By Jared Dillian, Mauldin Economics:
When most people think of distressed investing, they think of buying CCC-rated bonds at 20 or 30 cents on the dollar, then maybe sitting in bankruptcy court to divvy up the capital structure, making healthy risk-adjusted returns in the end. You just need to hire a few lawyers.
Distressed investors are a different breed of cat. It’s one of those countercyclical businesses, like repo men, who do well when everyone else is getting hammered.
I remember distressed guys killing it in 2002. Most people remember the dot-com bust, but there was a nasty credit crunch that went along with it. Nasty. High yield/distressed investments had some amazing years in 2003 and 2004. Convertible bonds in particular.
Funny thing about distressed investors is that they like to stay within their comfort zone. In my experience, they’re not keen on commodities. Like coal mining, which this week saw one bankruptcy filing and another one in the works. Distressed guys hate commodities because they are just timing the earnings cycle – which is the same as market timing. Distressed guys want less volatile earnings so their projections aren’t totally dependent on commodity prices rising.
Coal is distressed, all right. But you don’t see the distressed guys getting involved. Even they are too scared!
Here’s a somewhat controversial statement: I think most commodities are distressed. Coal is definitely distressed. So is iron ore. Copper, too. And yes, even gold.
Corn and beans have had a nice little run, but metals and energy in particular have been a complete horrorshow.
So I think it’s time to start looking at commodities as a distressed asset class. The assumption is that fair value of these commodities/producers is well above current market prices, and current market prices are wrong because of, well, a lot of things. In particular, a self-reinforcing process where selling begets more selling.
If you’re a distressed investor and you’re buying something at a deep discount, if you have a long enough time horizon, you’ll be vindicated eventually. Sometimes, it takes a long time. Sometimes, not very long at all. It’s pretty great when it works.
Gold: A Special Case
Gold is a little different. How do you value gold? It has no cash flows. An industrial commodity like copper is pretty easy to value. With gold, you’re trying to gauge investment demand (at the retail or sovereign level), which is hard, against mining production, which is a little easier.
But what an ounce of gold is worth is entirely subjective. More subjective than copper or cocoa or coffee. For example, if everyone started using bitcoin, there would be little to no demand for gold. (For the record, I think cryptocurrencies indeed have had an impact on gold demand.)
Basically, people want gold when they think their government no longer cares about the purchasing power of their currency. In our case, that was when the Fed was conducting quantitative easing, known colloquially as printing money.
But that’s not really what people were nervous about. Think about it. The Fed was printing money for monetary policy reasons. They were trying to effect monetary policy with interest rates at the zero bound. That’s different from printing money to buy government bonds because nobody else wants to. That’s called debt monetization.
When budget deficits get sufficiently large, people worry about things like failed bond auctions, that the Fed will have to step in and be the buyer of last resort. This is the nightmare scenario described in Greenspan’s Gold and Economic Freedom essay.
We had $1.8 trillion deficits not that long ago. The bond auctions were a little scary. I thought debt monetization was a possibility.
The deficit is lower today, mostly because of higher taxes, more aggressive revenue collection, and economic growth. As you can see, the price of gold has corresponded almost perfectly with the budget deficit.
With a small deficit today, nobody cares about gold.
Is the deficit going higher or lower in the future? Higher. Ding-ding-ding, we have a winner. One of the reasons I’m happy owning gold as a part of my portfolio.
Paper vs. Things
Asset allocation gets a lot easier when you figure out that the financial markets are a tug-of-war between paper and things. Sometimes, like now, financial assets (stocks and bonds) outperform. Stocks are overpriced, and bonds are way overpriced. Other times, like 10 years ago, commodities outperformed.
It has to do with the degree of confidence people have in… other people. A bond is a promise to repay. A stock is a promise to pay dividends, or that there will be something left over at the end. A dollar is a promise that it’s worth something, namely, a divisible part of the sum total of the productive abilities of all the people in the country.
These are pieces of paper. Paper promises. When confidence in promises is high, nobody needs gold, coal, or copper. When confidence in promises is low, time to build that underground bunker in the backyard.
Confidence in promises is currently at all-time highs. Without making a positive statement either way, I’d say that only in the year 2000 were commodities more undervalued than they are right now.
