Whether it be financial, political or social, there’s the potential for any decision we make to be fueled by emotion. In particular, when participating in a high risk, high reward area of the market, like the junior resource sector, it can be lethal to your odds of success.
In my experience, those who can use arithmetic as their primary “truth” are the best at eliminating bias and reducing the amount of emotion contained in an investment. Today, I have for you an interview with a man who uses arithmetic to construct, what I believe, is the most compelling argument for gold that I have ever heard.
This man is Trey Reik, a Senior Portfolio Manager with Sprott USA. Reik is a commentator on gold markets and monetary policy, including policies and actions of global central banks, global conditions for money and credit, and factors affecting supply/demand conditions for gold bullion.
I first heard Reik speak at the 2015 Sprott Natural Resources Symposium in Vancouver, British Columbia. From then on, I’ve always paid attention when I’ve heard or seen the name, ‘Trey Reik;’ there’s a lot you can learn from him, especially when it comes to his commentary on gold.
Without further ado, a conversation with Trey Reik.
Brian: In my view, we live in a society of paradigms or bias that lock us into thought patterns that keep many of us blind to other alternatives – alternatives that may be more efficient or beneficial.
In reference to financial markets and in particular gold, in your opinion, how does one keep an open mind and see through paradigms and their own inherent bias?
Trey Reik: I think that a lot of what’s been going on, at least in markets since the turn of the millennium, so the 2000s, is that we’ve hit a period in which central banking has become probably the most important variable on the investment landscape, and I would add much more important than it should be. This has really cast a prism or a rose-coloured glasses view of what’s really going on in the world. It has, I think, relieved people and investors from reality, to a great degree.
Let me just back up a teeny bit, and talk about it from the perspective of gold. Number one, I’ve given probably 1,000 presentations about gold over the 15 years in which I have been covering it, and I’ve never once convinced anybody to buy gold. I don’t expect to change people’s views today any more than I did yesterday or last month. Number two, gold’s a funny topic because almost everybody has an opinion, generally unburdened by a real strong command of any relevant underlying fundamentals or facts. Third, gold has more investment queues than any other asset with which I’ve been involved over my career.
Some people think it’s an inflation hedge, some people think it’s a deflation hedge. Some people think gold is a risk-on trade, other people would look at it as a risk-off investment. When we have stress in the financial system, some people would view gold as a safe harbour. Other people would still favour the US dollar, although far fewer than would have made that determination say, in 2008. Given the negative reflexive relationship between the dollar and the US gold price, you could actually have a situation where stress in the financial system has a reflexively negative impact on gold.
Now, I went through all of that because my gold thesis is a little different than most. I don’t really think gold has much to do with CPI-type inflation. The way I would pose this is that if the price of hedonically adjusted hot dogs in Houston goes up, why would you buy gold? I don’t really see a strong connection there. Another way to look at inflation is if the prices of goods and services go up for healthy reasons, like a strengthening economy, I’m not really sure the price of gold should go up any faster than say, thumbtacks. If the inflation is of the monetary sort or variety, then I think gold should logically do a lot better.
Now, over the last 17 years, gold is up in 14 of those 17 years and has amassed a compound annual return since year end 2000 through year end 2017 of just about 9.5%. Actually, 9.65%. Over the same 17 years, the compound annual return of the S&P 500, including reinvestment of dividends was 6.32%. Gold has significantly outperformed the S&P with reinvestment of dividends for 17 years and is up in 14 of the 17. Now, if gold is up in 14 of the 17 years, it proves my point that it’s not related to some of these knee-jerk reactions that get ascribed in the press all the time to gold investors. In other words, we’ve had periods of inflation and periods of deflation over that timeframe. We’ve had round trips in equities and commodities. We’ve had yields on both the short end and the long end, largely falling over the timeframe, but we even had periods like June of ’04 to June of ’06 where the Fed raised rates at 17 consecutive FOMC meetings and quintupled the Fed funds rates from one-percent to five-and-a-quarter-percent, and gold went up during that timeframe by as much as 86%.
