In last week’s letter we recommended investors buy the U.S. S&P 500 for a rally. Here are some of the reasons behind our recommendations:
- The U.S. labor market is gaining some traction. Job creation is slowly turning up. We aren’t getting overexcited because once again the government is playing loose with statistics by failing to count those who have been unemployed for longer periods and classifying them as so-called “discouraged”. If we were to speak with those discouraged folks, we’re sure they would likely classify themselves as unemployed.
These individuals should be counted among the unemployed, and not discounted by government statisticians who may wish to paint a rosier picture.
- The current fiscal squeeze means more government layoffs and more difficulty in enforcing regulatory expansion. Government em-ployment fell by 12,000 in December. While we don’t celebrate any-one losing his or her job, one statistic we do like to see is government shrinkage. Federal, state, and local government regulation has become burdensome and harmful to the economy.
- Chinese monetary policy is loosening and providing more liquidity. This will cause growth within China, and China remains the primary engine of global growth. We’ll discuss this development further in a moment.
- Many other countries are also providing more liquidity as interest rates begin to fall in Asia and Latin America.
- Multiple backstops are being put in place to ensure that European banks do not fail. Some European nations may fail to repay their sovereign debt, but we believe that the European banking system as a whole will be saved. A stable banking system is a key to global growth. We’ve discussed this issue in detail in several recent letters.
Please refer to our archives for those details. To access our commentary archive, please click the following link https://www.guildinvestment.com/commentary/.
We See Sunshine Ahead, But Not Clear Skies
For one thing, don’t count out major turmoil in 2012, much of it originating in Europe. We expect some coun-
tries will opt out of the Euro-zone because the pain of compliance with European Community edicts will lead to depression-like economic contractions. Such contractions, in turn, will ignite public outcry and general strikes. We think more than one European nation will leave the Euro nest and when that happens the departing country will have to nationalize its banking system and start over with a new currency. Reneging on debt will make it hard to borrow. Services will be cut. Unemployment will rise to 20-25 percent.
Economic activity will slow to a crawl and become an extended depression. This type of event may frighten many observers. Some may predict a spreading economic decline in Europe and, beyond the Old World, a major depression for the entire world. We disagree! As long as the major banks in the global banking system are saved and the world banking system as a whole is held together, we see no worldwide depression developing. A nation with a stable banking structure that is part of the world banking system will be OK. It is only those countries who choose not to take the medicine of cutting costs and balancing budgets that will see their debt collapse in value and will see their economies fall into depression.
Healthy Banking System Trumps Government Solvency
In our opinion, the health of the world banking system is a transcendent issue, the magnitude of which is poorly understood by 99 percent of the people living on the planet. In many ways, banking systems are more
important to a societal standard of living than are the headline-making fiscal woes of nations.
Here’s what we mean by that. If your home country has the problem of sovereign debt defaults, your standard of living will suffer. But if your banking system fails, your standard of living is toast. Whether people like the idea or not, banks in the developed world and most of the developing world are totally braided into a global banking system. Every major bank in India, Brazil, Europe, Japan, and the U.S., and many other countries are tied into and relies upon the world’s banking system.
If the global banking system stays stable and solvent, your bank has a better chance to remain stable. If your bank remains stable, the odds are good that the economy of the country in which you live will continue to function normally.
If banks fail on a global scale, the consequence is an economic setback far more devastating than the average citizen can imagine. A failure of confidence in banks could lead to mass bank closings like those that occurred during the Great Depression of the 1930s in the U.S. Without banks, many common transactions cannot take place. Many businesses would have to close their doors. Unemployment would skyrocket. If the banking system does not reopen rapidly and begin to function normally, a barter economy would develop to replace the banking economy. Stop and think about how difficult life would be with a barter economy. Your life would change dramatically.
We are very concerned about the health of banks. This is why we dedicate so much space to this pivotal subject in our letters, and most recently to the efforts going on to support global banking.
India Watch: Markets Set to Rise
In terms of stock market valuation, Indian equities are among the cheapest in the world. Historically, when Indian stocks have fallen into the range of current levels
on earnings that means the market has outperformed developed and other developing markets. Why is the market so cheap? In addition to slowing global growth, the market has had the following headwinds:
- Big budget deficits caused by government subsidies for fuel, food, and other commodities ― the legacy of unwise
Fabian socialist practices put into place after the Indian independence decades ago. These slow economic growth.
- Very high inflation that is now slowing and will cause
interest rates to fall in coming months. Lower interest rates mean higher stock prices.
Due to lower inflation and lower interest rates ahead, we are recommending a buy of the Indian Stock Market.
We will measure our recommendation versus the Bombay Stock Exchange BSE 500 Index.
