Eric Sprott: A Rude Awakening In Precious Metals

Eric Sprott is the Chairman of Board of Sprott, Inc., the parent company of Sprott Asset Management USA Inc. Eric has more than 35 years of experience in the investment industry. After earning his designation as a chartered accountant, Eric entered the investment industry as a research analyst at Merrill Lynch.

In 1981, he founded Sprott Securities (now called Cormark Securities Inc.), which today is one of Canada’s largest independently owned securities firms. After establishing Sprott Asset Management Inc. in December 2001 as a separate entity, Eric divested his entire ownership of Sprott Securities to its employees.

Eric’s investment abilities are well represented in his track record in managing the Sprott Hedge Fund L.P., Sprott Hedge Fund L.P. II, Sprott Bull/Bear RSP Fund, Sprott Offshore Funds, Sprott Canadian Equity Fund, Sprott Energy Fund and Sprott Managed Accounts. In December 2007, Eric was named Fund Manager of the Year by Investment Executive, a widely circulated publication for Canadian financial advisors.

Eric’s predictions on the state of the North American financial markets have been captured throughout the last several years in an investment strategy article that he authors titled “Markets At A Glance.”

I had the pleasure of recently speaking with Eric Sprott over the phone. The following is the transcript of this interview.

Patrick MontesDeOca: Hallo Eric, and thank you once again for sharing your insight here in this most opportune time. Getting right into the interview, first of all, can I have your opinion on a report or a summary that you recently published on your website Sprott Asset Management called Markets At A Glance. In this report you cover in detail the eurozone crisis currently basically happening in the eurozone…Cyprus, and all the other peripheral countries. Can you give us your opinion and insight on that?

Eric Sprott: Sure. Well, Patrick great to talk to you again first of all and again congratulations for keeping people informed on events that are transpiring that perhaps aren’t in the mainstream media but are important for people to follow very closely. The Markets At A Glance I can probably explain it in 2 words. And that is the title of the article and that is… Caveat Depositor.

Obviously, when Mr Diesel Boom suggested that there was no template he was not being very forthright because there is a template and in fact, I think in his first interview he basically said the same thing four times because when the banks have risks those banks risks have to be shared with the various people who have liabilities of the firm which is of course the depositors as one, and we saw that of course play out in Cyprus and it was very unfair what happened and the more I think about it and I don’t think many people have commented on this but what I find most interesting is that the depositors take the first hit in other words when the ECB says they are going to put in $10 billion which we are not even sure what they are going to put it in, they get a piece of paper in return, they say they have a loan to somebody and therefore it could possibly be repaid.

The depositor walks away with a loss, day one, he doesn’t get a piece of paper and in fact I think I even heard that the ECB is exempting any deposits they might have any liabilities that they already had with Cyprus, as exempt from the haircut so that is just a travesty of how things should work ok, the depositor taking the first hit. In fact the bigger they hit the depositor the more likely the ECB is to collect their $10 billion, because of the hierarchy on the balance sheet right? But essentially what we said is because we’ve seen what happens in other countries in so for example New Zealand, the banking authority just passed the same sort of thing, ok, that if there is a systemically important bank, here is what is going to happen, the same as happened in Cyprus.

The government in Canada recently introduced legislation to do the same thing . The US and the UK have done the same thing, so obviously there has been a decision made by the governments who realize that their financial systems are at risk, their banking systems I should probably say when their banking systems are at risk, how are we going to deal with this problem? Because the problems are bigger than the countries, because the banks are so much bigger than the countries and that is obviously their solution.

PM: You know one of the things that I find disturbing is the complacency of investors realizing that the central bank leader’s intentions to levy, basically to steal deposits to save the banks, they are not really understanding what the consequences are. Could Cyprus possibly be the Black Swan in the Eurozone banking system or will it disappear from the headlines?

ES: Sure. Well Patrick, for the first part of the question, you know, that people are being benign about it, I’m not so sure in fact that is the case. We judge that by what’s happening in the precious metals market and the stock market you know, and if it’s gee..The stock market is going up and the precious metals market is going down and therefore everyone is complacent about it. I don’t think that is the case whatsoever in the real world.

As you know the stock market is almost a function of central bank printing of money, that is essentially what is happening, ok? And I have written many times that I think the western central banks continue to supply physical gold to the gold market to suppress the price and I fully believe it and I fully documented it. And the other thing I would say is we have noticed that there has been a pick up in buying of precious metals since the Cyprus thing happened.

