Gold Avalanche Note: This article from Rick Rule is a must read in our opinion, given today's volatile investing environment. The Key is this: if you bought something for $1 because it represented good value, and it further declines to $0.70, buy more of it, because now its undervalued and it gives you a chance to average down your costs. This strategy assumes that you have done due diligence in figuring out the value of the company (or index).
Source: Special to The Gold Report (3/28/12)
Global Resource Investments Founder and Chairman Rick Rule is worried
about the impact trillions of dollars of manufactured liquidity will
have on global markets. In this summary of his recent web broadcast for The Gold Report, he outlines his new strategy for staying above water for the volatile 3–12 months he sees on the economic radar screen.
To put that financial influx in perspective, Rule got down to basics. "What is this liquidity?" he asked rhetorically. "There is an old-fashioned name for things like quantitative easing, it's counterfeiting." He estimated that the U.S. government is receiving in tax about 40% of what it spends. It is funding the other 60% either by issuing debt or through printing, which means it is spending money it creating out of thin air. "Is this good or bad?" he again asked rhetorically. "I think it's bad, but it's good for the market. The result of this has been extraordinary liquidity available in the banking sector that would otherwise probably be broke."
Rule also noted that creating currency results in very low interest rates and big opportunities. For depositors this means "a war on savers." When savings accounts pay 5 basis points, but inflation is running at 500 basis points, the result is lost purchasing power at about the rate of 5% compounded per year. He pointed out that the consequence of not rewarding savings or lower risk investments like bonds is that people are forced into the equities markets. "The central governments are forcing you to take more and more risk with your money and alter your investing—this is very bullish." He called the $8T in investable cash on the sidelines in the U.S. "a tremendous pool available to invest." Most of this money, if interest rates were to rise, would probably remain in cash or go into bonds, Rule explained. But as a consequence of very low interest rates, institutional investors who have been bobbing on the sidelines with their cash started dipping their toes in the market in the last three to four weeks. "Traditionally, this institutional capitulation has short-term market tops. So, it wouldn't surprise me to see this general securities bull market roll over, although I'm consistently a skeptic on markets that I think are driven by liquidity rather than markets that are driven by earnings," he cautioned.
Rule outlined the negative impact of manufactured liquidity-driven economics. "First, stressed, very stressed public sector financials. We mentioned earlier that the federal government is earning, if you will, through taxation, about 40% of what it spends. Don't try this at home. The idea that over time a nation will be allowed by its trading partners and the savers in other countries to take in $0.40 in revenue for every dollar that it spends is nonsense. It's not going to happen. If you did that at your house—take in $100 thousand (K) a year and spend $240K/year—it might be fun for a year or two, but the party would come to a screeching halt. Eventually this public sector party will come to a halt whether or not the party is taking place in the euro, the dollar or the renminbi," he warned. "The idea that these governments are spending substantially more than they're taking in provides near-term liquidity that provides long-term risk."
The second outcome, Rule said, is stressed private sector banking balance sheets. He pointed to European banks that are broke as a consequence of owning too much sovereign debt from countries like Portugal, Italy, Ireland, Greece and Spain. "These banks are zombies. They are walking dead. They are kept alive by official sectors supporting Europe. They have already effectively been nationalized and will increasingly become political organs of central governments. These are the same central governments, by the way, that ran up unsustainable debts—not a particularly pleasant outcome."
The third and the scariest outcome of all, according to Rule, is the moral hazard. "There has been a suggestion in markets for 10 or 15 years that investors, corporations and governments can take leave of their senses, participate in leveraged transactions and stay in overpriced markets because ultimately the Fed or its foreign counterparts will bail them out with liquidity. What this has done is create an inverted pyramid of risk where very little equity is evidenced across very large balance sheets."
The result of all of this liquidity in the system, and the confidence this liquidity has bred, along with the low interest rates and the fact that this liquidity is being forced into equity at the same time that we have these systemic risks and malfunction, will be unprecedented volatility, Rule concluded. "For substantial periods of time in this calendar year you'll see the volatility index (VIX), above 30%," he predicted." Volatility is not a bad thing if you're prepared for it, but you as investors and speculators absolutely need to be prepared for it," he warned.
