Irish Mortgage Brokers Blog

In this video Toby Birch of Guernsey Gold talks to CNBC about Islamic Finance, Toby is a worldwide respected expert and practitioner on the topic of Islamic Finance.

This is the video taken at the Radisson Golden Lane in which Kevin O’Rourke of TCD delivered a talk about ‘The Great Depression to the Great Credit Crisis, similarities, differences and lessons’. It is a great video, well worth watching if you weren’t able to attend the event.

Kevin O’Rourke talks to CFA Ireland 26th Nov 09′ from CFA Ireland on Vimeo.

While we are bullish on precious metals (in particular silver) it is important to remember that many commodities are dollar denominated assets and for that reason they will often appreciate if the dollar weakens, this happens with oil, and it is currently happening in gold (see chart below).

The recent gains in gold are at least in part due to dollar weakness, price gold in euro or loonie and it looks relatively flat for the last seven months in which historic nominal highs were tested. Low carry costs and future inflation risks are in that mix as well, however, in the respect of an inflation hedge gold is still the master metal and silver has good upside potential as well. That doesn’t mean caution can be thrown to the wind in expectation of gains, although physical demand is up a reverse in financial gold plays could happen swiftly and undo much of the current range in a few days trading and for that reason holding metals should be (as we always advise) part of a play or portfolio and not THE portfolio.

Gold prices broke the $1,000 mark again and have been hovering around that mark for some time (today’s spot price is $991.91), this is making headlines as people comment on ‘record highs’ that the metal has reached in nominal terms (no inflation factored in), if you adjust for inflation the current price would need to be c. $2,500 to match the $850 peak reached in January 1980.

The Dow/Gold ratio is currently 9.7 historically during a crash you would see gold prices surge, the peaks in the graph below are the low points of gold prices/high Dow, and you can see that in the past (c. 2000) it would have taken 40 oz of gold to buy the Dow, the historic average was around the 5 or 6 oz mark which would mean either the Dow is overpriced or gold is under priced, a ratio of c. 6 would put gold at a price of $1,605 (Dow at 9630) and at 5oz would price gold at $1,926. The hidden aspect of the whole equation is that of inflation, by viewing prices relative to gold prices it tends to strip out some of the market trend linked to inflation.

Given the historic issues mentioned thus far, it is (in my opinion) fair to say that gold is not excessively overpriced, or perhaps even overpriced at all.

But this was a blog meant to be about silver?! Yep, its about silver, but with the historical importance of putting gold in perspective in order to make the point which is this: Silver probably has higher upside than gold in 2010.

From the time of Alexander the Great, through the life of Jesus, and until the end of the Roman Empire gold was priced at c. 12 ounces of Silver. During the bi-metalism era the ratio was c. 15 and the average over time is around 16, so irrespective of prices at the time, historically if you have 1 ounce of gold you can buy 16 ounces of silver with it and vice-versa, it actually correlates to the amount of silver and gold occurring in nature that comes out of the ground at extraction. So hopefully you are seeing why the price of gold is so important now?

There are basically two situations at hand, either gold is wildly over priced or it is not, and if it isn’t then the gold silver ratio of 62 (silver trading at c. $16) means that there is a sizeable upside on the price of silver - using the more recently historical average of 50 (approx) would put gold at a price of $750 and there are few in the market (even amongst precious metal doomsday commentators) that would see gold trading at those levels any time soon after such continued resistance at levels over $900, and thus we have a compelling argument for the upside in silver, because, unless ‘this time it’s different’ then the ratio needs to revise to mean.

If hypothetically gold lost half of its value and went to $500 (dow/gold or gold/oil ratios aside), the traditional gold/silver ratio of 16 would assume a price of $31 which is about double the price today - but the return of that ratio is only likely if we re-enter a 70’s style stagflation economy (and in that event gold would likely push higher in any case).

Silver historically has a tight correlation with gold and while the long term historic trend was a SGR of 16 the reality is that for many years it has steadily been more in the 45-55 range which still implies a silver price of $18 which would still represent a 13% gain if the range is met at 55 (which is more the more conservative figure).

Interestingly, many mining companies use the 55/1 ratio in valuing their non-primary extraction: so a primarily gold mining company will value its silver finds at 55/1 and a primarily silver mining company will do the reverse for any gold they extract converting its by-product gold into the cash equivalent of silver ounces.

