Marketdepth

Morning on Howe Street

It’s morning again on Howe Street.

That’s right, Howe Street, the ancestral home of “pump and dump,” is rising again.  This time, however, it is not the push of aggressive promotion, but the powerful pull of fundamentals that is creating opportunity for our city’s most notorious industry.

Precious metals are soaring as gold and silver become re-established as monetary standards.  Base metal demand is set to expand rapidly in the large-population economies of Asia and South America.  Metal stocks are cheap compared to bullion prices.  The world economy is desperately short mine production.  These are the opportunities Howe Street exists for.

Figure 1: The Exchange Building on Howe Street – Early Days 
 

Howe Street’s resurgence, and the return of the speculative mining issue to mainstream portfolios, will create bountiful profits for some.  Others will make losses.  As we head into another potentially euphoric period for mining equities, it may help investors to recall a little history. 

Howe Street, The First Generation 

Until the mid 1960’s, the Vancouver Stock Exchange existed as a sleepy regional market, focussed largely on timber companies.  That changed with the strike in 1965 of a rich lead-zinc deposit in the Northwest Territories by the interestingly-named Pyramid Mines Ltd.  The company’s stock which, for its time, was relatively widely held across Canada, shot from 25c to $22 almost overnight. .  Ultimately the company was sold to a senior entity, Pine Point Mines, for $33 million.  [While that doesn’t sound like much, recall at the time that a Big Mac was 15c and Berkshire Hathaway stock was trading at $18.]  

The Pyramid Mines discovery started a bonanza that brought mining investors and promoters from around the world to Vancouver.  Amongst these was the inimitable Murray Pezim, formerly a Toronto-area butcher, who quickly became Howe Street’s promoter-in-chief. 

For a while, the momentum was unstoppable.  Buy orders placed in the morning showed profits by the afternoon.  Cars stopped in the middle of Howe Street as drivers rushed into the exchange building to place trades.  

Buy on Mystery, Sell on History

And there were other successes.  Carolin Mines was another 40-bagger gold discovery.  Dia Met and Diamond Fields also worked out well later on.  But unfortunately, Howe Street’s reputation was made mostly by the scam artists who preyed on the gullible in the decades following the Pyramid Mines success. 

The schemes were often “close-ology” plays, with promoters staking nearby tracts to large discoveries.  “Wash trades” within a close circle of insiders would drive up prices steeply in advance of the release of bogus drilling results.  Hapless investors would buy in at the peak, only to watch share values plummet.  Insiders profited from outsiders.  It was the Vancouver way. 

But by the 1980’s the inflationary fundamentals that had underpinned Howe Street’s rise went into reverse.  In the era of 20% interest rates, bonds and blue chips were far better values than $800 gold bullion or junior gold speculations.  The Dow Jones Industrials grew by more than 10x from 1982 to 1999, while the VSE Composite index tanked.  Initiated at 1000 pts in 1982, the VSE Composite closed in October 1999 at 395. 

And in 1999, just as bottom of the gold cycle was being reached, Howe Street’s exchange was disbanded and merged into the CDNX.  Ironically, the end of the VSE marked the point of extreme fundamental undervaluation of this city’s mining juniors.  Alas, by 1999 those who understood the fundamentals were so discredited that no one would listen.  Buy on mystery, sell on history. The strategy of the know-nothing retail investor was ultimately applied to the VSE itself. 

What to do now

In the last ten years mining stocks have recovered and the safe money has been made.  However, my read of this cycle is that a speculative blow-off phase lies ahead.  The gold market didn’t spend 20 years bumping along around $350 per ounce to stop at a mere quadrupling, in my view.  

Likewise junior mining stocks that can deliver reserve growth breakthroughs appear to be very fertile territory.  I spend time these days looking at the tier of juniors just below the size of companies that are eligible for the exchange-traded funds.  Within this class, companies with capable management teams and decent properties should be the basis of a portfolio that can properly capitalize on the return of Howe Street.  

I’m doing my own digging into junior miners with potential, but if any of the esteemed readers of this blog have particular names they think I should investigate or avoid I’m all ears.   

 

Change We Can Believe In

Every good skier understands snow.  Why should good investors not understand money?  This thought occurred to me as I listened to various reactions to the US Federal Reserve’s announcement of phase two of its “quantitative easing” program. 

No longer shrouded by the fog of crisis, “QE2” has laid bare the Fed’s dollar debasement strategy.  The government of the United States is now funding its entire $100 billion per month budget deficit through printing money to buy its own bonds.  Were it not for the necessity to ensure that Wall Street’s bonus pool stays filled, the Federal Reserve might as well cut out the New York middlemen and just dispatch trucks around the country loaded with “Benjamins.” 

