Eric Sprott Cautions Investors To Fear The Financial System

The dire economic situation that persists globally despite the best efforts of central planners to make things seem normal leads Sprott Inc.'s legendary Chairman Eric Sprott to broadcast a loud message of caution: "Fear the financial system." In this exclusive interview with The Gold Report, Sprott says it's time for people to take matters into their own hands and that means pushing further and further into precious metals equities as well as physical gold and silver. With 80% of his own portfolio in that arena, he certainly puts his money where his mouth is.

The Gold Report: You've stated before that the price of gold should be above $3,200/ounce (oz) and the price of silver above $200/oz but market manipulation keeps both metals artificially low. Who is manipulating it?

Eric Sprott: I suspect the G6 central banks have a hand in subverting the gold price because as the canary in the coal mine, high gold prices might tip everyone off to the severity of the ongoing financial crisis. I don't think anyone can doubt that we're in the middle of a financial crisis, primarily in the banking system, when month after month one program after another is rolled out to save somebody, whether it's Long-Term Refinancing Operations (LTROs), quantitative easings (QEs), bank bailouts in Spain or rollovers of debt in Greece.

TGR: Are you saying that the gold price manipulation is a new phenomenon?

ES: In the 1960s, the London Gold Pool was trying to suppress the price of gold but lost that battle, and the price rocketed up. My own analysis of the physical supply and demand for gold suggests a dramatic increase in demand over the last 12 years—a 2,500 ton net change at a minimum. This is in the 4,000 ton/year gold market, which hasn't increased in the past 12 years. The supply has basically been static. Yet we have exchange traded funds and central banks buying. You have to ask yourself where all the gold's coming from with all these new sources of demand, because mine supply over that period is negligible.

I can only conclude that acting in concert, the G6 central banks are supplying that gold from their reserves by leasing the central bank gold into the gold market. Of course, they pretend they still own it, because the item on their balance sheet is now called "gold and gold receivables." The receivable is what they've loaned to a bullion bank, but it's actually been sold into the market and consumed and won't be coming back again. To buy it back physically would drive the price absolutely crazy.

That's why I think the price of gold should be considerably higher than it is, and why I believe, much as anyone in the Gold Anti-Trust Action (GATA) organization, that there's been continual pressure from the central banks in cooperation with bullion banks to keep the price down.

TGR: Does the fact that the silver market is so much smaller than the gold market make it easier to manipulate?

ES: I think it's more easily manipulated; it doesn't take as many dollars in the paper silver market because it doesn't trade as many dollars as the gold market would. For example, when silver hit $49.50/oz in the Q2/11, on some days silver traded a billion ounces of paper a day where the mine supply on a yearly basis is 900 million ounces (Moz) and probably the amount available for investment is about 200 Moz.

TGR: Those numbers don't add up.

ES: No, they don't. How can we trade a billion ounces of paper silver on a single day with 200 Moz available for investment for a whole year? I always ask people to think about what the seller was thinking. I'm going to sell a billion ounces of silver today and one-fifth of that is available for investment on a yearly basis. As a result, the paper was determining the price of the physical commodity.

TGR: You recently raised another $200 million (M) for the Sprott Physical Silver Trust with the goal of buying 7 Moz of silver.

ES: We've had a number of issues in that trust. We raised $250M in July, including over-allotment, and $350M back in Q1/12.

TGR: Could that affect supply and demand and therefore manipulate the market?

ES: The silver we buy theoretically stays off the market, so it does have some impact—but had we not bought it someone might have tried to move the price a little lower. Actually, I think the silver price exhibited more stability than it would have otherwise experienced.

TGR: You also operate Sprott Money, a service for buying physical gold and silver. Is that because you view precious metals as a store of value and therefore a hedge against inflation?

ES: I've been a believer in gold and silver for the last 12 years and I guess a disbeliever in paper assets. I'm quite surprised that things—such as currency debasements by central banks getting involved in supporting their bond markets and banking systems—have evolved to make the case for owning gold and silver since 2000 way stronger than anything I might have imagined.

I basically got into gold because I anticipated a physical shortage, but I didn't expect the headwinds of the level of financial irresponsibility shown at either the fiscal level of governments with all their deficits or at the involvement of the financial markets by way of QEs, LTROs, operation twists and unlimited swap lines. In my mind, all of this ultimately will further debase the currencies, which gives us an even more powerful reason to own gold and silver.

TGR: How does Sprott Money work?

ES: It's basically a mechanism for people to own what I think will be the thing that saves them, which is hard assets. Over the last 12 years, I've been a strong proponent that people should have a sizeable piece of their investments in gold and silver. Sprott Money, operating now for over three years, was set up to make that easier.

TGR: How sizeable should a portion of a portfolio be in physical metals?