This still bides well for silver even if gold stays at the current level, however, if you are still bullish on gold and expect to see it at $1,200 within the next year then it would imply (at worst) a SGR pricing of silver at $21.80 which is a 36% upside on silver versus at c. 20% upside on gold. The other thing that happens when gold runs strong is that silver sometimes goes over value in tandem with it, in 1980 the SGR was 17 when gold hit a high, if that happened today silver would trade at $58! That is a bit too ‘pie in the sky’ for my personal liking, but silver trading somewhat regularly over the $20 in the next year isn’t.

The point is simple, silver may currently be the better metal of the two most well known nobles to get involved in. It also doesn’t hurt to consider some past performance (although we prefer to concentrate on future upside!).

Silver has actually outperformed (in Dollar or Euro) every other comparable in the graph above over a five year period in both $/€ and also in the 1yr range and it only loses out to oil in the YTD. (many thanks to Dublin based GoldCore for the figures!).

To actually buy silver you can do it one of several ways, you can buy certificates, bullion or coins, we’ll do another post sometime explaining the various processes, you do need to be careful of VAT liabilities depending on how you proceed, if you can’t wait for that post and want specific answers you can always call us of course.

The fact that so many Irish investors totally overlook precious metals is a shortcoming of our investment community, precious metals have a proven record of maintaining their value in the face of any contingency, and responsible portfolio design should include some level of exposure to precious metals, if yours doesn’t then you shouldn’t question your adviser, you should question your choice of where you obtain your advice, you don’t have to master every aspect of the investment world, but if you are paying for advice either directly or via management fees then there is somebody out there who is paid to do that and you should at the very least be given the option and argument for precious metals.

Here is a simple question: ‘how do you protect or even augment your portfolio returns when markets are crashing or where there is systemic risk?’ if you have an answer then you can be a little smug because the majority of fund managers, the best and brightest the world of finance has to offer, for the most part didn’t have an answer during the last two years and if they did they didn’t (by and large) act upon it.

The classic definition of a hedgefund is not the ponzi-schemes run by the likes of Bernie Madoff, rather it was a fund that strategically goes long and short to produce positive gains regardless of whether the market goes up or down, that was what Winslow Jones was doing when he started the first hedge fund in 1949, while managed fund managers are happy to post a 20% loss when the averaage is -30% (for instance), hedgefund managers are meant to be able to outperform bull markets but also post positive returns in bear markets, sadly, many hedgefunds in the last few years weren’t even hedged! They were basically long only equity funds that liked to charge high commissions based on returns which were largely posted due to excessive leverage!

How did that work? Well, a fund starts off with €100 and then they go and borrow €900 so now they have €1000. If the market goes up 3% they make €30 which looks like a 30% return on funds invested if they pay back the leverage (borrowings) but this is false economy because if prices don’t go up funds get margin calls and then they are often coupled with problems of not being able to ‘roll-over’ their borrowings, repo markets [to a degree] have the ability to stand over any fund once in a 24hr period but in many cases this mechanism failed as credit providers lost confidence in repo-borrowers.

It is worth taking a moment to understand the ‘repo’ market, it doesn’t mean ‘repossessed’ rather it means ‘repurchase’ because what happens is that collateral is given up overnight in order to obtain operating funds, if this doesn’t happen, for instance if your counter-party doesn’t trust your collateral or thinks you might not be able to repay tomorrow then you can literally be shut out in an instant and you close down rapidly, this is what happened to Lehman and Bear Stearns.

Back on topic, the way to ‘hedge’ is to include investments that have an inverse correlation to the broad stock market or to particular shares held in the fund. The Japanese Yen is an example of a currency that does this, when markets crash the Yen strengthens, since around August 2007 - where the first hit of the current crisis started to play into the market. Every time the market took a dive the Yen has risen.

Often when stocks crash institutional investors rush to cash out of their stocks and repay their Yen denominated loans (Yen was used due to its low interest rate), that is called the ‘unwinding of the carry trade’ which we have covered before - the ‘carry’ trade occurred where people borrowed in yen to leverage up because a ZIRP (zero interest rate policy) meant it was a good currency to borrow to the hilt with.

Gold is another hedging tool, the deeper the crisis got in the early days the faster gold rose, going over the $1,000 mark in 2008, since then it fell back to the low 700’s and is trading again in the 900’s, the part to remember is that gold has

There are beneficiaries of systemic risk and systemic collapse, the downside is that many investors are nowhere near a life raft when the ship is sinking. I like the analogy of the Titanic, you see, for all the history of tragedy associated with the Titanic, it must be remembered, there were also a lot of survivors, they were the ones who got onto the available life rafts.

Dollar hegemony or dollar supremacy is likely going to change significantly in the next decade, the transition will be difficult and will feed through to commodity prices and equities. So being ready for volatility is vital.