My point is, for gold to do as well as it has for so long, posting the best performance of any global asset, there’s obviously something more going on. I think what that is, is that at the margin, we have about $280 trillion now in global financial assets, and each year, in my opinion, my thought experiment, if you will, is that a very small portion of that global wealth seeks a home in hard assets, things that can’t be debased or defaulted upon, things that can’t be printed. That’s why fine art, in my opinion, has done so well over a period that has not exactly been exhibiting breakneck growth, but nonetheless, the art market’s been on fire. Things like Honus Wagner baseball cards, fine Bordeaux wines, all that kind of stuff has done really, really well.
Gold has benefited, I think from that migration. Each year, we have a different rate of migration from the financial asset pile to things like gold, and in certain years, that migration may have even reversed, like 2013, for example. The whole gold thesis is about that rate of migration going from say 1/10th of 1% to say, 1/2 of 1% ’cause 1/2 of 1% of $290 trillion is $1.45 trillion. The available gold stock is about $2.8 trillion. $1.5 trillion isn’t going to get into $2.8 trillion without a serious price dislocation.
When you talk about paradigms or things being misleading or that type of thing, although that’s a leading, almost political kind of question, I think the biggest misdirection, I think, of markets is the degree to which certainly over the past three years especially, but over the last 17 years, how big a part of financial asset valuations has become central bank policy.
Now, to back this up to two weeks ago, I think most of the market still believes that this disturbance that we had is–just as when we had the crisis of 2007, ’08, and ’09—the first words out of people’s mouths are always, “It’s contained.” Just as we thought in 2007 that the disturbance was limited to subprime mortgages, we are currently, I think, a large percentage of folks would say that the current disturbance is limited to a very small group of perhaps leverage, but certainly a short bet on the VIX. I look at it very differently. I would suggest that after nine years of ZIRP and QE, but 17 years of egregious central policy and interventions really starting with Mr. Greenspan, the entire financial system has been imbued with this short-volatility way of looking at the world. I’m sure given your situation, that you’ve read Chris Cole’s stuff from Artemis, but he’s the Michael Burry of this trade. You remember Burry was the guy that figured out the subprime-short trade for Scion Capital in the movie The Big Short. Coles is, I think, the Michael Barry of this trade. If you’ve read his stuff, he estimates that there’s about $2 trillion-worth of short-volatility exposures.
He’s got it all broken out in the stuff that he’s written. If you have about $2 trillion of exposures left, we haven’t even really started to scratch the surface of re-pricing things back to reality. I would say that in an environment of 0% interest rates and QE, we’ve lost the ability to assess the demand for anything.
People who laugh or criticize gold, like Warren Buffett–here’s a guy, he’s got more financial assets, paper assets than any other human being on the planet, or I guess Jeff Bezos might be up there with him now.Warren Buffett, who has more to lose from gold doing well than any other person on the planet, and ask him what he thinks about gold? But yet we do. When we do, he says, “Well, if you take all the gold in the world and you fit it on a tennis court, you got this big lump of gold and then in the other, box B, you could have five General Motors or GEs, and all the farmland in America, and you’d still have a trillion dollars leftover. Who wouldn’t pick box B?” The answer is anybody who thinks box A, which is all the gold in the world, is going to go up faster than box B.
We have a system where people think they have these franchises and these moats and all the stuff that Buffett writes about, and impenetrable franchises, but in fact, the denominator of all of these things, the unit of account, even if you’re talking about cash flow, is dollars. The one thing that is not stable as a unit of account is dollars, so no one really has any idea what the value of any of these franchises are.
If we normalized rates, and we took say, Fed funds to, well what’s normal anymore? We took them from 1% to 5.25% as recently as 2006, but if we took them to 4-5%, and we took the 10-year Treasury yield to eight percent, would the financial systems still be intact? I think the answer is no.
Until we can normalize rates, we don’t know what the list of Buffett’s companies–the Nebraska Furniture Mart and Wells Fargo and he just sold his IBMno one knows what the demand for anything is at these companies with this much monetary debasement.
Brian: Since 2008, I have personally suffered from being too pessimistic on paper currencies, mainly the U.S. dollar and risk in the broader market. Depending on perspective, this view both made me and cost me money.
