October 31, 2012; John Embry – Gold Bull

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, it pays to talk to people who were alive and active during cycles that were similar to the one we are in right now. I am referring to gold in the 1970s. We saw gold rise from about $35 an ounce all the way up to over $800 an ounce. There are people who are alive and active in the market today, that you have been with this last week, who were actively participating back in the 1970s. Tell us about that.

David: Yes, I had a great time at the New Orleans Investment Conference and had a wonderful dinner with Rick Rule, Robert Prechter, David Tice, Ian McAvity – a whole host of folks who have been around long enough to see major trends and to be nuanced enough in their approach to have benefited, then, and now.

Painting an adequate picture is very important to us so that investors know where we are, and where we are going. Today’s conversation is a part of that. John Embry with Sprott Asset Management has been around and has seen and done a tremendous amount as it relates to the gold market, and to continue bringing in nuances and reinforcing where we are, and where we are going, we want to have that conversation with John today.

Kevin: John is known for putting his money where his mouth is. Wherever you see him quoted, he is giving quotations as to where he thinks the year will end, and it is usually bold, and he has been right over the last 4 or 5 years. David, I would like to hear your conversation with John.

David: John, we have spent more than a decade with prices of gold and precious metals appreciating. What would you say to the skeptic at this point? How much further do you think the markets can go?

John Embry: That’s an interesting observation because there have been so many skeptics for so long, and yet, gold is probably one of the few assets, if not the only asset, that is going to post a higher year-end close for 12 consecutive years, and that’s what seems to be in the offing at this moment for gold.

To me, the fact that they are still trying to paint it as a bubble is ridiculous. The fact is that gold is reasserting itself as a currency, and when you have all of the major currencies in the world subject to quantitative easing of some degree or another, to me, gold is just going nowhere but higher, and the pace of the ascent is probably going to accelerate.

David: One of the key observations we have made in 2000, 2001, and up to about 2009, is that central bankers seemed to think that it was truly a barbaric relic, and as fast as they could get it off their balance sheets, they would. Strangely enough, the emerging markets and those with decent dollar reserve holdings, are moving into gold, and instead of being net sellers, we now have net buyers in the central bank space. Do you think that is part and parcel of this “remonetization” or shall we say, it being treated as a currency?

John: I think that’s exactly what it is, and the fact is that one of the things that has kept pressure on the gold price, even though it has risen for 12 consecutive years, has been the relentless central bank not only selling, but leasing gold. It was almost exclusively Western central banks, and they were trying to protect their currency systems, allowing them to keep interest rates low and keeping their financial bubbles going.

But a spanner has been thrown into it by the Eastern central banks who were, as you said, very heavily invested in U.S. dollars. They recognized how vulnerable they are, and they are now trying to get off these dollars as quickly as possible. One of the avenues is to buy gold, and they are buying a lot of it.

It’s really quite an amazing turnaround because for years the central banks, I think, were supplying well over a 1,000 tons to the market through their leasing and selling activities and now, the Western central banks aren’t putting much into the market, and the Eastern central banks are taking it out to the tune of 400-500 tons a year, and the swing has been dramatic. I think this underwrites materially higher prices as we go forward.

David: The investment component is also significant and we would be remiss in not pointing out that in this last decade, as central banks have gone from liquidators to purchasers, private investment has actually eclipsed central banks in terms of total ownership of ounces or tons. What does that say about the investment community, the sophisticated large investors who prioritize gold? Could we view that as a personal gold standard since central banks don’t…

John: I think it’s just the early adaptors, the people that have figured out what is going on in the fiat currency system, and they are just running for cover as quickly as possible. At this point, I think, as I said earlier, the buyers have been the Eastern central banks and a lot of private investors in the East – China and India, for instance.

But we have sophisticated people in the West, large moneyed interests, who are starting to go in the direction of gold. We have seen some major names, like Bill Gross at PIMCO, who has been quite positive on the gold situation. John Paulson has been bullish, as well as the hedge fund manager, David Einhorn.