Publicly I said at the end of November that I saw real value showing in Irish banks, they were trading well below the €1 mark, they fell right down but came back with a vengeance, hence I followed up with a sell call in June 09′when the major bank shares in Ireland were trading closer to €2. It is important to have an exit plan whenever you get into anything (again, make sure you have access to that life raft!).

the thing to understand is that there is always a bull market somewhere, you just have to find it, sometimes that means using inverse ETF’s or shorting strategies (which can be done via options as well), or just going long in the right places, we hope you don’t lose sight of the desitination because of the current scenery on the journey! Wealth is built in small steps, one day at a time.

Hugo Bouleau’s (pseudonym of the author) book was for me, perhaps the most riveting reading of 2008. I like to underline important sentences in books, it’s a habit I picked up from a history teacher in secondary school. Looking back through ‘The Final Crash’ I can safely say I went through a whole pencil!

Bouleau writes the book not only from his practitioner experience as an asset manager for a large private bank in the Channel Islands (he is also a fellow of the Securities & Investment Institute), not only from his educational background from City University in London, but from that of a concerned citizen of the world who realises the core issue of the financial crisis, the one that remains largely uncovered in the day to day reporting, that of debt and leverage, in particular, that of irresponsible debt, and excessive leverage.

Bouleau has since changed careers, having recently started a Sharia compliant Islamic Finance operation. I caught up with him on the phone just as he returned from Saudi Arabia but before he took some time off in France.

I had the opportunity of speaking with Hugo today (I’m such a nerd that I got kind of ‘finance star-struck’!), my own psychosis aside, I found him to be a really affable character with massive dose of what you might call ‘British common sense’, his are pragmatic, not far different than that which an older relative might give you, he talked about the importance of not incurring too much debt and the problems with interest, money creation and other areas.

The conversation we had is outlined below, while it loosely covers many of the topics talked about in the book, the book itself is a wealth of information and poignant commentary, and certainly worth every penny.

Some of the things mentioned in the ‘Final Crash’ (written in 2006, published in 07′) have already come to pass, but it is the breadth of knowledge and tying together discordant worldwide occurrences as well as policy changes then putting them into a meaningful and understandable story that mere mortals can comprehend which is the true genius his work. ‘The Final Crash, addictive debt and the deformation of the world economy‘ is available on Amazon.

Hugo generously gave me a half hour of his time, some of the questions I asked, and his answers to them, are below.

Hugo, if you could take control of the world economy tomorrow what would you change?

‘There three things, first of all, a lot of stability was created in the Victorian era with the gold standard, but there is not enough gold now to go back down that road, gold would need to be trading at $40,000 an ounce to match the creation of money since the Vietnam war (i.e.: the time when the USA de-pegged from gold c.1971), the USD money supply has increased 30 fold since then.’

‘What is possible would be to go for a precious metal standard which would include all precious metals, gold, silver, and platinum (I asked why other nobles such as palladium and rhodium were not in this list and he told me that the ‘basket mix doesn’t matter so much as it being a basket’), basically match the money that is out there with precious metals at current prices that way supply of precious metal could meet demand of fiat currency presently whilst simultaneously deterring further money creation. So first, get a stranglehold on further money creation.

‘Secondly, in order to do that, we have to stop private banks from creating large amounts of money from small deposits, fractional reserve banking certainly has its downsides’. I wanted to know if Sharia compliant financial products were a solution (as he recently moved into this market), ‘Islamic banks try to mimic western ideas but they are not allowed to create money the way western banks do. Interest gets you a return due to asymmetric information, you don’t know as much about a company so you charge a ‘rate’ of return, and we base that on prevailing interest rates. However, a profit share might fix that, it is very grown up, and furthermore it is possible in an electric/digital age. It takes more effort, along with a change in perspective. The idea is that if you are doing work you should get paid for it, nobody has an issue with that, providing liquidity or infrastructure should come with a charge but benchmarking to an interest rate doesn’t have to be the way the charge is incurred.’

That struck me as quite interesting, why do we have to be slaves to prevailing rates? It creates massive peak/trough debt experiences, anybody with a variable rate mortgage knows how much their repayments have come down recently (and we see that as good yet we don’t’ see the disastrous economy which prompted the rate drop as good!), but everybody knows that this will be followed by an increase.

‘So we are stuck in a cycle where money creates money and private banks have a monopoly on money creation, Abraham Lincoln believed that governments should have the responsibility for creating money, and Zimbabwe is touted as the downside of this, but the idea is that if the state are creating money and they receive the tax base then there is no earthly reason why the state should pay interest, they should be the lender, not the borrower. People need help, governments want to help and stuck in the middle of all this is the entire banking system.’