Now, 10 years later, I have taken time to reflect on my investment choices and believe that bias or the so called “gold bug” in me prevented me from having a clearer picture of what was actually happening in the world.
However, I still believe that there is a price to pay for the massive amounts of money printing and low interest rates we have seen over the last 10 years. To me it is a “when” not “if” question.
My question for you is, has the “when” already occurred in the gold market? Meaning, realistically, should investors view the current gold price around $1300 USD/oz as the payback for the QE and low interest rates, or is the “when” still to come?
Trey Reik: I do believe there is no empirical equation that could generate a gold price that really means anything. The gold price is the reciprocal of your comfort with the financial system, the dollar, and central-bank stewardship. If you’re of the opinion as an investor that those three are fine, gold really serves no purpose. If you are like me, of the opinion that all three of those are deeply in doubt, meaning the value of the US dollar, debt levels, central bank stewardship, etc., then gold is a mandatory investment.
It doesn’t really matter if the price is $1,200 or $2,300, if those three issues are still a problem, you need to have gold in your portfolio. That’s what I was saying earlier; I have three litmus tests for when gold is a mandatory portfolio investment. I was sharing the first with you, which is whether you could normalize rates and then you have to decide what normalizing means. Let’s even call it 3% on Fed funds. I don’t think we can get there without a financial calamity or 6-8% on the 10-year Treasury. If you could normalize rates without big impact, gold’s role may have diminished.
The second litmus test would be if we take the ratio of debt-to-GDP, for the last 100 years the ratio of debt-to-GDP in this country has averaged 140-170%, except for two events. The depression and the Alan Greenspan/Bernanke/Yellen era. In the first example, we had GDP fall 50%, the debt remained constant, so the ratio got up to like 260%. FDR had to devalue the dollar and confiscate gold in the US and make it illegal, for what turned out to be 41 years. In the current environment, which is a numerator event, we’re just piling all this debt on top of relatively stable GDP. If we don’t get that debt-to-GDP ratio back to say, 200% from its current level of about 370%, goldwill remain a mandatory investment.
The reason is, that in order to get that ratio back into balance, the only two options are default or debasement. Each time the markets try to choose default, the Fed steps with QE1, QE2, QE3, Operation Twist, etc., and they will again. We’re either going to have 20 trillion or so of credit in the United States go away, or the other way to look at this is household net worth.
In March of 2009, household net worth, which is the Fed’s measure from Z1; basically it’s stocks, bonds, real estate, minus debt. Household net worth in March of 2009 was $54.79 trillion, GDP was $14.09 trillion. Today, household net worth is $96.94 trillion and GDP is $19.5 trillion. GDP has gone up $5.4 trillion from $14.09 trillion to $19.5 trillion, and household net worth over the same time period has gone up $42 trillion from $54 trillion to $96.94 trillion.
This means that over the past—let’s see, March of ’09, and now we’re in March of ’18, so the past nine years, household net worth has grown 7.77 times, or call it eight times faster than GDP growth. Now, the one thing I know for certain is you can’t grow wealth eight times faster than output forever. Once again, is gold necessary? Have we had the ‘when’ yet? Absolutely not. In the household net worth type of multiple to GDP, if you look at the 40’s, the 50’s, the 60’s, the 70’s, everything really through the 80’s, we used to have about a 3.5 times multiple to GDP and savings, is what household net worth should be.
Probably 30, 35, 40 trillion dollars worth of household net worth has to go away to get the system back in balance. This is like litmus test number two. We either need $20 trillion in credit, or $30-35 trillion in the combination of real estate, stocks, and bonds, (minus debt) to go away to bring the system back in balance. Until that happens, I think gold is a mandatory portfolio component because, once again, the only two options are default or debasement.
Then the third litmus test would be if we could get back to some sort of normalized GDP growth, and once again, we’re debating these days what “normal” is. Trends, capability, normal, say 3%, used to be 3.5%. We used to accomplish 3.5% growth with a savings rate, very importantly, in the 8-10% area. That would be healthy growth. It wouldn’t require the non-financial credit expansion that is now necessary to keep the debt pyramid from toppling, which is on the order of $2 trillion a year. Again, to review the three litmus tests would be normalizing rates without crashing the financial system, rationalizing the excess paper claims in the economy, whether it’s debt or the household net worth, and the third would be normalize GDP supported by savings as opposed to non-financial credit creation.