Corruption ― India’s Self-Destructive Addiction
Aprerequisite for consideration of the Indian economy is to understand the corruption culture that pervades most aspects of national life. India is a highly-bureaucratized country. Anytime you need the approval to do
something you have to run a gauntlet of bureaucrats. Unless they receive some favor, they will slow down your approval process or stop the process entirely. As examples, that means handouts to get government approval to buy a house, invest in land, or any activity that requires permits, or to register a business, start a new line of business, or expand a business operation. Corruption even extends to getting government officials to show up at their offices to manage the affairs for which they are paid and to get teachers to show up at school. Sometimes even to mail a letter.
The people of India are tired of having to pay somebody, or several somebodies, to get things done. This ruinous behavior affects everyone in the smallest villages or the biggest cities. The practice is unsustainable. Although corruption has a long tradition, the suffering public which has tolerated this gross inefficiency for years has been rising up to complain and demand that politicians do something. Religious and business leaders, social activ-ists, foreign investors and others are also raising their voices. Several high-profile figures have gone on hunger strikes. Hopefully, the corrupt political and bureaucratic classes will get the message and realize that reform
is necessary if the country is to ever to fulfill its great economic potential. Strong anti-corruption legislation is critically needed to stop the corruption and its drag on everyday activities. When that happens, India can count on a huge surge in foreign investments. But so far, the ruling Congress party has been unable to pass strong anti-corruption legislation.
At the very least, politicians need to remove some of the ponderous burden caused by administrative hurdles and make the environment more friendly to business. Even if they just dismantle some of the decades-old socialist economic practices, such as subsidizing prices for certain commodities, or subsidizing bank loans to those who cannot repay, then the vast but stifled industrious energies of India could be unleashed, and the Indian economy, standard of living, and stock market could move forward dynamically.
China is moving smartly forward to expand its money supply and increase lending capital to banks. To the surprise of many, Chinese banks made more loans in December than expected. Year-on-year loans grew by
about 15.8 percent. As we have pointed out in the past, credit growth is a key factor because Chinese growth is much more dependent upon available bank capital to make loans than many other economies. Two reasons: the bond market is small and undeveloped, and Chinese stock markets in Shenzhen, Shanghai and Hong Kong are not yet major sources of funding for the growth of companies.
December’s increase in lending was the result of the Chinese government doling out more reserves to the banks ―1.23 trillion Yuan (about $195 billion) ― and encouraging lending to small- and medium-sized businesses. When central banks increase liquidity to the banking system and encourage more lending, it is effectively engaging in a form of quantative easing (money printing). Money supply and bank deposit growth also rose stimulating loan growth.
Now that we see efforts by China to expand its economic activity and stimulate borrowing for business expansion, we expect more of the same going forward. China continues to be a VIP in the world economy. We expect
slightly slower economic growth rate in China for a few months followed by a robust expansion in the second half of 2012 as the money flow starts to have an effect.
Covering The Oil Front: North American Oil Taking Center Stage
We aren’t meteorologists here at Guild Investment, but we have learned to expect political heat and unrest to rise in the Middle East with cooler seasonal weather. That’s what’s happening now. Social turmoil
continues to simmer in Bahrain and boil in Syria. There’s escalating bickering between Shiites, Sunnis, and Kurds in Iraq. And, of course, there’s the endless threats and counter-threats between nuclear-bound Iran and the West.
The Middle East is all about politics and oil revenue. Looking ahead, we anticipate more political instability. The more intense the level of instability the higher goes the price of oil. So, any declines in price levels along the way should serve as buy signals for investors.
As far as oil production is concerned, regional turmoil has had a negative impact in several areas. Examples: Production has not returned to normal in Libya, Syria, and Iraq. Predictions of increased production in 2012 appear unrealistically optimistic to us. Both history and current events in the Middle East make it clear why major foreign oil investors are increasingly flocking to energy opportunities in the shale and oil sands of politically-stable North America. For instance, France, China, and Spain have enlarged their North American oil assets.
In just one day last week, Sinopec, China’s second largest oil company, committed $2.5 billion to partner with Devon Energy of Tulsa in five shale properties, and Total, the large French oil company, invested $2.3 billion in an Ohio oil and gas shale project with two American producers, Chesapeake and EnerVest. Not long before that, PetroChina, China’s largest oil and gas producer and distributor, spent $680 million Canadian to purchase the remaining 40 percent that it did not own of the Athabasca Oil Sands property in Northern Alberta.They now own 100 percent of the project. These are just two of numerous investments by Chinese companies in Canadian oil and gas enterprises over the last few years. Even Spain has gotten into the action. Just before Christmas, the Spanish oil giant Repsol invested $1 billion in a joint venture with Sandridge Energy’s oil acreage in Oklahoma and Kansas.