How should a smart investor prepare? Rule counseled investors to remember that volatility is not risk. "If you are of an opinion that a stock is worth $1, and you own the stock for $1 and you see a decline in price to $0.70, this decline is not a bad thing. The dollar bill went on sale, which is a very good trade. If, conversely, you see a stock that is worth $1 and it trades up to $1.30, that is not a good thing unless you are quick to sell." The trick is to make money buying and selling investments by buying low and selling high. The market is a facility for doing that; it's not a source of information, Rule warned. "If you look at volatility to confirm your bias about valuations, you can and will be hurt. If you develop information yourself concerning the value of assets and simply use the market to buy things cheaply and sell them when they become expensive, you will have a very good year indeed."
Rule also cautioned about the threats and opportunities inherent in black swan economic risk and political risk. "None of the conditions precedent to the psychotic break that we saw in the market collapse in 2008 has been addressed with the single exception of public sector liquidity." From the U.S. to Iran and Europe to China, Rule warned that he sees a flock of potential black swans on the horizon that could test the confidence created by all this liquidity. "Who will win the dumb presidents contest between Iran, the U.S. and Israel and could it escalate into a nuclear confrontation?" he asked. "What will be the next domino to fall in Europe? Ireland? Spain? Portugal? Will Germany have another failed bond auction because everybody understands that the Germans will be left to hold the bag, and the wage-earning and tax-paying Germans are not particularly happy about this set of circumstances? Will China have a hard landing?" A lot of potential challenges could shake people's confidence, he warned and the result of the crisis in confidence would be a psychotic break in markets. This could be either a penalty or a huge boon to the individual investor depending on what measures are taken in the coming weeks.
Rule believes the resource bull markets are still very much intact still. He pointed to a 20-year bear market in resources as a powerful force to create a bull market in capital-intensive, cyclical businesses. That bear market constrained investment and hence constrained supply. In today's tight credit markets with historic underinvestment in resources, we are going to have supply constraints for up to seven years. At the same time that we have constrained supply, we have increasing demand brought about by low relative pricing in natural resources and increasing political liberalization in emerging markets where increasing incomes at the bottom of the demographic pyramid will lead to outsized increased demand for food and stuff. "Remember this always: the cure for low prices is low prices. The cure for high prices is high prices. Markets work," he said.
One example of market balance at work is high natural gas prices that plagued the country only eight years ago. Congress sought a political solution to the crisis until the market took care of it, investing in new technologies and eventually delivering the record low prices now challenging energy investors. "God knows what the price of natural gas would be if Congress had actually acted to save us from ourselves," Rule speculated.
Rule next pointed out that junior stock valuations and senior stock valuations in the sector are reasonable, perhaps not cheap, but reasonable. "The big constraint we had in 2009–2010 is that although the macro-conditions were good, the micro-conditions were lousy because the stocks had run so far. That corrected itself. The valuations are at least reasonable now." He cautioned that junior market capitalizations are always overinflated because 80% of listings have no value whatsoever. All of the value and all of the performance in the sector over time is exhibited by a very small subset of companies. That is why investors have to be very careful about where they put their money in the sector. All the performance will be contained within a very small subset of stocks.
One thing Rule suggested for the first time in years is that as much value may now be in the large-cap and ultra large-cap sector as in the small-cap sector. He also spoke positively about private placements. "We think this year will be a very good year for the private placement business because when the junior equity market went soft in 2011, many of the issuers deferred financing, waiting for higher prices, but they didn't defer expenditures. They acted like many governments, spending money that they didn't take in. I call that financial roulette." Companies engage in a circular and dangerous practice of spending money to generate news to generate enthusiasm to generate higher share prices so they can raise money. They are spending money to raise money. "That's wonderful if it works," he said, "but the probability of it working is very low. My suspicion is that they were able to get away with that last year because of the large amounts of money that they were able to raise in 2009 and 2010. That party also is coming to a halt. These issuers will be forced to come into a market to raise money.