I think we are seeing sophisticated investors in the West, who know perfectly well where this is going, moving toward gold. I think this is going to be a phenomenon that will continue and that will be one of the major factors in driving the price much higher, and the thing that will lead to the parabolic up-move will be when the public, itself, finally realizes this is a good idea.

David: Amazingly, I think for many there is this conception that the public is in gold.

John: No, not at all.

David: Going back to the 1970s, if you looked at global equities, government debt, private investments, gold came close to 14% of the total value of all of those markets, so gold played a major dominant role in asset allocation within the market of the day in the 1970s. Today it’s between 2 and 2-¼%.

John: I didn’t think it was that high, but that would just be splitting hairs. The fact is, the public isn’t there at all. I’ll give you a perfect anecdote. My partner, Eric Sprott, went down to speak to a group of reasonably sophisticated investors outside of Toronto, about 100-120 people in the room. He asked the question at the beginning of his address, “How many people in the room own gold?” One person put his hand up.

So the idea that the public is invested in gold at this point is wrong. They aren’t. And that will be one of the big factors going forward. There is a lot of money on the sidelines that will come into the picture before this is over.

David: This is all demand-related, looking at either central bank demand, investor demand, or EPF demand. Maybe you can speak to the supply side. What are the trends that you follow from Toronto that would be important? Do you have anything that comes out of Toronto, a lot of financing?

John: There are two aspects, really. One thing that has been a bit of a deterrent to higher prices has been an enormous increase in scrap supply. I deal with a chap who is in that area, and he tells me that the public is desperate for cash and they are bringing in every piece of gold jewelry, anything that has gold in it, and melting it down. But that has a finite life. I’m told that they did the same thing in Portugal, and now they’ve pretty well cleaned out the populace.

I don’t see that as a long-term issue, although it has been a bit of a short-term deterrent. More important is the mine supply, which is 2500 tons, give or take. This is where it is open to considerable debate. There are a lot of people who think mine supply is going to rise materially as the price moves higher, but I don’t think so, certainly, in the next five years, for several reasons. Clearly there are geopolitical issues. We have seen these issues down in South Africa where there has been enormous production interruption.

But the other thing that is going to be difficult, is that there are not a lot of new large ore bodies being discovered, and anything that is being discovered, particularly if it is out in a reasonably remote area, the cost of bringing this stuff into production now is enormous. So I would daresay that if five years from now the gold price is, just for the sake of argument, twice where it is now, I don’t think mine production will be up at all. I think it will still be stuck about where it is today. So I see nothing alleviating the shortage of gold from a rising demand coming out of the mine side.

David: On the mine side, we have $200 an ounce, which was the cost to mine gold 10-12 years ago. Now, as I understand it, it is over $1000, maybe even pressing $1300 dollars an ounce on average. You are right, there is not a lot of motive for ore bodies to be brought into production, because we are not talking about tremendous return, looking at R&D and everything that goes into bringing something on line. I guess the big issue is that we haven’t seen major ore bodies discovered.

John: That’s an excellent observation. Most of the stuff that is being discovered is in the neighborhood of existing mines. There are very few what I would call greenfield discoveries. One of the problems is that where these things may occur, it is often geopolitically questionable. I remember being involved with a situation in Ecuador where they found, I would think, probably the biggest virgin ore body in the last 10-15 years, but it still hasn’t gone anywhere because the government down there has gotten in the way. I don’t see additional mine supply being any sort of a factor in suppressing the price going forward. I think we are going to have major physical shortages.

David: By geopolitical, a part of what you are saying is that it is just a less friendly geography. You can’t ramp up production. There are no Nevadas waiting around in the wings that are very open to a robust and mature mining industry getting going.

John: That’s correct. They are finding ore bodies in Eritrea, Ecuador, and all sorts of exotic places where you would never go for a holiday. It’s really hard, particularly in a difficult economic environment where governments need every cent, to get a fair regime that is going to treat a mine fairly, because they see the mine as being on their property. So I think that from an investment perspective, I am much more comfortable in places like Canada, the United States, and Australia, and the like, where there is the rule of law and a long history of respecting people’s property rights.

