lake Shore Gold Corp. (TSX:LSG); I own a lot of that. Colossus Minerals Inc. (TSX:CSI) down in Brazil, Andean Resources (TSX:AND) (ASX:AND) in Argentina, and a number in Canada, such as Rubicon Minerals Corp. (TSX:RMX) (NYSE.A:RBY) and Premier Gold Mines Ltd. (TSX:PG). The list unfortunately isn't as long as you might think. Some of these aren’t in production yet but possess exciting ore bodies.
TGR: What would you advise investors who are just coming into the gold market?
JE: I was responding to a questionnaire recently about how to construct a gold portfolio in today's market. If you're being relatively conservative, you would always have a solid core in bullion. I don't mean ETFs. I mean real bullion or a vehicle where you can audit the fact that the gold is there and not just trust someone saying that it is.
TGR: How much would you put in that core holding?
JE: Physical gold would be 20% to 25% of my portfolio. But for the equities, as I indicated, I would not focus on the majors where everybody huddles and prices are too high. Instead, I would tilt my stock positions—the major weight of my stock portfolio—toward those small producers and explorers with legitimate projects that are reasonably advanced. Getting into the really junior explorers, you'd have to know the company to make sure you have a real asset to take advantage of the rising gold price.
TGR: So would you put maybe 50% of your gold investment in those smaller producers?
JE: Yes, small producers and advanced exploration vehicles. I'd put another 25% for the sake of stock liquidity into some of the big ones. The best of the big ones is Gold Fields Ltd. (NYSE:GFI)(JSE:GFI); given their reserve base, their discount for having half their assets in South Africa, and the fact that it's relatively very cheap.
TGR: But you see the real opportunities in the smaller stocks because that's where you get the leverage?
JE: You get huge leverage and, right now, the public isn't there in any big way. We've seen some strength recently, but nothing compared to what will happen if gold makes a clean breakout through $1,000 and really starts moving—which I think will happen. At that point, investors will want exposure and, quite frankly, the whole sector's market cap is so puny that it won't take much to really drive these stocks north. I'm quite convinced that there will be numerous 5- and-10 baggers over the next few years.
TGR: Even after the run-up they've had already?
JE: They're barely back to where they were a year ago. The big surprise is the degree to which they fell. And there's one other thing. What does $950 gold mean for gold equities? Believe it or not, $950 isn't a good price for the economics of gold mining. There's been a lot of smoke and mirrors about the economics of this industry. The fact is that it's still very expensive to mine and that is why gold mining production has been falling steadily now for three or four years.
I think it's going to take dramatically higher prices to lead to expansion of gold mining output, and when higher prices are realized, it will take years to achieve the actual higher output.
TGR: Where does that price have to be for it to make economic sense?
JE: I think at $1,500 you'd get good returns on the capital employed. This is a very risky, hard business; and if you're in it, you deserve to be rewarded for your efforts. If you look at returns on capital over the last 15 to 20 years, they're pathetic if there's any return at all. That's going to all change one day.
The thing that people have to realize is that the central banks and the western governments have made a concerted effort to control gold because they see it as the major competition for their fiat money system, which is failing. And when it fails—and it will—that's when gold comes into its real heyday.
TGR: You said you don't do a lot in stocks any more. Who's doing the day-to-day portfolio stock picking at Sprott Asset Management?
JE: Oh, we've got a great team—Charles Oliver and Jamie Horvat. They're absolutely outstanding.
TGR: And what are you up to?
JE: I spend most of my time studying the macro. It's a good time for that because I think it's going to be the thing that separates the men from the boys. For most of my career you could assume a relatively level playing field, but we're in a situation now that none of us has ever seen before. People are just throwing stuff at the wall to see what will stick.
I'm from the school of Austrian economics, and I basically believe that all economic cycles are credit cycles. We had the mother of all credit cycles. It broke, with far too much debt in the system, exacerbated by derivatives. There's no easy out. You can't just recreate what we've had because we overdid it. The idea that we can print ourselves out of debt is not going to work. It will lead to some sort of hyperinflation if it's successful, but the economy will be sloppy at best.
This is not novel thinking on my part. Just last week Angela Merkel, the German Chancellor, did something a German politician has never done before—she criticized central banks. She said what the U.S. and Great Britain and the European Central Bank were doing in terms of ‘quantitative easing,' which is just money printing, is wrong and won't work. In fact, it probably will exacerbate problems. I think Ms. Merkel must be a bit of an Austrian economist at heart and I certainly don't disagree with her.
But if they don't keep creating money, we will have some sort of deflationary event, and the one thing people remember clearly is the 1930s. Nobody thinks about hyperinflation very often, because very few have experienced it.
TGR: That's true. The poor souls in Zimbabwe.
JE: I don't think we'd ever get anywhere close to that on a worldwide basis, but we could certainly see some very unpleasant inflation as governments continue creating more money just to keep the debt afloat. Hyperinflations always have been contained within a region. Clearly I don't think a global experience would be as preposterous as some of the domestic, local hyperinflations but it would be worldwide inflation like we've never seen before. It certainly would dwarf what we saw in the '70s, which was pretty bad.
TGR: How high might the inflation rate rise worldwide?
JE: I don't know. It tends to be an accelerating factor; you can't get to 30% before you get to 10%. I think it's headed in that direction, but it will take a little while to stick. We're nowhere close to 10% yet. Ask me again when we get to that point.
I certainly can picture Americans taking it worse than a lot of other people who have been the underdogs over the last 60 years. It's a matter of relativity. In the post-war era particularly, America has clearly been top dog; and because of that Americans have been somewhat insulated in many ways. They can't imagine hard times. I don't think they really have any ominous sense that there's something going horribly wrong yet.
DISCLOSURE: John Embry
I personally and/or my family own the following companies mentioned in this interview: Wesdome Mines, Lake Shore Gold, Goldcorp.
I personally and/or my family am paid by the following companies mentioned in this interview: None
John Embry is chief investment strategist at Sprott Asset Management and Sprott Gold and Precious Minerals Fund. He also co-chairs the Central GoldTrust Board of Trustees. An industry expert in precious metals, John's industry experience as a portfolio management specialist spans more than 45 years; he's simultaneously researched the gold sector for 30-plus of those years. He joined Sprott in 2003, after 15 years as Vice-President Equities at RBC Global Investment.
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