ES: That's a great question, and the answer I always give is what I do with my own portfolio. Between the stocks and bullion, I have about 80% of my money in precious metals. I think that's the only sound investment there is. Around the world, on average people have less than 1% of their portfolios in precious metals, and there's a long distance between 1% and 80%. Nevertheless, I certainly believe it should be well north of 1%.

That being said, no way can everyone have 10% of his or her portfolios in gold and silver because there isn't enough gold and silver in the world to do that. There's already a physical shortage of gold and undoubtedly a very tight situation in the silver market. If people and institutions put even 5% of their money into gold and silver, there's no way to accomplish that without driving the prices up dramatically.

TGR: When you suggest investing in the commodities, are you talking about taking delivery of physical bars, bullion and coins? What's the best way?

ES: The best thing is either to take physical delivery and store it somewhere safe or to buy a fund where you know the metal is there. Just looking at the short position in the SPDR Gold Trust (GLD) and the iShares Silver Trust (SLV), I can tell you there can't possibly be one ounce of gold for every ounce of certificates that people own because some of the paper was sold short. I have reservations about SPDR Gold Trust and iShares Silver Trust for that reason.

But with other funds, I know the gold and silver are there, so they can give you way more assurance that your precious metal is in safe hands rather than buying something on the commodity exchange, for example. A piece of paper may say you might get it, but what if a force majeure results in too many people claiming what turns out to be not enough physical gold and silver? You have to pick your spots.

TGR: Such as?

ES: Central Fund of Canada is one, as well as Sprott's own physical gold trust or physical silver trust, and funds in other countries that have the physical products, such as GoldMoney, which is actually a competitor of Sprott Money.

TGR: Going back to the manipulation issue, you're cosponsoring the conference, "Navigating the Politicized Economy" with Casey Research. Is currency manipulation really worse than it was 10, 20 or 30 years ago?

ES: As things get more desperate in the economy, the moves politicians make become more desperate. It's because the economy is in such dire shape that the people in charge turn to more and more unconventional methods to make it look as if everything's normal. In reality, everything is quite abnormal.

TGR: You've said that we don't need more regulation to protect us from this manipulation. What can individual investors do to protect themselves from market manipulation?

ES: We have more regulations than you can imagine, but most of them are either not enforced or the problems escape the sight of the regulators, whether it's MF Global or Bernie Madoff. These things went on for years and years, when it would seem that the regulators could identify it. Even when they're tipped off, they can't seem to reconcile it.

Based on experience, a blanket case that more regulation will solve a problem is naive. People have to take matters into their own hands, whether they think they're being ripped off in the stock market because of high-frequency trading or that they're being hurt by rule changes on the commodity exchange. They have to assess their own situations and ask, "What kind of risk am I prepared to take?" The system has failed a lot of people.

That's why I pointblank say gold and silver are the only things you should own. They're the safest things I can possibly recommend. If you own gold and silver and you're 100% certain that it's where you think it is, you should be okay. That's the way I approach it.

TGR: Turning to the equities, in a previous interview you said that when gold prices go up, equities move three times faster. That didn't happen when gold went to $1,900/oz. Was that a fluke, or is the ratio you told us about still relevant?

ES: I think it is. For instance, in 2000 the NYSE Arca Gold BUGS Index (HUI) went as low as 35. Today it's 420, so it's gone up by 1,100%, 2.1 times the increase in the price of gold. At the margin, the increase in the price of gold is all profit, so another sustained rally would dramatically change the profit picture for all these companies. Assume the average miner makes $800/oz. At that rate, a $400/oz increase in the price of gold would push the stock up by 50%.

Looking at that another way, a $400/oz move in the price of gold is today a 25% gain, whereas the miner's profits go up by twice that—an automatic 2:1 in the equities outperforming gold. And because further increases in the gold price would be all profit and because the equity prices have been so incredibly depressed, it's not illogical to assume that the precious metal stocks would outperform gold by a 3:1 ratio.

TGR: What will it take to move this market higher?

ES: I see huge macro changes that in the physical sense alone should cause the price to go up. The biggest thing now is the buying out of China, which has grown by about 600% over the last 12 months. China is buying almost 50 tons of gold a month—600 tons a year of brand-new buying and no increase in supply in a 4,000-ton market. Then bring into the picture central bank buying, which has changed dramatically, particularly from 2010 to 2011. It increased by about 800 tons, again with no increase in supply. You have to wonder where all this gold is coming from.

The central bank buying includes obvious moves by some non-G6 countries, not only China but also Turkey, Mexico, Kazakhstan and Russia. Even South Korea has been a recent buyer. These non-G6 central banks see what's going on in the G6 and have decided to step up their allocations to gold. I think ultimately this will have a dramatic impact on the price of physical gold.

Gold equities will go up when the price of gold goes up. And, as I've said, the G6 central banks are already surreptitiously supplying a considerable shortfall in the physical gold market.