The investing playbook for this era of quantitative easing is fairly straightforward.  Avoid anything that looks like a government bond and buy things like wheat and silver which represent relatively cheap, hoardable commodities. 

Figure 1:  Silver Quarters – Change We Can Believe In

  

But while hoarding is definitely the best investing play of 2010, it does strike me as a rather dubious long term economic strategy.  Can the troubles of excess debt and inflation be addressed by bringing back the gold standard?  Absolutely, I say.

Canada and the Gold Standard

Many people do not realize that this country has a long history of operating on a gold standard.  Canadian dollars were exchangeable into a specified quantity (23 grains of gold or 4.7 hundredths of a troy ounce) from the 1850's through to the outset of Word War I and also for a period following that War. 

Between 1933 and 1971, Canada ran on a kind of second-hand gold standard, under which the government committed to maintain the C$ value in a range relative to the US dollar (and the British pound in the early part of this period).  The US dollar was in turn fixed to gold at $35 per ounce.  Under the post-WWII Bretton Woods system, Canada and other countries maintained a virtual peg to the US dollar.

The beginning of the end for Canada’s gold standard came on December 23, 1966.  On that day, Mitchell Sharp, Canada’s Minister of Finance announced that coins of the 10c, 25c and 50c denominations would no longer be cast according to their long-standing mix of 80% silver and 20% copper.  Given that the price of silver had by then caused the coins’ metal value to pass through their face value, Sharp presented to Parliament an amendment to the Currency, Mint and Exchange Fund Act which would eliminate the use of precious metal.  By 1968, the deed was done.  Canada's silver coins were removed from circulation in favour of the slugs that continue to be stamped out by the Mint at the cheapest practical cost. 

By 1971, America's massive borrowing to fund the Vietnam War eventually led President Nixon to abandon gold convertibility of the US dollar in 1971.  Canada's implicit gold standard, already imperilled by the end of silver coinage, died simultaneously.  So if you ever wondered who really decided that Canada should have completely faith-based fiat currency, the answer is Richard Nixon.  Did I just hear someone say, “Only in Canada?”

Gold Standard Benefits

The benefits of a gold standard are simple, but unfortunately a significant period of time is required to demonstrate them.  For this reason many countries have been forced to learn the same lesson over and over again.  Fiat money leads to inflation, wealth destruction, and ultimately, chaos.

The most important feature of a gold standard is that the supply of money, and credit, can only grow in proportion to the speed at which total gold reserves can be expanded through the acquisition of mine output.  Given that we already have many centuries worth of production stored above the surface, this effectively limits the growth of money at most to a few percentage points per year.  With credit growth thus constrained, the emergence of debt-fuelled bubbles such as the dot-com fiasco or the various housing bubbles would have been well-nigh impossible. 

The allocation of resources in a society on a gold standard involves choices made in plain view of market participants.  In a fiat world, bankers and speculators can conspire to build huge asset valuations backed by easy credit.  When the inevitable crack-up follows, a government must choose between a prolonged deflationary recession or a bailout.  Under a bailout, all the bubble’s non-participants pay by pro-rata dilution of their monetary assets.

The hidden cost of fiat money is a long-run reduction of capital investment of any kind.  Investors, burned by confiscatory inflation, become hesitant to make long-term loans at any price.  The economic troubles of Latin America over the past three decades has its root causes in undisciplined fiat money regimes.  And as the West’s currency and sovereign debt problems now demonstrate, there is nothing fundamentally different about fiat money north of the Rio Grande.

However, if one were trying to fix the problem, as opposed to merely profit from it, there is of course a somewhat different prescription required.  Here is my best guess at how we might proceed.

Five Not So Simple Steps

The way out of the mess begins with 1) a recognition that the debts are too big.  I laid out some of my homework on that topic here.  The next step 2) would be to apply some kind of haircut to outstanding debts.  The better places to take the haircuts would be at the levels of private and sub-national debts, so that Canada as a nation might remains a somewhat creditworthy entity.  I would suggest forcing banks to take an across-the-board haircut on consumer debts and mortgages.  Other sub-national governments might also be moved to haircut their debts to the extent that they are not manageable. 

What cannot be achieved through debt writedowns could also be achieved through step 3) a co-ordinated, one-time emission of fiat cash.  If we want to extinguish the provincial debt of Quebec, for instance, it could be bought back with a load of freshly printed fiat cash.  It would be important that the emission of fiat cash be a one-time measure.  Another key step in the process 4) would be in the significant reduction in unfunded entitlement programs that would put Canada on a more sustainable go-forward fiscal footing.  Finally, we would reach step 5) the critical part of this process, which would be a permanent fixing of the currency of a newly solvent Canada against gold.  What the exchange level might be would depend on circumstances at the time.  If it were to be done today, the fix might be applied at C$2500 per gold ounce.