Where’s The U.S. Government In All This?
We would not be far off the mark to say, with disappointment, that Washington has its head in the sand. Politicians are under pressure from environmental groups to deny laying pipelines through the U.S. carying southbound oil from Canada. Some groups are also against hydraulic fracturing (fracking) for oil and gas wells (fracking involves applying pressurize fluid to fracture rock layers in order to release oil and natural gas for extraction).
While we support some of the environmentalist’s concerns, we remain confident that a factual debate will show that fracturing and pipelines are not sufficiently risky to the environment to warrant stopping them. It is high time for a serious and factual debate about the risks and rewards. The benefits include hundreds of thousands of new jobs, energy self-sufficiency, lower energy prices, and military energy security. Shouldn’t those benefits be priority items on Washington’s checklist?
It is obvious to us that nations put themselves in a stronger geopolitical position when they have access to large energy supplies. For example, Saudi Arabia wields significant influence in spite of its small population of only 18 million citizens (and 9 million guest workers). The Saudis have global muscle because of their energy reserves. Any country with energy self-sufficiency is much stronger than an otherwise comparable country with-out such self-sufficiency. That’s the geopolitical reality in today’s world. The U.S. should encourage the development of its oil and gas resources and those of its close ally Canada. If we ignore energy security now, we can count on future generations cursing our stupidity.
Among readers who may be members of Congress, the executive branch of the U.S. Administration, or in government positions at state and local levels, we sincerely appeal for reality ahead of politics. The oil and gas reserves in the U.S. and Canada should be valued at premium prices. Please wake up and approve the Keystone pipeline. The U.S. needs the secure and available Canadian oil. Do not encourage Canada to send its energy reserves to Kittimat in British Columbia for shipment to China.
Oil Investments
We like U.S. oil producers with strong current dividend yields and the probability of increasing yields in coming years as the price of oil rises. We additionally anticipate for capital gains as investors gravitate to
more high-yielding and energy-related securities. We may recommend some of them in coming letters.
Covering The Gold Front: Diagnosing Gold Mine Anemia
Gold mining company stocks performed poorly in 2011 while gold bullion rose in price. The price of gold
bullion has climbed for 11 years in a row and will, in our opinion, continue to rise for some time. Why the disconnect between the price of bullion and mining shares?
We see two primary reasons:
- The emergence of gold ETFs as an investment vehicle. The ETFs have attracted investors who might otherwise have bought gold mining shares instead of futures.
- The underperformance of the mining industry, a result of the difficulty finding new gold properties along with the rising costs of mining. Large companies have not had big success in finding new properties.
We’d like to expand on the second point, and specifically the need of big companies to make acquisitions of gold mining properties or related enterprises in order to grow. Often, it is less expensive to acquire smaller min-ers with attractive, underdeveloped properties than it is to find new reserves. Some smaller gold miners sell below their asset value and should rise as investors realize that the value of their reserves exceeds their market value.
In our experience, there are three key differentiators among small gold miners that explain why some stay small and others grow or become acquired. To be attractive, they must first and foremost be located in a politically-stable country. The government needs to allow the companies to keep a fair and reasonable share of profits for stockholders, while at the same time receiving satisfactory income from royalties, co-ownership, or taxes. From our perspective, we see strong, reasonable, and well-managed governments…as well as bad ones…on every continent. For example, we view Canada, Mexico, Australia, Chile, Colombia, Tanzania, Ghana, and Philip-
pines as reasonable. On the other side of the gold coin, we see Venezuela, Bolivia, Argentina, South Africa, Zimbabwe, among others, as unreasonable.
Going further in our analysis, let’s discuss three types of small gold mining companies that may be available for investment.
- Type 1
Run by promoters on sites with no proven or probable gold reserves. They have possibilities, hope, and some land, and may possibly produce gold. The challenges for these companies are finding gold, raising capital, and financing the company during the time it takes to bring any gold to market.
- Type 2
Run by geologists who know mining but are ignorant of financing gold ventures. They often fall into traps such as selling their future production in the forward market. They end up with greatly-diluted equity, a result of inability to keep income above costs and having locked in their income when they sold forward their future production. These operators may be honest and have solid gold reserves, but lack a coherent plan for exploiting their reserves.
- Type 3
Run by managements with identifiable reserves, mining and engineering expertise, and solid financial planning.
These are the operations best equipped to bring mines to fruition and to become recognized by value investors.
Overall, if you are interested in high risk, high upside potential stocks that have been beaten down to historical-ly-low valuation levels, gold mining stocks may be an attractive choice.
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