There is no doubt that it is happening whether you want to look at the US Mint statistics. We have a company called Sprott Money and we see more buying of gold and silver happening there . You can see that people, people aren’t stupid, particularly when you realize that the people at risk are the people with over 100,000 euros in the bank, these are not stupid people, these are people that got that kind of wealth because they anticipated things right? And I think that things are going on and I think it is a black swan , and you know that thing I am watching the most is, ok I am thinking is what’s the next bank? Ok, Because there are weak banks out there and we know who they are. Do we not think there will be a bank run going on in some of those banks right now?

PM: Well just the peripheral countries should be affected by this economically so its a domino reaction it has to be.

ES: And there’s weak banks in those countries, we all know who they are, so if you are sitting there with money in a weak bank do you think people are leaving their money there. I mean all they have to do is change banks. Like move it to at least a stronger bank!

PM: Well I think that is the danger is third party risk at the highest level that you have ever seen.

ES: Right, you know the money has got to be moving and of course here is the problem, banks can’t fund the deposit withdrawal because they don’t have that much in current assets, you know, cash ready assets so when the money starts leaving, we have an example we had

Banco di Montepaschi said well we’ve had a few billion dollars, undefined by the way, leave the bank, well, you know you have to sell something in order to fund these deposit withdrawals which means you have to sell an asset and lots of cases banks don’t have assets that are readily sellable, or the first ones to go they sell and then of course if gets tougher

I mean you can’t just liquidate a mortgage portfolio particularly when everyone else is trying to liquidate it. I would imagine that there are bank runs going on right now in some of these lower quality banks which you are not going to hear about but you know it has to be happening.

PM: What does this mean for the US fragile economy and the stock market moving forward from here?

ES: Sure. Well, I have always been of the view that there is no recovery. That we are always told this is great recovery, as we were told last year you know 2012 this is going to be a great year, we finally get to the end of the year and GDP is up .1% so there was no recovery going on even as it was much touted earlier on in the year.

And as I look at 2013 I’ve argued there is even more reason for there to be no recovery this year. We have had people who have taken a tax increase, we have had a sequester that is going to negatively affect people and everyone is merrily looking at the stock market saying oh well everything must be fine, but recent data is not very good, I mean we’ve have the PMI’s go down, purchasers manufactured index go down, we’ve had jobless claims are going back up, we had announced job cuts went up 30% in March in the US this year versus last year. We had announced job hirings that went down by 90% this year in March versus last year.

So my view is that it is not very robust at all, we’ve had lots of earnings warnings from Caterpillar (CAT) and Fedex (FDX), Oracle (ORCL) and restaurant chain sales went down 5.6% in February which is totally in line with what would be happening to disposable income of workers in this case because of the increase in tax. So I don’t think there is recovery, I think the market goes up on the fumes generated by the Fed but sooner or later we are going to look at things in the light of day, what’s really happening here and I am very much looking forward to seeing the first quarter both revenues and earnings and see if this huge rally that we’ve had of the 209 low is substantiated.

PM: You know Eric, we have covered the eurozone greatly in our previous interviews and we talked about the possibility of bank runs and price controls , this is the very thing that we are witnessing right now. Are we moving closer to a total collapse of the monetary system as we know it or do you think there is hope that things will get fixed?

ES: Well of course, I think that we are getting closer to a total monetary collapse if I took myself back 10 years, which we wrote about at the time, the problem is that the banks are too levered, OK, they are all levered twenty and thirty to one, well if you are levered thirty to one you could take a 3% hit on your assets and you are have no capital , well what the hell is a 3% hit!

I mean if you are in Greek bonds or Cypriot bonds, you know what the percentages are, they are just unbelievably greater than that. And that is the problem, the financial system got too leveraged. And it got too leveraged, and if you want to go back and review it, because the banks thought they could generate this 15% return on equity every year and the banks as a group became such an important part of the economy, for example I think it was at one point it was nearly 25- 30% of the stock market, well when you are 25 -30% of the stock market if you grow at 15% a year for about 15 years you are 100% of the stock market, it is impossible, how can you do that?

But they believed it, and the only way they could grow that way is they had to keep levering so they just levered and levered in order to keep up this facade of being this wonderful business so that could forever produce a 15% ROI well world GDP grew at 2 or 3% so we know it couldn’t continue to happen.

PM: What are the alternatives to deleveraging or what is the process?

