Leonard Melman: Good Reasons for Optimism in Metals

April 05, 2009 | By: The Gold Report

Leonard Melman, prodigious writer (The Melman Report) and leading authority in the metals and mining arenas, sees opportunity for some "really good moves" and "fabulous returns" on the horizon, citing vibrant charts on random juniors whose values have multiplied during the last six months. Also noting the possibility of some "good price pops" in the metals themselves, Leonard considers the price of the base metals as a real key to the future of the economy. On the other hand, he shares some serious concerns about the economy in this exclusive interview with The Gold Report. For example, he is alert to several "ominous red flags" that warn of the potential for devastating hyperinflation and worries that the Humpty Dumpty of savaged financial assets may be beyond repair.

The Gold Report: We’re finally seeing some good economic news. Have we hit the bottom?

Leonard Melman: As far as the general economy is concerned, I’m not exactly prepared to make a clear statement. I’ve been checking news headlines from around the world and still see a lot of dismal information. Japan’s export economy dropped by 50% this February compared to February of 2008. Their car sales have collapsed by 43%. Toyota (TM) is talking about cutting worldwide production by half, which will just drive their economy nuts. We’re getting stories out of Germany that are very negative. Czechoslovakia has just ousted its prime minister; they’re in a state of chaos. Latvia and Hungary have currency problems. Poland’s economy is contracting. I could go on and on. So while the United States is starting to report some good news, there’s still a lot of gloom and doom, so the picture is in flux.

As far as the metal side of things, I’m getting more and more encouraged. Gold is behaving beautifully. That last decline stopped at about $860, which is still well above long-term up-trends. We’re back in the $930 range again, so there is support out there. With money creation going on at the rate it is, you have to feel good about that.

Virtually every base metal—nickel, copper, zinc, lead—has risen quite dramatically since last fall’s lows. So I think there is good reason for optimism on the metal side and a balanced outlook on the economic side.

TGR: Given that scenario, what should the investors be looking at?

LM: I think there is the opportunity for some really good moves. I’ve been looking at several charts of junior companies just at random. While some still have some difficulty to overcome and they’re still fairly close to their bottoms, others quite surprisingly have doubled and tripled during the last six months. The two most widely followed mining indices, the XAU and the HUI, have broken out to relative highs for the past four to five months. So there is a chance for some very substantial gains.

TGR: So some juniors appear pretty promising.

LM: Yes, and there’s always the great advantage the junior mining shares have when it comes to the total investment picture. They’re very thinly traded in comparison, say, to a stock such as IBM or GE. It takes substantial sums to move those shares significantly, but it only takes a few thousand to move junior shares. With some of those junior shares dropping so far during the last year, say, from 80 cents down to 7 or 8 cents, it takes very few $1,000 investments to drive those shares higher. If you’re prepared to stand the risk that the scenario may not play out quite as you want, I think there are significant potential returns over the next year.

TGR: You say a few thousand shares can drive the price up; the same can be true for driving it down.

LM: Absolutely.

TGR: What are the baseline economics that this will rise over a year or two?

LM: Even though I don’t agree with the basic economic concept of all this stimulation, there is an excellent chance it will work in the sense of creating at least a boomlet—if not a full-scale boom, at least an improvement in the world’s economic picture over the rest of this year. If that happens, demand for all natural resources will go up and that specifically is going to include the base metals, which are in demand for virtually any kind of manufacturing. In turn, that could cause good price pops in the metals themselves. If that happens, of course, the metal shares would likely participate on a very leveraged basis.

My problem is whether this boomlet will create increased business activity looking out a year and a half or farther. If the increased business activity behaves as it has in the past, it will stimulate demand, stimulate price increases, and with the trillions of dollars involved in stimulative and rescue programs over the last year, inflation could heat up very quickly should business conditions improve substantially. If inflation heats up, by nature that would drive interest rates higher. And rising interest rates could cut short the boom.

So I think we’re playing with a fairly short-term timeframe when it comes to improving the economy dramatically. Beyond a year and a half, I really do get concerned about the potential for a hyperinflationary burst, which could create real economic and social disorder. But I hope that’s a long time away if it’s going to happen.

TGR: Let’s hope it doesn’t happen.

LM: Exactly. But some of the preliminary things that in the past have led to hyperinflations are taking place: The unlimited creation of fiat currency, the tendency to concentrate a great deal of economic authority in a few central hands. These are ominous red flags for me looking farther down the road.

TGR: It’s very scary.

LM: It is. Even scarier is that in previous occurrences of hyperinflation—France during and immediately after the revolution, 1789 to 1795; Germany in 1922 and 1923; Zimbabwe today—happened to single nations, and they were nations that didn’t dominate the world's economic scene. If the United States currency lapses into hyperinflation… imagine the implications of a postage stamp going from 50 cents to a dollar, then $5, $10, $50, $100—or, as happened in Germany, from 4 deutschmarks for a single postage stamp in 1920 to 50 billion deutschmarks for a single postage stamp in 1923—what happens to the world's economic structure?