Unless you have basically all of those, or even two out of three, gold is still a mandatory portfolio investment, in my opinion. Which is, by the way, why even though it never gets any accolades, it is the best performing asset and is up in 14 of the past 17 years. That’s going to continue until we get the system in better balance between claims on future output and the future output itself.
Brian: Is there an event or series of events that would have to occur for you to change your mind about the long-term fundamentals of gold?
Trey Reik: One of the reasons that I’m as confident as I am is I’ve spent more time thinking about the underlying fundamentals than most human beings. There’s a lot of people that invest in gold for lots of different reasons, as we already discussed, but I’m not in that group. I’m investing in gold for a very specific tenant, which has to do with monetary variables and the claim on future output. There’s just too much paper claim out there. Until those imbalances are solved, one way or another, and I’m suggesting the only two solutions are default or debasement, there isn’t any other solution.
Well, the third solution would be we grow into it, but in order to grow into it, even if we had GDP at 10% for each of the next eight quarters, it would take GDP from $19.5 trillion to maybe $22 or $23 trillion, and that can’t support $66 trillion of debt any more than $19.5 trillion. Further, if the variables that I just gave you in the last 17 years hold anywhere remotely true, when we get GDP up to $22 or $24 trillion, the debt won’t have remained constant. It would probably be up seven times faster than the GDP growth. You can’t grow out of it, you’ve got to have default or debasement. These imbalances are so profound that I’m not swayed to change my mind at all, even by periods like September 2011 to December 2015, when the high tick for gold was 1911 down to 1050 because these imbalances are still there.
Over the past 17 years, by the way, people always ask when’s gold gonna do its thing? Or why isn’t it doing better?… My response is always, It’s the best performing asset on the planet for 17 friggin’ years. I’ll be fine if gold keeps performing just like this, you know what I mean?
Brian: Yes, absolutely.
Trey Reik: Now, you mentioned the currency thing. I believe all fiat currencies have become an extension of the US dollar. Currency people have to pick one of the seven or five, or however many you want to say there are. That’s a shell game, and that’s all fine. It has gone on much longer than I would have thought possible. It is amazing that 2008 was 10 years ago, and here we are, but things are starting to change.
People talk a lot about the dollar and this is just an interesting thing, if you take the 10 worst market days in each year and you look at those 10 worst market days, you’d have 50 if you looked at five years. From 2008 to 2012, the 50 days when the DOW dropped at least 100 points, the dollar tended to rally on those days. During those days, dollar index rallied 80% of the time and an average 0.6% on these bad days.
Now, if you look at the next five years, from ’13 to ’17, and we look at the 10 worst days for the DOW, the dollar fell on those 50 days an average of .3 and it only rose 26% of the time. What I’m saying here is we are and, by the way, what happened on those 2,000 point days, I think fiat currencies are starting to fail. That’s a bench-clearing statement, but I think it’s true. We are in the early stages of a potential currency collapse, and so we may be getting “there.”
Brian: In your opinion, is the investment thesis for only gold the same as the thesis for only gold mining companies?
Trey Reik: The thesis is the same, but the deployment or the execution is obviously tricky. Gold is the best performing asset on the planet, as I mentioned, since 2000. Gold equities have had three big runs. The three big runs in gold equities were November 2000 to December 2003, , May 2005 to March 2008 and then November 2008 to September 2011.
Now, ironically, each one of the three was within a month or two of exactly three years. I believe that gold equities provide unparalelled alpha when the faith in US financial assets is being recalibrated. We never want to say stocks could go down, so I’ve come up with that phrase.
If we look at November 17th, 2000, through December 2, ’03, the GDX was up 342%, the S&P was down 22%. The next three year period, the GDX was up 185% and the S&P was up 10%. Then, in the third, it was 309% versus 39.70%. Now, if we compound the advance of the GDX in those three periods, which by the way, is nine years out of the past 16 years, it’s a little over 55% of the time you get a compound performance of 5,081.61%. The coincident performance of the S&P, to the day, was 20.39%, which means that gold equities outperformed the S&P by a factor of 249-to-one in nine of the past 16.5 years.