‘You can throw bailouts at banks all you want and they will suck in capital and effectively atomise it, it is feeding the off balance sheet stuff that you cant see. They are trying to squirrel it away to provide a layer of protection. Existing loans that were packaged and sold on (via securitisation) leaving them with what looked like a clean slate, but you have layer upon layer of bad loans, and these are coming back to haunt banks via bond insurance etc. and when people need to sue somebody it comes back to the person with the deepest pockets which will be banks themselves.’

You gave a picture in 2006/07 of what the world would be like in the near future, much of this has come to pass, so what next?

‘I am actually very positive about the future at the moment, what we are going through is highly beneficial, sometimes you go down a path and a door slams in your face and it hurts, but the path we were on was destructive, permanent growth has no equilibrium, the very environment itself and much else was hurting, the high-water mark of the past market is now like a ’scum mark’. You can actually have prosperity without inflation, equilibrium economically is possible, however, the contraction will still happen’.

A depression is by definition a 10% contraction in GDP, so Hugo is waiting to see ‘A period where not only the economy but stock markets stay flat. Almost everything wrong in our current economy seems to get back to the end of the gold standard’.

We talked about the recent equities rally that has taken place since March ‘this big rally is pretty classic, but was during the Great Depression that the biggest rally prior to this occurred’.

Do you believe in the transfer of power and wealth from west to east or is this merely a cyclical high for BRIC nations the same as in the 70’s when some were touting Brazil as the next world super power?

In previous decades it was western institutions lending to developing nations, so they started with shackles, countries with the highest IMF debt, incidentally, have the highest levels of deforestation, there is a correlation between western style lending to developing or emerging economies and destruction of those economies. Now these countries are the actual surplus nations. Lately, commodity rich nations are much less aggressive than they used to be in dealing with each other, the Chinese and Russians are getting along a bit more now, providing infrastructure projects for free effectively, the real wealth of the future is actual ‘thing’s, actual goods, such as commodities, not bonds and paper. The infrastructure approach means you are providing capital and helping provide for the future so you get long term benefits, the Chinese approach is more of a partnership (from a business ethic perspective not a political one).

The Guernsey Experiment - how do we make money that doesn’t cause inflation?

If you keep printing money for projects you add to the money supply, this will inevitably create inflation. The figures in the US stopped being produced (M3) in 2006 so it isn’t easy to measure it correctly any more (money creation) The velocity argument still holds credence, when you see charts of base money there has been a steady rise since the 70’s in the last two years it has gone straight up!

Any exponential chart, irrespective of what it is about is generally a risk, even natural examples show that, cancer cells replicating fast are bad, yeast can replicate rapidly and kill itself off (anybody who enjoys a pint has consumed the reality of that!).

The last time this happened was during the Weimar Republic, interestingly during the first 6 months the Reichmark actually got stronger in value, but is like a tsunami, things go one way then slam into the opposite direction. If you keep producing money it then its like ketchup in a bottle, you shake the bottle trying to get the ketchup out (credit flowing) then suddenly it all pours out at once, the inflation will come thick and fast.

Regarding Guernsey, they had money which rather than having notes saying ‘payable on demand’ they had a sell by date. A government bond has a maturity date, the Guernsey note experiment was done whereby the state or government would create the money for local materials and local people, at the end the debt would have to be cancelled, you create money to do a job then destroy it. When you strip interest out of the equation then it becomes a method of exchange (which is actually the original reason for money existing), and therefore money has no intrinsic value in its own right. It is only when money literally makes money that you have a problem.

But surely when it is coming to the expiration date people spend them like crazy and then cause inflation anyway?

Interestingly they didn’t, the state they would issue more notes on maturity if required, the money supply can be created or destroyed at will. By creating real money to finance real things (eg: town market, town hall) rather than speculative deals then it makes a perpetual income source. The more projects funded, the more rental income and then you have a permanent sinking fund to pay off past debt, you can go on to build harbours, schools etc. (as they did in Guernsey using this system).

During that time there were still private banks, and the local banks complained because they were being sidestepped. Funny enough, Government projects were capped at £40,000 but private banks could print whatever they wanted, but when they were not being used they felt hard done by.

What do you think of alternative currencies: freedom dollars, liberty dollars or other ideas in the USA?