David: So far in the conversation we haven’t talked about quantitative easing. We haven’t talked about monetary policies, or fiscal policies driving the gold price. The back story is really something very basic. If you go back to Econ 101, it is supply and demand, that simple, then you have the icing on the cake. You can speak to that, whether it is the fiscal cliff or monetary policies that you see accelerating that.

John: You have identified the single most important factor in why people should own precious metals. There is a finite supply of precious metals, as there has been through all of history, and right now we are in yet another experiment with fiat paper currency where we have gone too far, and the only solution to keeping this thing afloat and moving forward, is quantitative easing to infinity, as my friend Jim Sinclair said, and I agree with him. I think that if they were to turn the taps off, and if they were to, heaven forbid, raise interest rates to any extent, the economy would literally collapse. And since nobody wants that to happen on their watch, what is going to happen is more and more quantitative easing in all of the Western countries, and to me, that means that there will be competitive currency devaluation going on everywhere. And gold stands out as a beacon of safety in that type of an environment.

David: This may be playing a little bit of devil’s advocate here, but going back ten years ago, maybe a little bit more, China and India were not quite the dominant force in the gold market that they are today. They have just about doubled their presence in the gold market, even while the U.S. and the Middle East have cut their interests in half. One concern would be, with the slowing global economy, with the idea that Chinese GDP is not growing gangbusters at double-digit rates, do you think that could have a negative impact on the gold price?

John: No, I don’t, for the simple reason that the Chinese have a vested interest in making sure that their economy moves forward, and certainly doesn’t lapse into a Western style decline. To do that, they will create more and more money, which I think will be inflationary. I think the Chinese public already has a healthy distrust of paper money, because that is where it was invented. So I don’t see that as being a deterrent, really. I think it is almost in their DNA, owning gold. Unless things were to just flat-out collapse, which might have a small deterrent in the short-run, I don’t see that as a factor at all.

There are two environments in which gold really shines. One is the obvious mounting inflation as the paper is debased. The other one is deflationary collapse, because at that point, nobody wants to really be comfortable with bonds or stocks or anything in that environment, and gold will, in that environment, emerge, too. So as long as you don’t have long-term disinflation as we had from 1980 to 2000, which was a terrible period for gold, and we aren’t going back there any time in my lifetime, certainly, I think the environment for gold is terrific.

David: That begs the question, in terms of a timeframe. For me, I think we have gone so far. Going back to what we talked about earlier, we have been in a bull market for 12 years. We have seen nearly double-digit growth rates for 12 years. The question of sustainability – maybe you can shed some light on what a commodity supercycle looks like. When one of these markets gets into motion, how far does it tend to go?

John: In this instance, when we are comparing it to paper currency, which is in a state of terminal decline, I think it is very hard to put an upside on this. I could tell you $10,000, but that’s not important. I think the key is to realize that it is in an upward trend, and the upward trend is going to accelerate, and I don’t know where it is going to go in terms of U.S. dollars, or any other currency on earth.

All I know is that it is going to go up a lot from where it is, and I think we should focus less on the actual numbers than on the parabolic trend that is coming, and the fact that so few people are there. There has probably never been an asset on earth that has gone up 7-fold, and everybody is disdainful of it. It is amazing. If the stock market had acted like this over the last 12 years, people would be falling all over themselves to get involved. The average person doesn’t have a clue. It’s amazing.

David. It is also interesting to see gold as a less correlated asset, though I wouldn’t say noncorrelated.

John: I would say it is noncorrelated certainly to financial assets unless you would say it is an opposite correlation.

David: And in that case, doesn’t it, with time, have even greater appeal to an investment community that is looking at paper assets and saying, “Maybe we need something different?”

John: Without question. You see why I am so optimistic right here is the very fact that this phenomenon hasn’t even started yet.

David: And it is the central bankers who are in the fray today, you think the investment community tomorrow, and perhaps the man-on-the-street still out there on the horizon?

