Trouble afoot in markets

COMMENTARY

— The following is the first of three edited parts of a speech presented at the recent Silver Summit in Coeur d’Alene, Idaho.

I am rabidly bullish on the prospects for precious metals and have been for a number of years. The good news is that we have barely scratched the surface of this bull market and the better news is that I believe we are currently on the cusp of the next sharp up leg.

When people ask me where we are in the bull market, my response is that we are currently digesting the first stage, where we true believers made a lot of serious money while the public remained blithely unaware. I believe that the second leg of the bull market is about to unfold, in which the public will both recognize and drive precious metals towards all-time real highs. I speak of gold and silver almost interchangeably in that I think they are currently both subject to many of the same influences, of both the economic and trading variety. I do, however, believe that silver will ultimately have greater upside potential, due to severely depleted inventories, new uses for the metal, and what can only be described as an enormous short position. The reasons for my optimism seem self-evident. However, much of the investing public has failed to appreciate the opportunity to date and their discovery of these reasons will fuel the second leg of the bull market.

The primary factor underpinning what will turn out to be spectacular upside in gold and silver will be the impending erosion of faith in paper money. French philosopher Voltaire got it right some 200 years ago when he observed that, “Paper money eventually returns to its intrinsic value — zero.” There are two tightly linked explanations for this conclusion. Literally speaking, paper money is inherently worth very little, relying on the continued faith of citizens to accept fiat currency as an acceptable method of payment and a reasonable store of value.

No less than Alan Greenspan once warned against this faith continuing without interruption. Testifying before the U.S. Congress in 1999, the former chairman of the Federal Reserve Board expressed his belief that gold still represents the ultimate form of payment in the world. It is interesting that Germany in 1944 could buy materials during the war only with gold, not with fiat, paper money. And gold is always accepted and is the ultimate means of payment and is perceived to be an element of stability in the currency and in the ultimate value of the currency and that historically has always been the reason why governments hold gold.

Greenspan confined his comments to gold, but I believe the same stabilizing qualities typified by gold are also exhibited by silver. From the first observation that fiat currency is inherently worthless, we can also understand its more consequential failings. Because governments can create paper currency at essentially no cost, and given the political imperatives that drive deficit spending, the structure of today’s monetary system provides little obstacle to the ongoing debasement of currency.

This truth can be obscured for long periods of time, as the spectacular results in paper assets during the 1980s and 1990s certainly attest. However, my sense is that the decades-old bull market in financial assets is largely behind us.

We now find ourselves on the slippery slope of a runaway credit expansion needed to sustain the debt buildup that went before. It is not a stretch to say that at this point, there is no turning back. Either credit creation continues to accelerate, or the U.S. economy in particular risks a dangerous lapse into deflation. An outrageous asset party could quickly morph into a vicious debt hangover.

Given the debt pyramid that has already been constructed, it will take greater and greater additional credit to generate a dollar of real gross domestic product (GDP) growth with each passing year. This could portend hyperinflation somewhere down the road, but I suspect that policymakers will judge this preferable to a deflationary collapse that could rival the 1930s. Indeed, Fed chairman Ben Bernanke is an expert on the Great Depression and I doubt very much that Helicopter Ben wants to preside over its sequel. So despite admirable efforts to portray himself as an inflation hawk, Bernanke’s academic work on The Depression firmly entrenches him in the dove camp.

But if Bernanke comprehends the dynamics of deflation, it is less obvious that he and financial markets are similarly cognizant of the risks posed by derivatives (financial securities whose value is derived from another “underlying” financial security, including options, futures, swaps, swaptions, and structured notes).

Warren Buffett had the misfortune of having to unwind some relatively minor derivative positions in an insurance company acquisition by Berkshire Hathaway, and later described these financial instruments as “weapons of mass financial destruction.” Some people argue that the proliferation of derivatives is akin to the tail wagging the dog. I would go further, and say that the tail may be swinging the dog around the room and bouncing it off all four walls. The notional amount of derivatives in the system today is preposterous, and raises the scary possibility that we have learned nothing since the Long Term Capital Management fiasco of 1998. With the notional value of derivatives now measured in hundreds of trillions, the mind boggles. What financial calamity a significant counter-party failure could reveal is yet to be seen.

At this point, suffice it to say that reported statistics on derivatives bear no resemblance to the world economy. Buried in a recent U.S. Office of the Comptroller of the Currency report was the fascinating revelation that J.P. Morgan Chase’s derivatives book grew to US$53.75 trillion in the first quarter of 2006 from a notional value of just over US$48.25 trillion in the fourth quarter of 2005. To put this in perspective, the growth of US$5.5 trillion is equivalent to about 44% of annual U.S. GDP. In addition, Morgan Chase’s outstanding book is over four times the country’s annual GDP. And although the largest player in derivatives markets, J.P. Morgan Chase is far from the only one.

This begs an obvious question: What is the purpose of these derivatives? For the longest time, my impression has been that the outsized use of derivatives relates not only to legitimate hedging activity, but also aids efforts to manage various markets. Whatever their purpose, the danger inherent in huge derivatives books seems clear. Greenspan was a leading apologist for derivatives, and would point out that only a very small portion of their notional value is ever at risk. Nevertheless, if even 1% of the Morgan Chase derivatives book is at risk, that would be extraordinarily significant when compared to its underlying equity. Thus, I tend to be skeptical if a government official attempts to rationalize the explosion in derivatives. They may be the smoking gun that all is not well with the financial system.

— The author is the chief investment strategist with Toronto-based Sprott Asset Management. Next week: Part II