‘In the big picture the use of precious metals is the best, naturally there is downside in the mercantilist effect of everybody going all out to accumulate gold, but as long as the mechanism is there it can work. On local level these things happen by themselves, in Germany during the late 1920’s/early 1930’s people used a local currency, Nazi’s stopped it when they took power. The likes of ‘Liberty dollars’ are a different story, the creators of them got arrested, its a little disturbing, it wasn’t harming anybody, it is clearly the IRS using bully tactics because they can, the founding fathers of america were real hero’s, they would not have agreed to that kind of approach.’
I would like to send a very large ‘Thank you!’ to Hugo Bouleau, not only for what was an epic and insightful read, but also for taking the time out of his day to talk to me and provide this interview.

The endurance of gold at above $900, rising oil prices, the weakening dollar and a Treasury/Fed combo that is increasing the money in circulation will lead us where?

I hate to harp on about inflation but it just doesn’t seem that further down the line we won’t see a lot of it, the market is pricing it in, the yield curve is suggesting it, and yet it remains on the periphery of commentary for the most part.

One important statement in this talk is the bit where one of the guys talks about the fractional reserve system and the multiplier effect that can turn 800+ billion into 8 trillion.

When we are advising longer term fixed rates to avoid the pain this will bring (and it won’t be in 09′, it will be 10′ or 11′ but rest assured it will come), bear in mind that in the short term you will pay more than you have to, but that when everybody else is hurting you will be insulated. The reason for fixing now rather than later is that the prices today won’t last as the market starts to get closer to the realisation of inflation, so you have to pre-empt it to a degree, and buy before the fact because once it becomes widely known then the prices will reflect that knowledge.

I have been a proponent of inflation being the greater risk to society than deflation for quite some time, so all said, I am in the ‘inflation is the true risk’ camp. Interestingly, it is starting to become the topic of the day now and apart from my feelings that a fixed rate now is a good idea, there are two debates from the major money channels below, one is from Bloomberg the other CNBC. They are well worth watching.

The first clip from Bloomberg has Tom Keene, Economics editor and Alan Blinder (formerly of the Fed)  of Princeton University.

The next clip is from CNBC on the same topic, featuring Larry Kudlow, Michael Darda, MKM Partners; Joe Lavorgna, Deutsche Bank and CNBC\’s Sharon Epperson.

Steve Leuthold talks on Bloomberg about the reasons he feels we are going to see a cyclical bull market (as opposed to the secular bear that many feel we are in). Small cap stocks (likely some pinksheets) and many others are headed upwards according to Leuthold who feels that this we are seeing the best valuations he has come across in his 45 years of studying the markets.  He says that a split of 65% in stocks is now advisable, that is a huge weighting given the market moves we have seen lately where equity holders have been continuously wiped out. Big tech stocks and gold both feature in his talk.

For quite some time (since late 2007) we have been advising our clients to buy gold, and  not many have listened! Today gold is once again trading above $900 per ounce, the current spot price is c. $913 per troy oz. Some commentators are now taking the view that gold will surpass the $1,000 mark per once and for all and remain in a secular bull market, this is contrary to many who felt gold was a ‘bubble asset’ up until recently.

Is gold in a bubble? Strictly speaking the price has risen enough to have bubble characteristics, and despite any bull arguments given for the upward trend one truth remains, ‘trees don’t grow to the sky’. Having said that, there are events in the world economy that challenge the bearish view against gold. For a start, gold is not the only noble metal witnessing gains, silver, platinum and palladium are trading strong as well, investors are finding physical supply difficult to come by and some countries such as Vietnam have a ban on the importation of gold.

Currency movements have had function in the rise of gold, as the dollar weakened gold rose, and if you look at historic gold prices it wasn’t until the USA un-pegged the Dollar from the gold standard (which had it priced at $35 an oz) that gold moved much at all, it is a store of wealth, and the only true monetary metal - albeit nobody uses it as actual money.

The situation now though is that credit contraction will do one of two things, it will either force up the price of gold or it will force liquidation of gold in favour of currency (for which to stay liquid) and the price will drop. A part of me believes the latter to be likely, another part thinks the former will happen. If I had to make a prediction it is this - there is still enough liquid cash in the right hands in this world to create demand for coin and bullion. Gold will break $1,000 in 2009.

Other metals such as silver are faring better after a strong fall off in 2008, silver does have many industrial applications but as deflation reduces demand the demand for silver equally drops and that is why gold will do better in a deflationary market, silver suits high industrial output markets (bull markets).

If you want to talk to us about investing in gold you can call 01 679 0990 and ask to speak to a consultant or email info(at)mortgagebrokers(dot)ie