Sidebar: it is tempting to treat commodities as an asset class, but you should try not to. They are idiosyncratic, and for most commodities, the cost of carry is high enough that it’s impractical to hold them for long periods of time.
Commodity-related equities are a different story.
Disclaimer
I’m kind of biased on this, and I always think commodities are undervalued because I’m a deeply suspicious person and I don’t believe promises. I’ve owned gold and silver for years (plus GLD and SLV, and GDX and SIL), and if prices get low enough, I will add to those positions.
Keep in mind that I worked for the government under the Clinton administration. Clinton’s mantra to government employees was, “Do more with less.” The man did a lot to restrain the growth of government—and he was a Democrat!
People resented him for it. They wanted their fancy toys and their boondoggles. Public servants have been much happier under Bush and Obama. Not coincidentally, gold bottomed in 2000, at the end of Clinton’s presidency, and has basically been going up since.
So here is the secret sauce: You want to know when commodities are going up? Watch the deficit. If someone dreams up free college for everyone, buy commodities with veins popping out of your neck.
By Jared Dillian. If you enjoyed Jared’s article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. Follow Jared on Twitter @dailydirtnap. The article The 10th Man: Distressed Investing was originally published at mauldineconomics.com.
But energy may not be ready for distressed investing just yet…. “Liquidity death spiral,” is what the principle is called whereby lenders whittle down the size of the credit line as the company runs deeper into trouble, and as it runs out of other funding options. It eventually ends in bankruptcy. Read… It’s Happening: Debt Is Tearing up the Fracking Revolution
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It’s too early. There’s still too much hope, although the gold bugs seem to be faltering. Instead of the typical claims of manipulation and eventual vindication I now see more pieces saying the price may drop further. That suggests capitulation is near. Other commodities are still sufficiently in the denial phase. Lots of people got burned when they figured oil bottomed out months ago and IMHO it’s still too early. It’s not enough to buy when there’s some pain. You have to wait until there’s disgust and revulsion.
When we see gold, base metal, coal and other miners shutting down and oil drillers folding it will be time to buy the survivors. Gold is definitely below the cost of production for many miners. Once a mine is closed it’s very expensive to reopen, which gives the survivors a moat. In the oil industry fracking is easier to restart than a capped conventional well, but the moat might be reluctance of lenders to fund them.
I see physical gold as a unique case since a lot of value can be stored in a shoebox (unlike oil or copper, $10,000 worth will fit in a shirt pocket) and unlike a gold miner a bar of gold owes no debt.
You make many salient points. May I add my two cents?
The irony is that gold investors believe that gold price is being manipulated. I ask them two questions. Why are you investing in something that you’re so sure is being manipulated to your disadvantage? And why is it that when it goes up it’s not manipulated but when it goes down it is?
For seven reasons I believe gold will go down a lot more. If I were to pick the most important one I would say it’s the reversion to the mean. Also, it costs “less” now to mine gold because energy cost is lower than say a year ago. So below production cost as of when? And just like any other so called commodity when prices fall below production cost every gold miner will try to produce even more to stay afloat and pay their debt. So production won’t ease for a while.
Gold is not money. What is money and what does it functions as??? Okay try to pay for your grocery or your utility bills with your gold. Really just try for once. Buy a loaf of bread. At the cash register hand over your gold and see what happens.
It’s not hard to look up the cost of extraction vs the price of gold if you are skeptical.
If you are losing money on every oz you sell you can’t make it up on volume.
The gold market, for whatever reason, is broken. Price falls, demand rises, price falls. What econ textbook explains that?
“If you are losing money on every oz you sell you can’t make it up on volume.”
My point is that they will continue to mine gold even if below cost as long as creditors/ lenders hope that price will bounce back and so continue to loan them money. Case in point is oil. Eventually some miners will have to shut down operations because lenders realize that their hope was nothing but an illusion. When credit dries up production stops.
What I said was that production won’t ease for a while. Not until lenders give up hope.
Well Cameron, I’m trying to pay my grocery and utility bills with dollars and the cashier seems to be demanding more and more of them for the same amount of product. Does that mean dollars are functioning less and less as money? By definition that would seem to be the case.
BTW, I don’t understand why I would hand over gold at the CASH register. It’s not a gold register. I hand in my gold at the dealer (the gold register) and he gives me some cash to take to the cash register. And I expect that he will be handing over larger and larger sums of cash for the same amount of gold in the future.
