OCTOBER 20, 2003
ERIC SPROTT 416·943·6420; SASHA SOLUNAC 416·943·6448
Chinese Water Torture
It’s not easy being a bear these days. In a market that seems to want to go up on a daily
basis, regardless of the news of the day, bears like us are being subjected to a type of
Chinese Water Torture: the constant drip, drip, drip of the market going up… and up…
and up. We feel strongly that we are ultimately right, yet the market is bent on trying to
prove the bears and the economy-naysayers presently wrong. Doubtless, most of you
have heard our shtick before and some of you may be wondering why we don’t just cave
and accept the recovery and the new bull market as being here to stay. Herd mentality can
be a powerful force, but we refuse to succumb to it. Call us masochists if you will, but
our will and convictions are too strong to be cracked by torture! Besides, the markets
have an uncanny ability of eventually proving the herd wrong.
We find it intellectually appalling the notion of this so-called bull market as something
that is sustainable and justifiable. We’ve believed, and still believe, that this is a bull rally
in a bear market – albeit, a rather powerful rally. But the rally will be true until it isn’t.
Optimism will be true until it isn’t. For the time being, we respect this rally. But at the
same time we are cognizant of the possibility that things can turn in a hurry given the
precariousness of the economy as we see it. There are too many positive stimuli that we
view as unsustainable. When it ends, as all unsustainable things must, there will be a
price to pay.
Our main sticking point, one that differs radically and fundamentally from the norm, is
with the views of the monetarists. Monetarists, such as all the bankers to a man on the
Federal Reserve, believe that the diligent application of monetary policy can be used to
cure all ills. The economy, stock markets, bond yields, housing prices; all these things
can be tweaked and manipulated by the handful of bankers who run the central banks. To
quote Federal Reserve governor Ben Bernanke: “If all goes as planned, the changes in
financial asset prices and returns induced by the actions of monetary policymakers lead to
the changes in economic behaviour that the policy was trying to achieve.” So there you
have it. If you want to make friends and influence people, be a central banker. These
people must view themselves as mighty indeed! But those who are of the Austrian School
of Economics (the train of thought towards which we lean) believe that the monetarists
are really only creating more distortions and making a mockery of free markets and
Adam Smith’s “invisible hand”. By trying to prevent the pain that ensues when rampant
excesses are corrected, what the monetarists are really doing is postponing the inevitable
and ensuring that the ultimate fall from grace will be that much more precipitous.
For the only way to avoid a credit deflation is by creating even more credit. But is
avoiding a hangover by drinking even more really the right thing to do? We think not.
More prudent is to accept the hangover now and get it over with. Take the hurt now or be
forced to take an even bigger hurt later. So says the Austrian School. Debt needs to be
either repaid or forcefully liquidated – it cannot be resolved by endlessly taking on even
more debt. Such a notion would make a mockery of the logic of a free market financial
system. The Fed could make ever-growing debt burdens less onerous by recklessly
inflating the money pool, thereby making debts in real terms easier to repay in the future.
But then who in their right minds would buy the bonds that America is endlessly issuing?
Woe to the bond investor who eventually wants his money back (real money, that is). The
bond market is by far the largest financial market out there, and anything that greatly
SPROTT ASSET MANAGEMENT INC.
1
OCTOBER 20, 2003
ERIC SPROTT 416·943·6420; SASHA SOLUNAC 416·943·6448
diminishes its value (such as higher interest rates) will cause a de facto asset price
deflation.
The Fed is of the opinion that, as long as there is no “inflation”, it can put the pedal to the
metal on money creation ad nauseum. But we, among others, find such a policy
questionable. An interesting, though lengthy, read on this is a Bank For International
Settlements working paper dated September 2003 titled “The Great Depression as a credit
boom gone wrong”. One of the views expressed in this piece is the following: “Central
banks should not be misled, in this view, by the disconnect between asset price inflation
and consumer price inflation. They should respond to the inflation of asset prices by
reining in credit and preventing the expansion from taking a form that ultimately renders
subsequent difficulties more severe.” (p. 3) Rampant asset price inflation, though it may
feel good today, can have devastating consequences in the future. This year, not only
have stocks enjoyed this asset price inflation (memories are short) but so have bonds
(earlier this year, not anymore) and especially houses. Some believe central banks should
be keeping an eye on asset bubbles in determining prudent monetary policy, but
monetarists believe otherwise.
But there is a price to pay – one that, for the time being, is by and large being completely
ignored by the stock markets. Keeping the Fed Fund rate at 1% indefinitely can hide a lot
of woes and create considerable financial speculation. Keeping the credit bubble in
housing afloat, through the unbridled financial dealings of the likes of Fannie Mae and
Freddie Mac, can mask many of the ills plaguing consumer incomes due to worsening
employment prospects. Is it any wonder that any legislative attempt to re-regulate Fannie
and Freddie, and put their shrouded activities under greater scrutiny, becomes dead in the
water soon after it is raised? It would appear that the government needs Fannie and
Freddie as much as Fannie and Freddie need the government. So for now, politicians
have chosen to adopt the head-in-the-sand approach – but at what future cost? Likewise,
burgeoning government deficits can hide many economic woes. But underneath it all is a
train wreck waiting to happen. Somebody, somewhere, is eventually going to have to pay
for all this financial debauchery.
