By LEWIS JOHNSON – Co-Chief Investment Officer | September 21, 2016
Something important happened in the markets last week. Something that has only happened twice before in the last forty years. The harder part is figuring out what it means. In this week’s “Trends and Tail Risks,” we outline the dramatic outperformance of one highly leveraged silver stock to see what it has to say about where we are in the cycle. We look back into our history of studying the silver industry to answer the question: what happens next?
Investing – A Game of Inches
It seems that in many highly competitive endeavors, the difference between winning and losing is a hair’s breadth. NASCAR racecar drivers will drive 500 miles in the course of one sultry afternoon only to win by a few feet. One big play on the football field can transform defeat into victory. I suppose investing, like competitive sports, is no different.
This idea flashed through my mind last week as I watched an obscure headline on my Bloomberg roll soundlessly down the screen of my terminal. Sometimes patterns fall together like that, in the blink of an eye, in a flash of inspiration.
World Champion Silver Stocks
The Bloomberg article was entitled “World’s best stock is a 460 percent gain in Peruvian silver miner.” The story that followed outlined that a silver miner from Peru, Hochshild (HOC LN in Bloomberg), was the best performing stock in the world this year out of the 5,125 in the Bloomberg World Index. The more interesting insight was not this one datapoint, however, but rather its connection to my long history of studying the global mining industry.
The headline instantly recalled a meeting I once had with the management team of Hecla Mining (HL US in Bloomberg), a silver mining company I have known for many years. Back in 2003 Hecla’s CEO shared with me that Hecla had the unique honor of being the best performing stock on the New York Stock Exchange not once but twice – first in 1979 and again in 2002. For whatever reason, that obscure statistic stuck in my mind. Now once again in 2016 a silver miner, this time Hochshild, is the leading equity in the world. What might that mean about where we are in the cycle?
The Lessons of History
There were different lessons for these prior periods of dramatic silver stock outperformance. For instance, 1979 was a unique year that proved to be the last full year in a long streak of powerful commodity returns for that cycle. It marked the end of a near decade-long bull market in commodities (especially silver) after Nixon devalued the U.S. dollar. Winning investments of the day were all tied to the mistaken assumption that galloping inflation would continue. These investments suffered greatly in the years to come. Why? Inflation, then rampant, was soon to peak. That peak would usher in an extended period of bond and equity market strength. The cycle’s polarity flipped: yesterday’s winners became tomorrow’s losers. Many of those who correctly identified this unanticipated cycle turn literally made a fortune in the years to come.
2002, the other year when Hecla’s performance was world-beating, was a far different environment from 1979. The world was still grappling with the specter of deflation. Its locus was the strong dollar that followed the deflationary collapse of the “Asian Tigers” during the Asian Crisis and the crash of the U.S. Tech Bubble. Commodities, following the lead of gold, were just beginning to rally after decades of underperformance. Sustained credit market weakness and the need for dramatic stimulus made it clear that Federal Reserve policy would remain accommodative for a long time. Students of the precious metals markets knew that meant falling real interest rates and thus rising precious metals prices. While this would, much later, lead to an inflation scare that would subsequently fail, the chief driver of precious metals strength remained the threat of deflation caused by overindebtedness.
We are on record with a few high conviction forecasts. First, that gold’s bruising five year and near 50% bear market is over (“Icarus Falls: The Gold/Silver Ratio Breaks Down,” July 14, 2016 ). Second, that gold’s low will also be the low for the broader commodity markets (“The Message of Gold,” March 23, 2016). Our framework driving these views is that an overindebted world cannot stand high real interest rates, and thus the world’s central banks are doomed to a low interest rate future.
These views have been profitable to those investors with the courage and insight to embrace them, especially in the handful of gold and silver royalty equities (“Franco Nevada: The Art of Stock Selection in the Gold Sector,” March 9, 2016.) We are gratified at their recent strength, especially the 116% year-to-date rally in Silver Wheaton (SLW) and the 58% year-to-date rally in Franco Nevada (FNV).
The Precious Metals Rally is in the First Inning: the Deflationary Weight of an Overindebted World Will Require Constant Stimulus
The strange but powerful distortions caused by an overindebted world have been the central theme throughout our research publications. We are nine years past the beginning of the Global Financial Crisis but its drivers and aftereffects, which still linger with us today, remain woefully misunderstood.
Those who shared our controversial views on this topic have profited from an enduring bond market rally in higher quality, longer duration bonds, the outperformance of the highest quality equities, and from – finally (!) – the turn in the precious metals cycle. This is a continuum of investments whose results are driven by the power of one single insight.
The world-beating performance of silver miner Hochshild harkens back to the lessons of Hecla’s outperformance in 2002. I would argue, however, that now the web of deflationary overindebtedness has spread its tendrils even farther and wider than in 2002. Back then, investors could delude themselves that our central bankers had the skill and ability to manage these forces.
Now, however, the once-confident promises of central bankers to “do whatever it takes” to “make sure it (deflation) doesn’t happen here” ring hollow. Despite many years of effort and even trillions of dollars invested in quantitative easing (QE) and other novel policies – interest rates are lower, overindebtedness is higher; and, faith in the “normalizing” of central bank policies is waning. This is the true message of the precious metals market. Investors would be wise to heed it.
These are the forces keeping our central bank on hold while others around the world have been forced to add ever more liquidity. So deflation is the fear and precious metals are performing well. The lessons from 2002 are holding. If anything, the strategies pursued by our central bankers are counterproductive and only add to the pile of unproductive debt that threatens the world. The higher this debt pile climbs, the less freedom our central bankers will have in managing it. They have painted themselves into a corner. The precious metals markets seem to have figured this out. Certainly the world-beating performance of silver miner Hochshild suggests that they have.
Our goal is to identify early and then to deeply understand what we think are the most dominant trends in the global markets. Overindebtedness is that trend. The next step is to study exhaustively the ways in which we might most profit from this trend – what specific securities to own and the most favorable trade structures through which to express our views. Lastly, we monitor our indicators for signs of cyclical change – challenging ourselves daily about all of our investments.
The explosive move in silver equities, such as Hochshild’s world-leading performance, is a clear sign that the market is beginning to understand where overindebtedness is taking us. Expect the pace and height of Fed rate hikes to disappoint. Expect more “unconventional” stimulus.
Despite years of constant study we know that we still have much to learn about this enigmatic topic. However, long experience has proven that the rewards of success more than outweigh the costs as we seek out profitable pathways forward in an overindebted world.