Now, the problem is the corrections between those advances measured negative 36%, negative 76%, and then after the last advance, negative 86%. If you compound those declines, you get basically 98%. That’s why gold equities in December of 2015 were trading below where they were at the end of the first of those three advances, where they were in December of 2003. The GDM in December of 2003 was at 799 and we got down below, I can’t remember the number, but it was much lower than by the end of ’15. Are they motivated by the same investment thesis? Loosely, but the key with gold equities is, as I think you learned after 2016, neither gold nor gold equities are a permanent investment. They serve different roles.
With what we call the jaws-of- life of the inverse correlation between the S&Ps, since October of 2012 through to today, never having been wider. The last time it was this inversely correlated, gold stocks was like 1996 to 2000, and we all know what was happening then. When people get dumb about US financial assets, gold stocks have a tendency to get left for dead. Then, when the inevitable correction comes, and there were two since 2000. The first was 50.5%, second was 57%. As I’ve proved in the prior example, gold stocks have a tendency to provide among the best alpha available in any asset class.
While I think it’s been necessary to have a good bullion allocation consistently in the last several years, I think that now would be an example of the time period where it’s also incumbent to have a representation in the equities themselves. It’s because of the alpha provided if we have one of these recalibrations of faith in US financial assets, and secondly, simply because of the inverse correlation, which has opened to such an egregious degree between the S&P and gold equities.
Brian: It has been a pleasure Trey, thank you very much for taking the time to answer my questions!
The world’s politicians and a good portion of the mainstream media would have you believe that the actions carried out by the world’s central banks, mainly QE and low interest rates, saved us from the depths of what could have been a much worse situation in 2008. In my opinion, this couldn’t be further from the truth. While, it has taken longer than I have expected, there will be a price to pay for this poor monetary policy and, unfortunately, for those who are blissfully unaware, they will be rudely awakened, one day, when the market re-adjusts.
In my discussion with Reik, he cited three Litmus tests which can be used to gauge whether gold is currently a mandatory investment within your portfolio. Ask yourself:
- First, is it possible to normalize interest rates?
- Second, can the debt to GDP ratio be reduced back to historical norms?
- Third, is it possible to get back to normalized GDP growth?
If you can honestly answer even one of these questions with a ‘yes,’ first, I’m surprised and, second, maybe gold isn’t a good investment choice for you. In my mind, Reik presents a compelling thesis for the investment in gold and gold equities, making it a “when” not “if” investment choice for your portfolio.
For those interested in purchasing the physical metal, yet would prefer the convenience of purchasing it through the stock market, I highly suggest checking out the Sprott Physical Gold Trust, which is traded on the NYSE under the ticker PHYS, or the Sprott Physical Gold and Silver Trust on the TSX under the ticker CEF.
The Sprott Trusts offer a few advantages. First, they differ from bullion funds, in that all of the bullion owned by the trusts is held in the trusts’ allocated accounts in physical form. Second, all of the Trusts’ bullion is stored at the Royal Canadian Mint, a Federal Crown Corporation of the Government of Canada. Thirdly, for U.S. non-corporate investors who hold units for more than one year and make a timely Qualified Election Form submission, gains realized on the sale of the Trust’s units are currently taxed at the long-term capital gains rate versus the maximum applied to most precious metals ETFs and physical gold coins.
Additionally, I highly suggest following Reik’s market commentary by subscribing to Sprott’s Thoughts, one of the best sources of financial commentary in the resource sector. Also, I highly suggest attending the Sprott Natural Resource Symposium in July, where you will be able to see and listen to Reik in person, along with a fantastic group of speakers which includes Rick Rule, Doug Casey, and James Grant, to just name a few. I hope to see you there!
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Until next time,
Brian Leni P.Eng
Founder – Junior Stock Review
Disclaimer: The following is not an investment recommendation, it is an investment idea. I am not a certified investment professional, nor do I know you and your individual investment needs. Please perform your own due diligence to decide whether this is a company(s) and sector that is best suited for your personal investment criteria. Junior Stock Review does not guarantee the accuracy of any of the analytics used in this report.