Harsh medicine, indeed.  It would make the imposition of the Goods and Services Tax look like a walk in the park.  Yet the alternative, to do nothing and twist into inevitable chaos, seems far worse.  As an investor, my bets are placed squarely on the do nothing option.  But as a citizen, I recognize that there is a plan that could pull this country from the chaos of a broken fiat money system.  Can we really leave this purgatory of excess debts and phoney cash for “change we can believe in?”  The answer is obvious.  Yes we can. 

The Value In Silver

Every good carpenter understands a little about wood.  Pastry chefs know flour.  Perhaps it stands to reason that investors should also think a little about money.  We live in a curious age, where money is intangible and created at no apparent cost by governments and their central banking bureaucracies.  It was not always that way. 

Figure 1:  If Money is Made for Free, Why is a Dollar Worth a Dollar? 

  

Prior to 1971 most wealthy countries issued scrip backed at least in principle by gold or silver.  However, today’s investor has precious few “hard currencies” from which to choose as a store of wealth.  In 2009, I see no government paper as attractive as silver, which may now be the world’s most undervalued currency.

 

That silver is a currency, of course, is a point of much contention.  Although accepted as such for thousands of years – to the extent that the word for silver, argent, literally means money in our country’s other official language – many investors think of silver’s monetary significance as a mere remnant of a barbarous past.  It is possible, however, that we are confusing fundamental debasement with technological advance. 

 

Growth in Money Supply, Shrink in Silver Supply

 

Since 1980, the supply of currency, bank deposits and other cash-like financial assets that the US government calculates as M2 has grown between five and six times.  Zero-maturity money has grown by over nine times.  The St. Louis Fed website offers wonderful charts outlining the spiraling growth in these monetary aggregates.

 

In lock-step with this increase in money supply, salaries, house prices (even now), stock market indices and many other assets have risen in sympathy.  Some factors have risen more quickly (baseball salaries, for instance, are up 22X), while others have risen more slowly (a brand new Pontiac is only up about 5X).  However, silver prices are actually lower in 2009 than they were in 1980, when the metal traded hands at an average price of US$20 per oz.  Adjusting the start point of this analysis can offer somewhat different results, but it is very difficult to conclude other than silver has lost considerable value share over the past few decades.

In stark contrast to the growth in money supply, the “silver supply” has been shrinking.  In 1975 silver inventories were 5 billion ounces, currently they are down to about one billion ounces.  Mine production has not kept pace with silver consumption.

Silver vs. Gold

A straight comparison against gold is also flattering to the pearly metal.  If we look back at historic money systems, the ratio of value between gold and silver was usually between 10:1 and 20:1 in favour of gold.  If one considers the ratios of physical inventories, then the scarcity factor is even less favorable to gold.  There is actually much more physical inventory of gold than there is of silver (5 billion oz of gold vs 1 billion oz of silver by one estimate).  While much silver exists in the form of cutlery and jewelry, it would be surprising to see that supply rush into the market unless prices were much higher.  Given this historical relationship, and the inventory levels, the current price relationship is surprising.  On yesterday’s fixing it took about 65 silver ounces to buy one gold ounce.

 

Weakness in silver has been partly due to the metal’s diminishing industrial use in the area of photography.  However, photography’s share of silver end use has already declined from almost a third of demand to about ten per cent.  The industrial use of silver is now far more prevalent in growing applications relating to electronic components, data storage and batteries.  An average cell phone, for example, contains about a third of a gram of silver.

 

As an overall proposition, silver at $14 per ounce seems to be a solid investment.  Compared to holding a bond denominated in paper currency, for which the marginal cost of production is zero, and the ultimate security of which depends on the success of heavily indebted western governments in holding back the forces of compound interest, holding a little silver seems like a fairly rational long-term diversification.

What to own

For the truly paranoid, nothing beats physical silver, preferably buried in a number of small quantities at locations known only to the holder.  However, for the foreseeable future, ETF’s are likely to do the trick.  The i-Shares Silver Trust (SLV) seems to be a pretty reasonably priced offering.  There are double-leveraged long and short ETF’s which have the unadvertised effect of magnifying longer-term gains and losses beyond the 2X factor due to their daily rebalancing.   I would tend to avoid these.

 

As for a target, how about 20:1 gold to silver?  At today’s prices that would imply about $50 per ounce silver.  That would be well within the bounds of historic precedent.