ES: Well there are only 2 ways to deal with, either you inflate the debt away thru hyperinflation which is one way of doing it, of course the other way is what you call a dead jubilee or where you all just agree hey we can’t pay off these debts let’s just write them all off, which of course would be disastrous for those who think they have some asset which is worth something in their portfolio and find out that they weren’t going to get repaid!

PM: Well isn’t that’s what is happening right now in Cyprus?

ES: That’s exactly what’s happening with Cyprus! And already happened in Greece, I mean that was a 100 billion dollar haircut there right? And it’ll happen in other countries. You know its funny that almost every month these European countries keep downgrading their GDP growth and upgrading what the size of their debt or deficit is going to be versus GDP every month it goes higher.

I have a theory that weakness begets weakness and there was when JP Morgan announced they were going to lay off 19,000 people, it not just the 19,000 people that are affected it is where the 19,000 people spend their money, they are also affected. There are only 2 ways to change a trend of weakness, fiscal policy and monetary policy, and its got to be sort of an exogenous event. We run a gamut on fiscal policy, nobody has got any room for fiscal policy changes here we even have austerity in the USA with sequestration right? Everything is austerity policies in Europe so we don’t have a fiscal policy that can change things so now you go to monetary policy, we have zero interest rate and we are printing money, I mean is there anything left in the tank here? I don’t think there is anything left in the tank!

PM: There is some discussion going around basically using gold as a collateral to replace austerity in the eurozone, Italy and some other countries, how much of a real possibility is that, that they could use their gold reserves?

ES: OK, In other words sell the reserves to spend more money?

PM: Not sell it, but basically collateralizing it lets say five to one in order to possibly to generate some liquidity and reduce the interest rate payments on the bonds.

ES: I don’t know who would want to be the guy backing that quite frankly, maybe the ECB would its just another form of printing money I mean they could may as well print the money right

PM: Well that’s essentially the same thing

ES: Have another LTRO right? guys whatever amount of money you want just take it so but all of these are essentially insane financial policies I mean, it comes down to pure insanity and we keep thinking and looking at the same things they do and they don’t work and we keep thinking the next ones going to work.QE1 didn’t work, QE2 didn’t work it doesn’t look lik3 QE3 is going to work.

I don’t know why people are always hopeful something is going to change the economy just doesn’t have any spunk to it the only things that are getting better are auto sales and home sales which are 100 percent reliant on ridiculous amount of credits. Particularly in autos, I was reading in an article where sub prime lending in autos has gone crazy. And so we keep having these people who can’t afford a car that get a car. Of course the interest rate is 25% then they put it in some package where they sell it off as a lump sum its almost as is like subprime in housing all over again

PM: Moving into the gold and silver market, Eric, what’s going on with the gold market. Have you ever seen such a disparity between the paper and the physically market in your career?

ES: Well it gets a little more bizarre all the time and I’ll just use 1 proximate, look at the US mint sales, they’re up 40% in gold and 40% in silver, that’s the statement about what people think of the system, and here we have the price of gold going down which is unfortunately is determined in the paper market and so there’s no decrease in demand for gold and silver here but I think there are so many reasons the western centrals banks to want the price of gold to be down, because it would be the towel on the responsibility of their financial policies and they know it.

We’re all looking in inflation to break out with all the printing of money, well, where are you going to look for inflation first? You think it would be manifested first in gold and silver because that would be the first physical thing that people would buy because it is so easy to store and it has a longer history, I mean we’re not all going to go out and buy wheat and soybeans and stuff like that. Natural thing to do is it to go and buy gold and silver and I see by the US Mint statistics that that’s what people are doing, they are buying it.

PM: Just to the common listener here to understand why is the price of metals going down if there is physical demand like you are describing?

ES: Well because the Comex market which is a paper market determines the price. So for example, I believe that if I single handedly wanted to go into the wheat market today, and sell a bunch of wheat contracts, I could probably to get the price down 5 percent today in the paper market. God forbid they ask me to deliver the wheat because I wouldn’t have it. But that’s what is going on, people are shorting the paper market and driving the price down, I think its the big banks, and were short or scaring the hedge fund into thinking gold and silver are going to go down they all start shorting it, and of course all the while the big bankers have been short the whole time and covering their shorts and now we’ve got all the hedge funds going to be short.

PM: The commitment of traders report showed that the large specs or managed money increased their short position to a massive 22,382 thousand contracts from about I think 2900 as of February 5th, that is huge.