John: Absolutely. I had a friend who was certainly a huge player in the 1970s. He said to me a long time ago, “John, the public won’t even notice this stuff until it’s over $2500.” I kind of scoffed at him, but you know what? He was right. (laughter)

David: It’s shocking. When you compare the options that investors have, as the Dow has moved to 13,000 and above, it has captured their imagination, and certainly, the idea of 15,000, 18,000, 20,000 on the Dow – it’s almost like the guy who wrote the book over a decade ago calling for 36,000.

John: The 36,000 guy, I know.

David: Maybe someday. But between now and then, we have had the Dow-gold ratio collapse from 42 or 43-to-1, down to about 8-to-1 today. What do you think is a reasonable relative relationship between paper assets and gold? Could the ratio go negative?

John: I think it could go negative, but I have no reason to believe that it won’t do what it has done several times in the past, getting down somewhere between 1-to-1, or 2-to-1. The question you can debate is whether the Dow is going to go down a lot so gold doesn’t go up as much, or if they are both going to go up, except gold is going to go up 6 or 8 times as fast.

It is interesting that you should bring that up, because I used to give speeches 8-10 years ago to disbelieving audiences, and I was using the Dow-gold ratio. At that time it was around 25 or 30-to-1, and I said, “This thing is probably headed for 2-to-1.” And they would just look at me like I had two heads. And guess what? We are already down to 8-to-1 and they still don’t get it.

David: And the amazing thing is that if they are doing the math, going from 42 or 43-to-1, to 8-to-1, which is a five times increase in purchasing power, but the difference, even on the conservative side, to 2-to-1 from current levels, is a greater increase than what we have seen over the last ten years.

John: I know. And I believe fervently that is going to happen. There is one other aspect that we haven’t even dealt with, and it is a huge part of the whole equation in my mind, and that is the fact that there is an enormous amount of what I would refer to as paper gold out there – ETFs, pooled accounts, gold certificates – and it is backed by a minimal amount of gold that has been hypothecated and re-hypothecated so many times that nobody knows who owns what.

But there is probably a $100 claim on every $1 worth of physical gold, and I honestly believe that before this thing runs its course, a lot of people that are holding paper gold are going to be disabused of their belief, and they are going to be forced to move toward the physical, and that is going to be one of the real catalysts to driving this price dramatically higher.

David: John, it is interesting you mention that, because this last week I spent some time with a trader, an options and futures contract trader who does this professionally in Chicago, and in his 25-year career he has had one client take delivery of 100 ounces of gold. Everyone else was content to hold warehouse receipts.

John: Just trading paper and making it make more paper. I think that will change.

David: He had never gone through the exercise. In 25 years in the profession he had never gone through the exercise of helping a client take physical delivery of gold.

John: That is correct.

David: It was mind-boggling. I thought, “You have to be kidding. Surely there are more people who, when they trade gold, every time they have a 100-ounce profit above and beyond what they want to keep and roll forward, look at their profits and say, ‘Hey, why don’t you send me 100 ounces?’” And he said that no, this was the first time in his career that anyone had taken 100 ounces off the exchange.

John: Well, that’s interesting, because I believe that is just starting. I’ve been told by several people in this kind of a position that there is interest now, that people are becoming a little queasy about their paper gold vehicles, and at the margin they are starting to sell them and look for real physical gold, or in the case where they have the right to demand delivery, they are doing that, too. In its massive stages, I think, given the number of claims there are on the average ounce, I think that this is going to be an enormous contributor to much higher prices.

David: John, we have a company in Europe, as well, and we have seen a huge retail demand for gold in Europe, for obvious reasons. It is now no longer an imaginative, hypothetical risk, out there on the horizon, but in real time people are concerned about what is going to happen to their savings should they put them in the local bank, and they are coming up with a solid no as an answer. Certainly, they have seen declines of 60%, 80%, even 90%, in certain equity markets in Europe, and they are concerned there, too. What do you think will drive the U.S. investor to an awareness of gold?