You got my vote. Commodities are going to keep sliding down but they’re looking might tempting. I couldn’t resist and bought a gold mining company recently when I saw them paying down a lot of their debt and not dropping along with the gold price. ASX:SBM in Oz for anyone interested..
When investing in commodities I think you really need to stop and take a look at what people are doing around you. It is not rocket science. If it goes into a car, cell phone, computer, or network, buy it. If they are wearing it or eating it, buy it. Do you need gold to do any of this? No. Silver? Yes. And so on and so forth as my math professors use to say.
Then why is silver down so much more than gold from their respective peaks?
Gold is being hoarded by countries like China and Russia which would keep the price artificially high. Since the Chinese economy has slowed the Chinese have dumped gold on the market and the price reflects it. Silver has more production uses than gold, it is also in larger supply, so the pricing pressure is not there. In the long term, I would rather hold silver than gold, until the utility of the metal changes in the market.
Actually, one small quibble that, in the end, supports your argument. There is less silver bullion in existence than gold bullion as it gets used whereas gold doesn’t. So it’s not really in larger supply. But since the near-end of film photography its consumption has plummeted. I think photography accounted for about 70% of its usage.
Gold is both money and commodity. So its value is hard to measure as one or the other. It could well be called quantum. We are in a deflationary cycle so the commodity is dragged down. It is not a currency. It is a weight so possession negates monetary value at times. However, I best describe precious metals as a lifeboat not an investment. An optional adornment just hanging around until time of need. Then its value leaves the realm of the finite and becomes infinite. Either you have one or you don’t. When the ship founders as they do from time to time, you don’t want to be without one and there’s no going back. You have left the world of dollars. They went down with the ship. You have entered the world of ounces. The value of the lifeboat has manifested. Be glad you have one. You’ll survive where others perish.
The real value of any commodity is utility. Gold’s utility has dropped significantly in modern times. It’s biggest use now is jewelry. In ancient times it was considered valuable for its uses, coins, jewelry, rust proof, durable, etc. Now the replacement for gold is energy because it has the highest utility in the marketplace. When the SHTF, as it has in many areas of the world, there are many other commodities that become more valuable for survival, food, energy, medicine, weapons, and ammo. Nobody will trade these for gold.
Gold to hold
Silver to spend
Lead to throw
I take issue with Jared’s premise that the price of gold (and by extension silver) is subjective. No. It is an objective constant, like the speed of light. The fiat ‘value’ is the subjective component. The only crypto-currency that might have a chance is the new bitgold. And that presumes that the underlying technology remains intact. A massive Carrington Event like the one in, I think, 1859 would fry the internet and your virtual purse would vanish! Spot gold and silver are cheap right now but the premiums are jumping up. I transitioned my 401k into silver mostly and some gold. People are blind to the threat – and as the saying goes, in the land of the blind, the one-eyed man is king. I am perfectly happy with my choice, these cheap prices worry me not at all. I notice that Jared did not discuss all the unfunded liabilities piling up as we slide off the demographic cliff, just as he does not discuss the Republican majorities in Congress that dragged Clinton screaming and kicking into those deficit reductions. The coming crash is going to make the Great Depression look like a Sunday school picnic, and people are scared – some with knowledge and some who don’t have a clue. Only time will tell who is right.
He was making some real sense until he started talking about buying PM ETF’s
I think gold and silver prices are tied to confidence, confidence in the government and it’s ability to pay it’s debt. If this is lost, we will see the flight to safety change over to the PMs. I hedge my investments accordingly.
I agree 100%, DLW. My confidence in the powers that be is zero. I’m on the sideline just waiting for everyone else to come out of the ether. Sites like this one which still follow the Founders dictum of reason and debate, are slowly making inroads…we can’t save them all but hopefully we will awaken a few.
This ratio is now becoming spectacularly overbought, and will probably remain true. You can replace Pring’s Index with the $CRB for comparison.
Note that the gold price is generally resilient here, rather than weak as others suggest. It’s always a question whether you see the glass as half full or half empty.
http://schrts.co/Keexry
Another chart I watch with some compulsivity is gold’s price volatility:
http://schrts.co/bZi84z