Gold momentum's picking up dramatically, says Eric Sprott
Source: The Gold Report , Author: Karen Roche
Posted: Sun November 15, 2009 6:53 pm

INTERNATIONAL. Although "quantitative easing" (QE) may be propping up the U.S. economy for the time being, it solves nothing. That's how Eric Sprott, Chief Executive Officer & Portfolio Manager of Sprott Asset Management and Chairman of Sprott Money Ltd., sees it.

It's not just that QE shoves problems from the private sector into the public sector. It's worse than that, because as Eric tells The Gold Report readers, QE is "just debasing the currency which will eventually lead to hyperinflation."

One upside though: "You can just feel the momentum in gold—it's picking up dramatically" and so too are prospects for a plethora of little-known small and mid-cap gold stocks.

The Gold Report: You have written quite a bit about the U.S. government's growing debt and a whole bunch on unfunded liabilities leading to a default on obligations or printing more money.

Eric Sprott: There aren't too many choices when you're in debt to the level that the U.S. government is. As we've outlined in some of our recent articles, one way of calculating it says there's US$72 trillion of debt and other way suggests it is $100 trillion. It's almost academic which calculation you use; it's just an overwhelmingly serious problem.

Thank goodness we have a zero interest rate policy. Otherwise, the cost of those obligations would be unbearable. As we analyze where we are and look at all the things that the administration is doing, it certainly seems that they're going to try to spend their way out of it. Last week's announcement regarding the extension of the homeowner credit, in addition to giving corporations loss carry-backs while paying unemployment benefits for an additional 20 weeks—these are all signs of trying to spend their way out of it. It is looking more and more like it will be an inflationary scenario. It could even be hyperinflationary.

I find it instructive that the U.K. has announced another quantitative easing program. I really think that once the Fed has spent the US$1.25 trillion buying the GSE paper that we might yet see another level of quantitative easing in the States.

TGR: Since there clearly isn't enough tax revenue to support spending their way out of this, are you looking at a situation in which the U.S. government is just going to be printing more money?

ES: That's what I would presume. I knew that net government revenues from taxes for '09 versus '08 were pretty brutal, but I recently looked back to '07. In October'07 the U.S. government received net $150 billion in taxes. In '08 it was something like US$133 billion and in '09 they got US$110 billion. That's at least three years in a row of contraction in tax revenues.

TGR: Do you see any scenario in which the government will begin to contract itself—meaning cut costs?

ES: I don't think they are going to restrict anything. They have no choice. We are in such a weak economy that any suggestion of tax increases or spending cuts would just tip people over, so I do not see that happening. I think we will continue to have a quantitative easing policy. It's funny. It's not a policy; it was an absolute necessity because no one was going to buy the bonds. I do not know why anyone would buy a U.S. government bond for 10 years, paying 3% or so when the currency fluctuates as much as it does, the financial position being what it is and the alternatives being what they are. You could buy stocks, you could buy commodities, and you could buy foreign markets. Every one of those has done better than the bond. Because I do not see who would likely buy those bonds, I consider the government purchasing its own securities a necessity, not a policy.

TGR: Given enough quantitative easing, the dollar may no longer be the reserve currency. If that happens, what's in store for the economy and for investors?

ES: As an investor I am pretty sure what areas of the market will do well, but I truly cannot tell you how things will function when the current fiat currency system fails. To be brutally honest, I have no idea. It is hard to imagine what happens when people turn their backs on currencies, but I would suggest that we are already seeing it happen as we speak. You can feel in the market; people do not want to own currencies today. Particularly U.S. currency.

I am not saying that this is anything imminent, but people are questioning many global currencies now, not just the U.S. dollar. I would question the U.K. pound today; I would question the Japanese yen today. Many governments have completely overdone it.

When the Indian government purchased 200 tons of IMF gold, the finance minister said that Europe and the U.S. had "collapsed." Those were his words. They wanted to get those dollars out of their treasury; they would obviously much rather own something physical.

TGR: Do you see the potential of any currency becoming the new reserve currency?

ES: The only one would be the Chinese yuan. However, I think collectively the world would probably say, "Having one reserve currency was a mistake the last time. We should probably use a basket to determine values."

TGR: So what are the options?

ES: Various members of the G-20 talk about commodity backing and so on. You could create a computer system where you could actually use commodities as currencies. It's pretty easy to quantify all these units, so maybe we will go there. Hardly any hard currency physically trades hands now, you could literally have everything just trade in gold and silver on computers. Maybe it goes to that. We will see.

TGR: If it had to be gold and silver, could you expand it into oil?

ES: Yes. You could include any number of commodities. As long as the units are backed by something. You would have to be able to get the unit on demand.

TGR: You said earlier that as an investor, you know which areas will do well. What are they?

ES: We have been seriously involved in precious metals for 10 years now. With some obvious ups and downs, it has been 10 great years. I had purchased gold and silver because I knew there would be more demand than supply, and I am sure that is the case today. I could not have predicted quantitative easing in 2009, nor could I have predicted that the financial world might actually buy into it. I still almost pinch myself when I think about it.

