Sprott’s state of the world (March 21, 2011)

If the location of Eric Sprott’s speech, the Prospectors and Developers Association of Canada convention, or the title of the speech, “Investment survival in the meltdown,” wasn’t enough to give away the investment guru’s final conclusions, Sprott made sure that his opening comments did.

“Ultimately I’m going to conclude that precious metals are the place to be,” he said to a packed luncheon crowd on March. 7. “But you all knew that didn’t you.”

With that laid out on the table, Sprott went about the more onerous task of backing it up in a compelling fashion.

Sprott, a well-known bear in the investment community, derives much of his strength from his ability to cut down often unquestioned tenets held in the financial world.

He began with an attack on a stalwart of modern economic theory, John Maynard Keynes.

“This Keynesian logic that all of the central banks have accepted,” he said, “I can tell you this formula does not work because at the end of the day you’ve got to pay the debt back.”

One of the central tenets of Keynesian theory is that government spending can increase aggregate demand, thus lifting gross domestic product and consequently pulling an economy out of recession.

Sprott, however, argues that any gains to gross domestic product brought on by increased spending are modest in comparison to the deficits that governments must incur to bring them about.

The way out for the U.S. has been to print more money, a process which de-values U.S. dollars but which could have serious inflationary consequences. Despite the prospect of runaway inflation, Sprott wouldn’t rule out the possibility of the U.S. Federal Reserve announcing a third phase of quantitative easing (QE3), once the current program expires in June.

“And if they go with QE3, the price of gold will be up so fast and it will take every other commodity along with it,” he said.

In such an economic environment, Sprott warned against putting faith in an over-leveraged banking system.

His argument is that, because banks are leveraged 20-to-1 on the assets they hold, they are extremely vulnerable to losses coupled with a devaluing of the paper assets they hold.

He used the case of Egypt to make the point. Holding just 5% of cash assets would not cover the demands of all depositors should they demand withdrawals simultaneously.

The banks would be in a position where they would have to sell the paper assets they hold to cover the depositors’ demands. But if those paper assets, mainly mortgages and loans of other varieties fall in value, as they did during the credit crisis of 2008, another wave of financial calamity could ensue.

The possibility of such an event leaves precious metals as the only store of value that investors can rely on – especially given the low interest rates that depositors are currently earning on cash deposits.

“Whether it’s Greece, Egypt, Argentina or Iceland, every time one of these countries goes down, I think why the hell wouldn’t you own gold?” he said. “Because when you have money in the bank you are lending to levered financial institution, don’t forget it.”

And while Sprott likes gold, he likes silver even better.

His case for the less-heralded precious metal is largely built on what he believes to be a distorted sense of the true supply and demand fundamentals of the metal.

One of the chief culprits in this distortion, in Sprott’s mind, is the metal consultancy group GFMS.

Sprott contends that GFMS reports consistently show the supply of the metal to equal demand. A conclusion GFMS comes to by way of an “implied net investment” metric which makes everything work out.

In actual fact, Sprott argues, demand far outstrips supply.

Where the GFMS put aggregate demand for silver at 293 million oz. for the whole decade, Sprott says his firm went to just seven organizations and learned that their demand for the metal was 519 million oz. over that same time period.

“And that’s only seven organizations. We didn’t go to the governments of Russia or China or Kazakhstan or whomever,” he said. “So I call their numbers… well, I better
not say it, but you know.”

He also ridiculed the organization’s forecasting track record.

“For the last decade they’ve been saying the price of gold and silver will go down… but it went up every time for ten years. I think this year they say it’s going to go up, which scares the hell out of me,” he said with a laugh.

But GFMS didn’t take Sprott’s entire wrath; he saved a good portion for COMEX traders as well.

“Every day they trade 400 million oz. (silver), and yet we only produce 800 million oz. a year. What the hell is going on?” he asked rhetorically. “It’s just fingers on a button. You think they’re taking delivery of this stuff? Forget it. It’s a paper market, where they try to see who has the most paper to move the market around.”

Bolstering Sprott’s contention are current lawsuits which accuse HSBC (HBC-N) and JP Morgan Chase (JPM-N) of colluding to keep silver prices low. The two banks were said to have held massive short positions on the metal. Sprott said he eagerly awaits the outcome of the cases.

Violations in silver market have also been noted by Commodities Futures Trading Commission (CFTC) commissioner Bart Chilton, who has remarked that market players have made “repeated and fraudulent efforts to persuade and deviously control silver prices.”

If such corruption can be cleaned up and silver prices are free to correspond to their true underlying supply and demand fundamentals, the metal could be poised for a historic run.

Providing further support to such a thesis is increasing demand from China.

In 2006 the country exported 100 million oz. of the metal. Now it imports 112 million oz.

“That’s a 200 million oz. change in one country. What does the former guy do that was getting the 200 million?” he asks. “There is a shortage of silver and the only reason the price hasn’t gone up is that certain people in banking thought they could control the market with paper.”

Sprott’s final point in his bullish case for silver has to do with ratio analysis.

Unlike gold, most of the silver produced gets consumed, a situation which has resulted in available supplies of gold being valued at US$76 an oz. to US$1 per oz. of available supplies of silver.

While that may not seem alarming in and of itself, it becomes more so when the dollar flows going into silver are compared to those going into gold.

He quoted statistics that showed gold trusts in the U.S. only attracting investment inflows to gold over silver of just 6-to-1. He went on to note that the U.S. Mint has reported that, on a dollar value, the purchase of silver coins was equal to that of gold.

The trend has been mirrored at Sprott Investments, where investment inflows to the two metals are occurring on roughly a one-to-one basis.

“How do we keep buying at a one-to-one ratio when the available supply is 76-to-1? You can’t do it. It’s the easiest call in the world,” he said.

As for the historical ratio of gold to silver prices, according to Sprott is well established at 16-to-1, much lower than the current ration of 41-to-1. Sprott believes that the historic ratio will return, which would put silver prices at US$100 per oz. should gold reach US$1,600 per oz.

“I’m not really a technical guy,” he said, “but when I was selling the silver trust the price was under US$24 per oz. I said look at this chart, what happens when we break through this big 30-year consolidation? Well there’s only one thing I can imagine happening. And here we are, we’re at US$37 per oz. and we don’t even have that much to go to get to US$50 per oz.”