On October 14, 2011 SmallCapPower published an interview with us as to whether to invest in gold. Part I of that interview follows.
Cymor Strategic Growth Funds CEO Larry Cyna, and Special Advisor David Toles offer practical advice on playing the small-cap space, replete with some small-cap names to get you started (Part 3 of the interview).
SmallCapPower.com: Gentlemen, gold recently underwent a dramatic correction. On the Cymor Strategic Growth Funds blog you wrote: “If you’re a gambler and like to take enormous risks, then buy gold.” Until recently gold was seen as a safe-haven investment and many would still argue that it is. Please explain the rationale behind your statement.
Cyna: In the last 20 years or so the price of gold has been on a pretty consistent uptrend, however during that uptrend there have been some dramatic falls where people have said: “We’ve reached the top of the cycle.” We are in the midst of a dramatic fall now, so a lot of people are looking at gold and asking: “Is gold still a safe haven or not?”
What’s really happened is that the pundits – the people on television and in newspapers – are using the economic uncertainties of the world as a means of filling space in their media. As a result, a lot of fear has been created, which was exacerbated by the debt crisis, and people have rushed to buy gold.
The problem with buying gold is that it’s not easy to buy. Over the last 10 years or so people started buying gold derivatives. People believe they’re buying gold but they’re not buying actual metal. They’re actually buying an ETF or some sort of derivative. As people rush to buy that derivative, the underlying gold is purchased or futures are acquired for gold in order to fill that consumer demand. So there’s a continual demand for gold that is filled by the ETF.
When and if something happens, either to show stability or instability in the world, people will withdraw or purchase more gold. If you believe that the instability will continue and that Italy will default on its debt or that Spain will, then perhaps gold is a wonderful thing to buy. Because people will see that instability as a currency crisis and buy more gold through their ETF or whatever and that demand will skyrocket the value of gold.
On the other hand, if you have an agreement to solve sovereign debt problems in Europe or the Democrats and the Republicans in the U.S. somehow reach an agreement on debt control, then people will get confident, sell their gold, and retreat to more conventional investments. That means there will be a surplus of gold on the market.
In either event, the price of gold can and will move dramatically. So, if you wish to gamble on instability, you gamble on buying gold. If you wish to gamble on stability, you sell gold or you short sell gold. It’s 50/50 as to which will happen.
SmallCapPower.com: That’s an either/or approach. Couldn’t you allot a certain amount of your portfolio to gold and at the same time take a moderate view of the world economic situation in other parts of your portfolio?
Cyna: That’s a very reasonable approach. Most advisors would say that 10% of your portfolio must be in gold or gold derivatives and I think that’s quite reasonable. We don’t exactly ascribe to that approach because if you believe that gold will go up in value, and you’re putting 10% of your portfolio into gold, it’s a wise thing to do.
But if you believe that gold will not move up, then what you’re really saying is: “I will lose on 10% of my portfolio. So, how much do I have to make on the remainder of my portfolio to remain even?” I don’t think that gold is a moderating influence on a portfolio. I think gold’s more of a gambler’s instinct.
I would add that gold tends to go up after events, not during events, so gold is not the safe investment during a period of volatility or instability.
Toles: What I’m hearing from the gold bugs is that gold is not an investment for growth – it’s for protection. But by having it there you basically cap the earning growth potential of your portfolio.
SmallCapPower.com: Where do you see gold bottoming?
Toles: I think it could go as low as US$800.
Cyna: I’ve heard a number of pundits say US$800. It depends on the time frame you’re looking at. I think US$1,200 is a very reasonable number. If you examine the fundamentals, I think US$1,200 is closest to the value of the metal compared to other metals and compared to its real uses in the real world. That’s not to say it’s going to go to US$1,200 because I still believe that it has an equal chance of rising in value.
SmallCapPower.com: In another blog entry on the Cymor Strategic Growth Funds website you discussed the off-balance sheet debts of Chinese banks and how those debts could ultimately cripple these institutions and perhaps even the Chinese economy. How likely is that?
Cyna: If you go back to off-balance sheet financing, you go back to the derivatives created by the American banks which, indeed, almost destroyed the economy in 2007 and 2008. That was a similar type of financing, although used for a different purpose.
You have the same effect in Japan where the amount of borrowing at earlier times had a dramatically negative effect over time.
China faces the same issue. If you borrow money you either repay it out of current GDP or future GDP. So should China’s economy slow down, the effect of this enormous amount of debt that they have could be quite dramatic. I personally believe that the chance of that happening is quite high. I would put it somewhere at 40-50%.
SmallCapPower.com: Wouldn’t that be a positive influence on the gold price?
Toles: It depends on the lending. After the first stimulus injection (quantitative easing) the U.S. government was saying: “See, it’s working. There are all these “green shoots” and the Chinese are investing heavily by building infrastructure.” Well, they’re still building and they’re buying all these commodities like steel and coal and copper. In reality it was really more a reflection of the Chinese banks that they would lend if there was some asset that they could lend to. They were basically hedging the commodity risk.
Cyna: The green shoots refer to signs of immediate recovery, which is what David is referring to. And there were certain signs. But the problem with gold is that is a supply-and-demand metal. The reason that gold has gone to US$1,900 or US$1,600, as it’s closer to now, is that there was a demand for gold.
Should China have an economic problem or a disruption in its growth pattern, the demand will drop from China, which reduces demand for gold. So, a disruption to China is not positive for gold.
SmallCapPower.com: Mr Cyna, you said that gold could bottom around US$1,200. Do you think investors will come back to gold at that point?
Cyna: In the last number of years investors have sought out gold because of the fear of inflation. Historically, throughout Eastern Europe and other countries, when inflation reared its ugly head, gold was the likely source of safety as people bought gold in order to protect themselves against inflation.
As the threat of inflation receded, the object of attention became debt, and debt crises. And that created instability in currencies and then people started flocking to gold because they didn’t see another asset class that would retain its value in great periods of instability. So gold will go higher or lower depending on whether the world is stable or unstable, which is why I said that it’s the great gamble.
If stability returns, investors will not be interested in gold but will seek more conventional investments.
Next: Part 2 of this interview
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