TGR: What must the American government—and other governments—do to make sure it doesn’t happen?

LM: If I were looking for what government should do, in my personal belief, it should try to reduce the intrusiveness of government into the production of natural resources and manufactured products to make them more efficient and increase the wealth of the country that way. It should also diminish the creation of unlimited amounts of fiat currency. And some long-term plan should be put into effect for governments to begin to accumulate gold and silver holdings, which would give an underlying value basis for their currency.

I’m a political realist. I know right now the political background does not seem conducive to those things, but I think society should work toward those directions.

TGR: Do you think the population will protest some of the currently announced government programs plans as they start to look at an inflationary environment? And would their protests act as a brake to hyperinflation?

LM: You’ve hit upon a terrific point. I believe we’re starting to see that happen. If you notice, President Obama has changed the direction of his emphasis quite dramatically in the last several weeks. He’s now talking about reining in deficits in the future. He’s talking about putting programs on a sound financial basis. In the late stages of his campaign and the early stages of his presidency, he simply talked about all the wonderful things his government would do. But I notice a real advancing pattern of discussion of economic reality and I think that’s been brought about by the public reaction to the staggering array of bailout rescues and dollar-creation programs.

America is a strange nation. Nobody thinks the public is very knowledgeable about these things, but they have a tradition of free enterprise and thinking that government should mind its own business, so to speak, and let the marketplace have its way. I think the public was aroused to a real danger in the direction of the first two months of the Obama administration. They’re starting to speak up. So I think the public is aware and they are starting to let those feelings be known.

TGR: So in your mind there is some hope that some of this will get reined in, particularly the unlimited fiat currency.

LM: I do believe that’s true. I also think there is the simple economic reality that, while America is still definitely the number-one economy, the relative position compared to 1960 or 1970, when they absolutely dominated the world scene, is that they are no longer the be-all and end-all of the world economies.

And messages are coming from other countries that something is going dreadfully wrong with America. The Director of the National Bank of China just blankly stated that they are very concerned about the future of their holdings in America because of this escalating monetary creation.

TGR: Let’s go back to the junior mining shares. You mentioned that some of the juniors are still close to their bottoms and others have tripled since their lows. Can you share with us what differentiates juniors that have tripled from those that are still bouncing along the bottom?

LM: I think there’s a very great distinction. Some of the companies were so hard hit during the past year or two that they have simply run out of money or their treasuries are down to near zero. They don’t have the capacity, at the moment at least, to generate new discovery programs. They’re just sort of lingering on hold to see whether they’re going to survive. Those are the ones that are sitting back.

Others still have a sound treasury and the capital to conduct further investigations, to build reserves, and to participate in any big rally that comes in. So I think the market is taking those and saying, “Hey, they’ve been beaten down by 90%; let’s start buying them.” That’s why some of them are doubling and tripling off their bases and it looks very, very encouraging.

So I think that’s the distinction. If they either have the cash on hand or the clear ability to raise new cash, the market is interested. But I think for the time being the market is avoiding those that simply have reached a care-and-maintenance situation.

TGR: So the balance sheet is driving investor sentiment rather than property or potential discoveries.

LM: Very definitely. If a company doesn’t have the money to conduct further investigation, they have nowhere to go at the moment. But the outlook could be very promising for those that have money, which can be identified by a study of their balance sheets.

TGR: To what extent do metal prices have to stay where they are or increase for the juniors that have risen two to three times from their lows to remain successful over the next year?

LM: It’s vitally important. Take copper, for example. It plunged from a high of $4.20, I believe, all the way down to the upper $1.20s. In the upper $1.20s, it’s very unlikely that any mining production can take place and show a good profit. We’re now almost at $1.80 for copper and at $1.80, suddenly the outlook is infinitely brighter.

If this economic boom does take place over the next year and a half, I believe it’s reasonable that we could see copper go to $2.50 to $3 a pound. In that case, some of these holdings in the ground that are proven reserves could become valuable mines. On the other hand, if copper were to fall back into the $1.20s or below, the prospects for a profitable mine would be virtually nil. So the price of the underlying metal is of considerable importance. That’s why we keep a real close watch on those trends.

TGR: So investors who are dabbling in the juniors market should be watching metals prices carefully as a signal of when, potentially, to take profits.

LM: Exactly. And there’s an additional point. The markets always tend to look ahead and the base metals are no different. So if the price of the base metals starts to rise unaccountably, that’s also a positive indication that this economic recovery or boomlet will indeed take place. So the price of the base metals is a real key to the future of the economy—at least it’s a good solid indication. And the precious metals are also historically very good indicators of monetary stability or instability. So price is a vital consideration.

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