John: I think there are two things. I think everything is just on hold right now for the election, and once that is behind us they are going to have to confront the fiscal cliff, and I don’t quite know what they are going to do. But if they were actually to address it and take an enormous amount of stimulus out of the economy, I think the economy might collapse, so I don’t think they will do that. I think then there will be another increase in the debt limit, and more and more people will start to realize that there is no solution to this.

And then, I think there is a very real probability, at some point in time, that the U.S. stock market is going to quit levitating, and if it were to take a real smack, I think at that point there would be more interest in protection and things like gold.

David: Back to that issue of noncorrelation, 2013-2016 could very well be the day that the U.S. balance sheet has been in the limelight, the U.S. investing public is drawn into gold in a real way, at least the investing community, if not the man-on-the-street. Any parting shots, any parting comments?

John: I think for sure that is going to happen. I happen to believe, and I don’t think it is accidental, that the focus has been on Europe. We have had the U.S. ratings agencies cutting all the rankings in various European countries and their debt. What this has done is to keep the focus off the United States, which has rolled merrily along without any attempt to control its budget deficits, and I think that it is an insoluble problem now. The lines are too far apart between revenues and expenditures.

The focus is going to come back to the United States, particularly when we have to deal with the fiscal cliff and debt limits. At that point, conceivably, there will be a percentage of the American public that says, “Oh my goodness, I need some protection.” I think that could be very positive for gold.

David: Looking at the sociological, psychological dynamics, you were very aware and very active in the last bull market in precious metals in the 1970s and early 1980s. What years do you think serve as a parallel to right now?

John: Where are we now? I would think it compares to 1974-1975 maybe, when we were going through a difficult period, maybe a little later, but most people forget that the vast move in the gold price came in the last year-and-a-half. For the longest time it languished between $200 and $400, and messed around there, and then all of a sudden between 1979 and 1980 it roared out there to $850.

We aren’t there at all yet, and I think that the next step will be, as we talked about earlier, that first we will get more of these investors in, and then eventually the public will get in, but that will be sort of the equivalent when that happens to what happened in 1979-1980, except this time the problems are far worse. There is less physical gold available, so I think the upside move will be, believe it or not, even greater.

David: And it argues that the parabolic move, however far out it is, how short the timespan may be, is particularly rewarding to someone who has a reasonably low-cost basis.

John: I have always said to people throughout this entire bull market that this market is interfered with quite regularly. I have never recommended buying particular strength, particularly if the open interest has grown a lot on COMEX. But if you just dollar-averaged, or bought obvious periods of weakness, and bought physical, you would put in position a wonderful inventory at great prices. At this point I would continue to do that, but at some point it will break away, and at that point people are going to have to chase it. But it hasn’t happened yet. You can pick your spots and just keep buying.

David: It is interesting that you mentioned dollar-cost averaging. I’ll let you in on a family secret. My dad is notoriously bad in timing, and he made the mistake at buying at the peak at $400, made the mistake of buying at the peak at $700, made the mistake again of buying at the peak at $900, and again at around $1100. He keeps on buying at exactly the wrong time, though I look in retrospect and say that I’m glad he is consistent. I’m glad he is consistent. Building a position over a long period of time, doing so on a dollar cost-average basis, in anticipation of a parabolic move…

John: There will be a huge move. If you are not on margin, and I always recommend to people to eschew margin, do not go near margin in a market that is this volatile, intentionally created. You have a position you can always maintain, and when you have excess cash and there is an opportunity, buy more, and I think that you will be in perfect position when the big move occurs. I suspect that will happen probably within the next 12-18 months.

David: We have been doing this commentary for five years, and I think you have been on at least five times. We appreciate your addition to the conversation. You bring sage insight and we always enjoy having you in on the conversation.

John: It is my pleasure. Any time you want to chat, you know where I am.

David: Thanks, John. We will be coming to Toronto soon.

John: Okay, take care.

Kevin: David, John is always a fascinating conversation, regarding gold. I also know that silver factors into this. Gold, of course, is more consistently rising. It is more predictable because it is a longer-term type of hedge, but silver factors into that, as well. We have watched the gold-silver ratio, and a lot of people are starting to eye silver right now because of the ratio. Would you comment on that?