I can assure you that based on Frank Veneroso's work, which got me interested in gold back in 1998, there was already a shortage of gold then. The central banks had been selling it for 15 or so years. Combining that with what's been happening in the last 12 years, not much gold can be left in those vaults. Sooner or later, the rubber will meet the road in terms of the physical market for gold.

TGR: And that will increase demand, which will in turn increase equity prices?

ES: We don't even need to increase demand. We need the central banks to stop selling gold surreptitiously, but that's not going to happen.

TGR: John Doody recently told us that the coming bottom of the market will offer a great opportunity to buy some great companies at a discount. Do you agree? If so, how do you determine what is a great company hit unfairly by the market and what's a company that just may not survive to see the upside?

ES: I totally agree, because all precious metal equities have been mauled. I can make a very strong case for companies that are trading at incredibly low cash flow multiples in what is almost a negative interest rate environment.

The fundamentals have improved dramatically for a lot of these companies because their stocks have gone down. That would argue that the upside is quite stunning, particularly if you factor in increases in the prices of precious metals along the way.

TGR: How can you tell which companies will be able to make it to the upside? It's been a tough market for raising capital and staying in business.

ES: Producers shouldn't have a problem because most of them are making money selling gold. They shouldn't have a problem surviving as long as they don't overexpand and stretch capital needs if the market won't supply. The very difficult time in capital markets isn't just in precious metals, but in all capital markets. The IPO market has been badly hurt, and the average investor is taking money out of the stock market, so it's not as though mutual funds have more money to throw into new equities.

In this environment, the well-funded company that has ongoing operations should do just perfectly. And, of course, some of these smaller to middle size companies are trading at probably lower multiples relative to the gold price than ever. I see company after company saying that they'll be trading at four times cash flow next year or two years from now. Where else will investors get that in a zero interest rate world? It's almost impossible.

The problem is the price of gold hasn't rallied. (Editor's Note: this interview was conducted before the gold rally of the past week to 1672.) We need that to give people some comfort that we're not going to $1,200/oz but to $2,000/oz.

TGR: You've been in the eye of a mergers and acquisitions flurry as nine recent takeover bids have involved stocks in your portfolio, including a controversial one with U.S. Silver Corp. (CYLQF.PK). Are the premiums as good as they would've been if these companies had other options, such as access to capital? Or are these fire sales?

ES: I'd call them all fire sales. Companies are up against the wall, and maybe their production hasn't come on as well as it should have. Typically, it's someone being opportune. Obviously, the price of precious metals hasn't helped, because everyone is worried. I think the average analyst is suggesting the price of gold will be $1,275/oz in a few years.

I don't believe that for one second, but that's what the analysts conventionally believe, so people think it will get worse before it gets better. I happen to be of the opposite view, that it will get better going forward than it has been in the last little while. Gold was up every year for the last 11 years. It's up again this year and the year's not over. As we get toward the end of the year, I think if we can push back toward the old highs, the valuations given to all of the precious metal producers will be dramatically different.

TGR: Finally, What is the best piece of investing advice you have ever received?

ES: I think the best piece of advice I have received was always try to buy a company with a low price-to-earnings multiple or a low price-to-cash-flow multiple, particularly one that's a little out of favor because ultimately if it's sustainable, it will attain the valuation that's appropriate in the market. That's why we typically look at small to midsize companies that are under-followed where we can see opportunities that maybe others haven't. I think that's the place where people should focus.

TGR: And any last bits of advice you would like to share with our readers?

ES: The biggest thing is they should fear the financial system. It's very, very volatile. We see what's happening on a day-to-day basis. It's staggering the things the central planners have to do to hold it together. I think people have to push further and further into the precious metals area. It's the one thing that will survive the financial fiasco that we're in. The safest thing is to own gold and silver, and don't buy some paper saying you own it unless you know the people behind it are trustworthy.

TGR: Thank you so much for taking the time to talk to us today.

With 40-plus years of experience in the investment industry, Eric Sprott is chairman of Sprott Inc., CEO, CIO and senior portfolio manager of Sprott Asset Management LP and chairman of Sprott Money Ltd. After earning his designation as a chartered accountant, Sprott entered the investment industry as a research analyst at Merrill Lynch and founded Sprott Securities in 1981. After establishing Sprott Asset Management Inc. as a separate entity in December 2001, he divested his entire ownership of Sprott Securities to its employees. Stunningly accurate in his predictions, including foreseeing the current financial crisis, Sprott chronicled the dangers of excessive leverage and the bubbles the Fed was creating, while also correctly forecasting the collapse of the housing and financial markets in 2008.

Disclosure:
1) JT Long of The Gold Report conducted this interview. She personally and/or her family own shares of the following companies mentioned in this interview: None.

2) The following companies mentioned in the interview are sponsors of The Gold Report: None. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.