ES: That’s what’s happening, you get everyone believing its going down and you get these reports of this, and others who has never been right on gold in my mind suggesting that gold price is dead or the markets over and everyone, herd like, goes into shorting the paper, well, they’re going to get a rude awakening when we find out that China still a buyer and Russia is a buyer and Turkey is a buyer and all these countries that have been buying gold, they’re not going to back away from the gold market, I mean, its like it’s on sale here. The physical guys will win the day here.

PM: What other metals do you like beside gold and silver?

ES: Well, Patrick, we just started a platinum and palladium trust the same as our silver and gold trust and we look at the supply demand for platinum and palladium its just outstandingly positive.

We even had Russia and South Africa talking about having their cartels in the metals and the price didn’t do anything they want get together and do something, they produce 80 percent of the world’s platinum and palladium so that will have a big impact. But again we had all these people coming in short those two markets too, where there was no activity in the futures market all of a sudden there’s these huge short positions in platinum and palladium, and I think they went in there because the shortage of platinum and palladium and the outlook is so positive but they didn’t want them to go because it might lean into silver and gold, people see platinum might go through 2000 people are going to buy gold too.

So they try to control these things and they control it because they know any central banker in his right mind must know that those policies are insane and irresponsible, they know it. And yet we’ve got to keep everyone in the game and keep them calm and keep the market going up keep gold a little subdued and everything looks normal. Cyprus is a one off event, oh yeah! Sure it is. It’ll be a one off event until we get the next event

PM: What do you think of the mining sector Eric? They’ve demolished that completely almost to the point of extinction, but that do you make of it?

ES: Well, you know there’s some tremendous opportunities in mining . I’m looking now at some companies that could pay very, very significant dividends, I’m talking of dividends of 20% per share and one of the things we have got to convince some of these managements is, look… is that if you pay the dividend and don’t start the new project your shares will react as long if you got a long life line just pay the dividend, your share price will probably double and it’ll still be yielding 10% you’ll be able to raise all the money you want for your future capex program . But, whatever you do, don’t commit to another project, because then the investors will say I won’t see that money for a while and now I gotta worry about the next mine and is it going to be capex is the mine going to work. and you put all this risk on the table that’s not necessary, because mining companies are quite profitable and they have a lot of free cash flow so they could easily pay it out. I’m working on trying to get some of these companies to go that route. and I suspect we’re gonna be successful.

PM: Eric, can you leave our audience with your wisdom and insight on how to deal with these unfolding and accelerating crisis here.

ES: Sure, Well I think the safest thing I can say, is paper assets are a very dangerous to own. I wouldn’t be caught dead with a Japanese bond or a US bond or a UK bond or an ECB bond. First of all, you get paid nothing. Much like a bank deposit was, right, you get paid nothing. Now you find out your risk, as it is Cyprus was 60%, my god you get paid nothing,and taking on all that risk. Do you ask as I’ve written on this many times before is effectively bankrupt their gap deficit was 6.6 trillion last January, except accounting principles deficit was 6.6 trillion as was announced by the department of the treasury, never made it to any newspaper by the way, but that is what they announced and this year it will be 7- 8 trillion, this is all in a $16 trillion economy. There is no way they are going to meet their entitlement so you just give yourself a little forward time here, it might happen in as little as 1 or 2 or 3 years here. I mean this whole paper thing could just implode in front of us, so I think get out of paper get into real.

PM: For the benefit of our audience Eric , how can they get in touch with you, and learn more about your product?

ES: Well, as you know Patrick , we have these gold and silver trust and now the platinum and palladium trust listed on the NYSE and in Toronto here. People who want to keep up to date on the things we write if they just send a note to sprott.com we’ll put them on our mailing list and they can see the various array of hedge funds and other funds we run here.

I think that if one thing we bring to the table is we bring a view that isn’t an accepted view, its always a little off the scale, it has been important to be off the scale in these last few years because here because we’ve gone through some pretty weird times that most people would never forecast, so if they go to sprott.com they’ll know everything they need to know!

PM: Once again Eric, thank you for your time and you insight and wisdom in this auspicious time and until next time my friend, you take care.

ES: OK, Patrick all the best to you now!

Additional disclosure: The information in the Market Commentaries was obtained from sources believed to be reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed therein constitutes a solicitation of the purchase or sale of any futures or options contracts.