David: Kevin, in our conversation with John, we were talking about paper currency as being in terminal decline and that being reflected in the price of gold. When you are talking about paper currency, the flip side of that is a hard currency like gold. Gold is the currency of kings, silver is the currency of the common man, and we are going to see silver move in lockstep with gold. I have said before that it would in fits and starts, but certainly, following the same trend. At a 53½-to-1 ratio today compared to gold, silver is likely to outperform handily.

The reality is that we look at precious metals not as a speculation, we are not in the contest for what performs best, we are just wanting to preserve assets and insure family net worth from one generation to the next. Having said that, if someone does not own silver, they should. Having said that, if they own too much silver, we don’t like that, because it truly is something that is more volatile, and will tend to give you more heartburn as time goes on, so for someone who has a cast-iron stomach, perhaps that is appropriate.

But our view is that it needs to be in the mix in precious metals. Our conversation with John today had to do with gold, primarily, but our position as a company is that silver is incredibly bullish and may be the investment of the decade.

Kevin: David, you said it right when you said that silver is more volatile, but I really appreciate what John Embry had to say about margin. We talk about trying to get more gain on something that we are speculating in by putting it on margin, but the problem is that they are so volatile, both gold and silver, and these markets are so unpredictable in the short run, that it can really burn you.

But what is amazing about the gold-silver ratio that I have always loved is that it has the same effect of margin in increasing your overall balance sheet, without putting you into a margin situation. Explain the ratio trade, that sometimes it is appropriate to have more silver, and sometimes it is appropriate to have less, but you actually, in a way, leverage your growth.

David: You and I have talked about never falling in love with an asset, and I think to be overly bullish on silver, or overly bullish on gold, should not be in light of the metal itself, it should be in relation to something else. And the reality is that if it is a better value, then it deserves an emphasis. If it not as good a value, then it doesn’t deserve an emphasis. That is why the historic relationship is so important to us. The average, for the last 200 years, has been 31-to-1 on the silver-to-gold ratio – 31 ounces of silver equals 1 ounce of gold.

Because it is in the 50 range, that speaks very loudly that silver is undervalued relative to gold. It shouldn’t take so many ounces of silver. In essence, you are getting 40% silver for free, when you are looking at that historic norm, not bringing in the Hunt brothers days, not bringing in a 15 or 16-to-1 ratio, which is a very popular dimension, but what I would say is really a long shot.

We know the in-ground numbers, we know the last few years have come out closer to 12-to-1, but still, we think the conservative number to shoot for is closer to 30-1. Having said that, we are only interested in silver because it fits that value equation. If it were overpriced, if it were a different number relative to gold, we might not even mention it.

Kevin: David, this goes back to a correct allocation with the whole portfolio. We have talked before that you always want to try to have one-third of your total liquid assets in precious metals, and then of that one-third a varied mix of gold and silver, sometimes more gold than silver, sometimes more silver than you normally would, relative to gold. In this particular case, we are saying it may be time to look at the allocation.

David: In final thought, I think John’s comment about us moving toward the parabolic move in gold would imply significantly higher prices, and I think silver is in that same step forward. But I want to caution investors to not be thinking with great excitement and enthusiasm about what that would do to improve their balance sheet, because the reality is that you have a harder decision.

It is not as important that you have already said yes to owning gold and silver, it is more important that you consider what you do as prices get to peak, and even unsustainable, levels. We don’t know if that is two years from now, or seven years from now, but this is where I think a mature investor begins to make the decision ahead of time: How many ounces of gold do you want to hand on to the next generation? How many ounces of gold will be enduring in your portfolio? The ones that exceed that amount, those are the ones that you need to be willing to let go of at some point.

Our suggestion of a reduction strategy – not an exit, but a reduction strategy – is absolutely paramount. Are we implementing that today? Emphatically no. But you have to process these things intellectually before you get to make the decision emotionally in a very difficult moment. That is why we think you need to be thinking ahead, even though there is a lot of enthusiasm and excitement about the way the next few years may shape up for us as precious metals investors.