I always knew there would be a bonus thrown in by fiat currencies being damaged, and with quantitative easing you know that the values of currencies are going down. That makes the precious metals story just that much more compelling and I am sure that is why India bought 200 tons of IMF gold and others will follow suit. We are also seeing many hedge funds and pension funds moving into gold. Whereas central banks used to sell gold, now they are buying it. Then there are the ETFs. You can just feel the momentum in gold—it's picking up dramatically.

TGR: With no interest in buying bonds given such low returns, and with so many currencies declining, is there really any upside in the market beyond precious metals?

ES: There is, but as one who runs hedge funds and has a short side in my portfolio, my biggest fear today is that we actually go into a hyperinflationary situation where all asset prices go up. Of course some will go up way more than others. Hard assets, including precious metals, would probably go up the most. Softer things such as bank shares probably would not perform as well. However, everything would go up in a hyperinflationary environment.

TGR: Do you see that happening in the short term?

ES: You cannot rule it out. It is shocking to think the Fed bought almost US$2 trillion of securities. If they have to announce another quantitative easing, it will not take too many people too long to figure out what the net result of that has to be. Looking at the price of gold makes me think a lot of people are catching on.

Although I think it is a distinct possibility, I have no idea when it would happen because it's a function of whether they continue quantitative easing. That is just debasing the currency which will eventually lead to hyperinflation.

TGR: Some people are predicting a fairly substantial market correction. From your viewpoint, would that just be a blip in light of the inflationary spiral you foresee?

ES: I think in many ways the rally off the bottom has been a little phony and it is interesting how it has coincided with quantitative easing. I am not so sure that we have really solved any problems. We have just moved them from private company statements onto public statements. We own GM, Fannie, Freddie, AIG, GMAC, whatever. We just moved the problem, but the problem has not disappeared. It may yet happen that the weakness continues to beget weakness. As people lose jobs, their homes are foreclosed upon, they declare bankruptcy, it's a permeating negativism that has to stop. You are never going to stop it until jobs are created and we still have not created any jobs. I am shocked that with all the stimulus and all the job creation that supposedly went with it, there has been nothing, net. There have been no new jobs.

TGR: But they say there's a delay between the market appreciating and when the jobs start, that the market is the leading indicator. And then you get someone like Warren Buffett, who just bought Burlington Northern. He's betting on America. What do you see that Warren doesn't?

ES: I would never criticize Warren Buffett. I am not criticizing him, but I do not think he saw the extent of the financial problems that we encountered and he is not perfectly right all the time. Yes, I think Warren has to bet on America. He is a big part of it and he may yet be right because Burlington Northern is a business that moves real things and real things will still have value in the situation that we all imagine us maybe going to. So he can be right and I can be right at the same time.

TGR: Your funds are heavily invested in precious metals, basically as a hedge against devaluing dollars. To what extent are you looking at physical metals versus equities in these funds?

ES: Early this year I began to move out of some of our physical gold and into mining stocks. There have been a plethora of mining stocks that had incredible value if you could buy into the companies' production forecasts and buy into the price of the metal at the time. When gold was US$850, we could buy stocks that in two years' time would have been trading at two times cash flow. When we were buying them at US$950, we could still do that. There were some phenomenal values and most in an agglomeration of names no one's ever heard of. Many of them are new with things just starting up. Of course, they had financing problems because of the decline in the market. But the opportunities were overwhelming. So we bought a lot of stocks of that nature.

TGR: Can you share with us some of the juniors that were relatively unknown that have given you some good returns?

ES: Sure. Some of the smaller producers are CGA Mining Limited (TSX:CGA; ASX:CGX), Medusa Mining Limited (ASX:MML) , Norton Gold Fields Limited (ASX:NGF), Norseman Gold Plc (LSE:NOGO.L), and Yukon-Nevada Gold Corp. (TSX:YNG). These are all very small market cap companies, but they can make significant amounts of money. You know, 100,000 ounces is US$100 million in sales. It is a very simple thing to put the three zeros on the end, right? If your costs are half the price of gold (i.e., US$500), you have US$50 million of cash flow. With US$50 million of cash flow in a stock trading at US$100 million, you have a cheap investment. There are lots of those names around.

TGR: How about in the exploration space?

ES: There have been lots of interesting exploration plays, some of which are in the States. We own a little company called Romarco Minerals (TSX.V:R). We own San Gold Corporation (TSX-V:SGR), which has had some tremendous exploration. There is one in Indonesia called East Asia Minerals Corporation (TSX-V:EAS) that could be very exciting on the exploration front. Galway Resources Ltd. (TSX-V:GWY); Galway picked up the gold property south of Ventana Gold Corp. (TSX:VEN). Ventana's been one of the hottest gold stocks around and that's brought a lot of attention to Galway.

TGR: Right now it seems that the metal is outperforming the producers and the junior companies. Do you see that changing?