Take a look at the budget deficit, for example, and how much expectations (and reality)
have changed in such a short period of time. As early as January of this year, the
Congressional Budget Office projected a US government budget deficit of $145 billion
for fiscal 2004. Now many economists (Merrill Lynch, HSBC, among others) are
projecting a 2004 deficit in the order of $600 billion – easily a record in absolute terms,
and as a percentage of GDP close to the record deficits of the mid-1980s. As early as last
year, the Bush Administration was predicting a return to surpluses in 2005. Now, even
the CBO is projecting deficits into the next decade. Clearly deficits of this magnitude are
not sustainable and can have severe economic and financial implications in the interim.
But are the stock markets worried? Apparently not. On the contrary, the more the budget
situation has worsened, the more the markets have gone up…so far.
The budget deficit is not alone. It has a twin called the current account deficit (which
includes the trade deficit), running at a similar rate of $600 billion. These twin deficits
have massive implications that should not, and cannot, be ignored. (See chart next page.)
This chart is another great example of Chinese Water Torture; albeit, instead of using
drops the torturers are using waterfalls. Getting out of these spiralling deficits will clearly
involve some pain. For one thing, the US has become too dependent on foreign financing
to maintain this level of over-consumption. Foreigners currently own over a third of all
issued US treasuries, most of which are held by foreign central banks, especially Japan
and China. Things look even worse when taken at the margin. The US current account
deficit is being funded by almost all the savings generated in the world this year. As
Bridgewater Associates succinctly put it: “when Asian central banks start to change their
minds about their wrong-headed support of the dollar and US credit markets, it could
SPROTT ASSET MANAGEMENT INC.
2
OCTOBER 20, 2003
ERIC SPROTT 416·943·6420; SASHA SOLUNAC 416·943·6448
have a large impact on US financial assets and US growth.” (“Bridgewater Daily
Observations: What Foreigners Own”, October 7, 2003) The implications are:
substantially higher US interest rates and a substantially lower US dollar.
Figure 1
Current Account + Budget Deficit as % of GDP
Source: Sprott Asset Management Inc.
One could use the argument that it is the foreigners’ “fault” that the US current account
deficit was allowed to reach such heady levels. After all, it is they who are willfully
financing this deficit by investing in US financial assets. Be that as it may, because of the
colossal size of their holdings (foreign central banks alone now hold $1 trillion of US
treasuries and agencies), the foreigners are now the judge, jury, and executioner of the
dollar and the treasuries market. They may not want to rock the boat just yet, but this will
only be true until it isn’t. History shows that it is usually the strong currencies that attract
foreign investment. Currently, the dollar is weakening and bond yields are rising. But this
may only be the tip of the iceberg if foreigners change their minds about the desirability
of investing in the US reflation game.
These are some of the macro reasons we don’t like the stock market. We are clearly not
alone. Everyday in section C of the Wall Street Journal there is a table titled “Insider
Trading Spotlight”. It lists the top ten largest insider buyers and sellers for the day. Under
the sellers column, the largest trade was for $10 million and the tenth largest was for $2
million. Under the buyers column, the largest insider buyer bought… wait for it…
$13,000! Not much more than what a kid would earn doing a paper route. What’s more,
the top ten insider buyers were actually only four. If you’re a corporate insider, and want
to see your name in the papers, just buy a couple shares of your company’s stock. You’d
make the top ten! Clearly, the smart money is not convinced about this new bull market.
We believe our views, and those of the Austrian Economists, will have their day even
though for the time being things are not working as planned. There will come a day of
reckoning. We are not smart enough to know exactly when this will be, but we believe it
is unavoidable. It is for this reason that we refuse to buy in to this bull market. For now
we are content to be sizeable holders of gold and gold stocks, which have gone a long
way towards easing the torture of this illogical and highly speculative stock market.
SPROTT ASSET MANAGEMENT INC.
3
OCTOBER 20, 2003
ERIC SPROTT 416·943·6420; SASHA SOLUNAC 416·943·6448
The opinions expressed are solely those of the author. They are based on information obtained from sources believed to be reliable,
but it is not guaranteed as being accurate. The report should not be regarded by recipients as a substitute for the exercise of their own
judgement. Any opinions expressed in this report are subject to change without any notice and SAM is not under any obligation to
update or keep current the information contained herein. SAM accepts no liability whatsoever for any loss or damage of any kind
arising out of the use of all or any part of this report. Sprott Asset Management Inc. is the investment manager to the Sprott Canadian
Equity Fund, Sprott Gold and Precious Minerals Fund, Sprott Bull/Bear RSP Fund, Sprott Hedge Fund L.P. and Sprott Hedge Fund
LP II. Important information about these funds, including management fees, other charges and expenses is contained in its simplified
prospectus and/or offering memorandum. Please read them carefully before investing. Mutual funds are not guaranteed; their unit
values and investment returns will fluctuate. Performance data represents past performance and is not indicative of future
performance. Performance comparisons are drawn from sources believed to be accurate. This is not a solicitation.
SPROTT ASSET MANAGEMENT INC.
4