Whether or not they are able to raise money on terms that suit them will really be a function of the market conditions at the time." That is where the volatility Rule warned about comes into play. "We will see situations where select issuers that are of high quality find a market unprepared to finance them. These are spectacular opportunities for investors with the knowledge, courage and cash to act. You see, for people who write checks, bad markets are good, and good markets are bad. Our job is to allocate cash to undervalued assets, something that doesn't happen in a strong market."
Rule also predicted a lot of takeovers in the next 18 months. "An unprecedented number of companies, probably 70 or 80 in the gold and energy sectors in particular, have added a lot more value in the past two years than the market has been giving them credit for," he said. "I think it's unlikely that those stocks will rise this year as a consequence of institutional participation because I think institutions will experience disintermediation, meaning that money will leave the institutions and they won't be able to buy it." Instead, Rule speculated that the buyers for these stocks will be other companies in the industry that have the sophistication to understand what they're actually worth and the cash to effect a takeover. "I would be surprised if in the next two years we didn't see 50 or 60 takeovers in the junior space, which would be a 300% increase over the annual level of amalgamation we've been seeing in years past." Investors who get in place before the takeover premium is paid will likely experience a bump both in the shares that get taken over and in the shares of the company that does the takeover, assuming that the acquisitions are attractively price. This is a phenomenon Rule calls "a truly a virtuous circle."
Finally, Rule shared his derisk strategy. "When you have a situation like this when some of the best companies in the business are attractively priced, it often suits you to derisk by buying the best companies in the sector. This will be particularly advantageous this year, ironically, precisely because of that volatility," he said. The obvious reason is because it is easier to determine relative valuations on larger companies; it is easier for investors to take advantage of discrepancies. But a more important reason, according to Rule, is that investors can sell the very volatility that is causing this opportunity. He gave an example. Suppose you think X,Y,Z Resources is worth $20/share and you sold the market the right to make you buy more at $17.50 for 90 days. It might be in a period of high volatility that the market would pay you $1 to make you buy more of something at $17.50 that you were happy to own at $20—not a bad trade. Conversely, the market might pay you another $1 for the right to make you sell the stock that you had just paid $20 for, for $22.50 in 90 days. In other words, there would be a $5 space between the put and the call that you would own for $2. If the stock didn't move, you'd get $2 in 90 days, reducing your basis from $20 to $18. Or, the stock you thought was fairly priced at $20 and you bought at $17, less the put premium of $1, less the call premium of $1 could result in a $15.50 price. This is the stock that you thought was attractively priced at $20—again, a good trade. Or if the stock goes up, it's called away from you at $22.50, but that isn't what you get. You get $22.50 plus the $1 put premium and the $1 call premium. In other words, in 90 days, having bought stock for $20, you get $24.50. "Allowing the market to pay you to do something that you would otherwise rationally do for free is a very, very good strategy," Rule said. "This is a strategy that we're going to be emphasizing in the next year. You have a choice with volatility. It's going to occur. You can be a beneficiary of it or a victim of it. The choice is yours."
Rule's final conclusion for keeping your portfolio above water: "Expect volatility. Expect political insanity. Expect a better junior market than you think. Expect a junior market where 80% of the stocks go down because they aren't worth anything, and 20% of the stocks do a better job than you think they are going to do. Expect to have opportunities in private placements, of the kind that we haven't seen in two or three years. And expect larger stocks to do relatively better than smaller stocks provided that you handle the volatility by selling puts and calls."
Founder and CEO of Global Resource Investments (GRI), Rick Rule began his career in the securities business in 1974 and has been principally involved in natural resource security investments ever since. He is a leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture. Rule's company has built a sterling reputation for its specialist expertise in taking advantage of global opportunities in the resources industries. Last month, Rule closed a landmark deal with Eric Sprott, another famous powerhouse in the arena. With GRI now a wholly owned subsidiary, Sprott, Inc. manages a portfolio of small-cap resource investments worth more than $8 billion and boasts a workforce of more than 130 professionals in Canada and the U.S. This article is based on Rule's March 27, Q1 2012 Market Commentary.
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