ES: I would not agree with that. I go back to 2000 when I started buying gold and gold shares and the HUI Gold Index was 35 then. It is about 660 today, so it has gone up about 1200% while the price of gold has gone up some 300%. Since the bottom in October, the HUI has risen maybe 190% from the bottom. I do not know what the bottom of gold was, but maybe it got as low as US$650, but the HUI Index has probably appreciated twice that.

A couple of months ago I saw a list of the top 100 performing junior gold stocks since the bottom. I don't have that list in front of me right now and cannot even tell you who did it, but to make the list, a company had to be up 400%. The average was 700%. It was shocking how much some of these stocks went up. You would have to be deep into small mining stocks to recognize the names.

TGR: Does gold have to increase for such stocks to see any more appreciable value or is there more upside for them?

ES: I probably own 25 or more names on that list, and really have not sold many of them. When this list was done, the price of gold might have been US$900. Now we are US$1,100. I am finding lots of upside opportunities in these small to mid-size gold companies. I have a tough time stomaching the incredible valuations in some of the bigger ones, but I still think there is pretty good value in the smaller names.

TGR: At The Gold Report we don't get a sense that the average investor is buying gold. Is that your sense as well?

ES: Yes, I agree that very few people have gone there. In fact, one of the funny things about the physical gold market and even mining stocks, for that matter, is that there is not a lot of room for everybody. Almost everything is spoken for. It's not as if gold is not owned by someone already. There is very little produced each year.

When I first got into gold, it was suggested there was a shortage of physical gold, and the only reason the price did not go up substantially then was because the central banks kept selling it. Now the central banks do not sell and you have all these new buyers. I have no idea where this gold is physically coming from. Even the array of gold stocks available to the world is not that large. We are very lucky to be based in Toronto, sort of the gold mining financing capital of the world. Everybody in the world of gold tends to come through here. There is not a big sense of gold mining in the United States for sure, but it's quite a topic in Toronto.

TGR: How likely are we to get into a gold mania if indeed people in some countries aren't even talking about it yet?

ES: You just have to watch the gold price. We are probably at a very significant level right now. Finance people looking at it have to be wondering what is going on. I do not think it is a secret now. You can hardly pick up a financial newspaper where they are not talking about the potential weakness of the U.S. dollar.

TGR: As you say here, we're trading around US$1,100 as of this interview. What catalyst is going to come up? I clearly think that India stepping up to the plate, making that buy—frankly, I expected China to do it before India.

ES: If the Chinese come in now, we all have a story. I am sure they will, and/or somebody else will. It is not a lot of money—US$6 billion or US$7 billion is a drop in the bucket for the Chinese. That could happen. I have always believed there could end up being some problems in the physical market some day, regarding the settlement of contracts. We have these huge concentrated short positions in both the silver and gold on the Comex. There was a day when the price of gold went up US$25; those shorts lost US$1 billion dollars that day—serious dough now. So there could be things happening in the physical markets.

TGR: Speaking of physical markets, where are premiums on coins these days?

ES: On gold coins it's about 6.5% and around 20% above intrinsic on silver. Wafers and bars are obviously less. If all of a sudden there is a run in coins, those premiums can change pretty quickly. It does vary a lot. There have been times when the U.S. mint is on-again, off-again in terms of output. Regardless we have had significant interest in large quantities and we are lucky that we have always had a substantial inventory of particularly gold Maple Leafs. We probably have US$50 million of them in inventory at all times, so we're not likely to run out. Besides, we have great supply sources, and we are constantly replenishing our inventory as we sell—regardless of how high the gold price is.

TGR: And considering your Sprott Money Ltd. enterprise, you're clearly a believer in holding the physical metal.

ES: I am. People should want to have their own physical gold and silver. A lot of them take certificates, but I certainly would never advise doing that.

Note. Eric Sprott has accumulated 35 years of experience in the investment industry. After earning his designation as a chartered accountant, he entered the investment industry as a research analyst at Merrill Lynch. In 1981, he founded Sprott Securities. After establishing Sprott Asset Management Inc. in December 2001 as a separate entity, Eric divested his entire ownership of Sprott Securities to its employees. In December 2004, the Sprott Hedge Fund L.P. won the Opportunistic Strategy Hedge Fund Award at the Canadian Investment Awards. The Sprott Offshore Fund, Ltd. won the 2006 Mar Hedge Annual Performance Award under the Canada-Based Manager category. Eric received the two Ernst & Young awards in 2006—Entrepreneur of the Year (Financial Services) and the Entrepreneur of the Year for Ontario. In December 2007, Investment Executive named Eric Fund Manager of the Year. Last year, the Sprott Offshore Fund Ltd. won the HFM Week's Best Long/Short Hedge Fund award globally. Sprott Money Ltd. is one of Eric's newest ventures. As one of Canada's largest owners of gold and silver bullion, the company's goal is to facilitate ownership of precious metals to the general public.

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