The Next Time Down

by Bill Fleckenstein


I have been in the money-management business since 1982. Since 1996, I have run a short-only hedge fund, been a director of Pan American Silver, and written a daily market column on the Internet. That column, and a copy of this talk, can be found at As I clearly state on my Web site, my personal motto is "Often Wrong, Never in Doubt." With that disclosure out of the way, I can get started.


Today I have a trifecta to share with all of you: a macro theme which I call "the next time down," a specific idea to profit from that theme, and, in the interest of evenhandedness, an idea that those of you who conclude I am dead-wrong can use, to express your negative opinion of my opinion.


I believe that the four years which have elapsed since the stock market peaked have essentially been one massive exercise in denial. Initially, folks were in denial about the fact that stocks had peaked and that we were in a bear market. Then, all of our economic and stock-market problems were blindly pinned on the attack of September 11, even though that attack wasn't the economy's true problem. The next excuse was pre-Iraq war fears.


Finally, the combination of the fall of Baghdad, 13 rate cuts (which heretofore had been not good enough), two tax cuts, two rounds of tax rebates, and the recent tax refund was potent enough to give us the year-long rally that recently ended, as well as a big bounce in the economy. However, from a stimulus standpoint, the government is out of bullets. No more tax cuts are coming, no more rate cuts are coming (though I think no more than a couple 25-basis-point hikes are coming, either). 


But most importantly, the "use-your-house-as-an-ATM-to-live-beyond-your-means" stimulus is finished, thanks to the recent de-leveraging/crackup in the bond market. The refi game and the bull market in housing it created postponed the consequences of the largest stock market bubble in history. Though the Fed and the rest of the government succeeded in postponing the fallout from the massive misallocation of capital that took place in the mania, they have also succeeded in compounding and exacerbating those consequences. Even more leverage was created in the system, as we attempted to speculate our way to prosperity.


In short, the excesses from the bubble have not been cleared away, but they will be, along with the recent excesses from the refi bubble. I believe the economic rebound has peaked, the economy will slow down in the second half, and we will ultimately slide back into recession. I believe we are headed for a large slide in the stock market, as well as a resumption in the decline of the dollar. These developments will tend to be self-reinforcing, and especially damaging, if and when housing prices join the decline.


If that weren't bad enough, in addition, the Fed is finally trapped. Easy Al can't cut rates when trouble starts, because he has already created a decent-sized inflation problem. As this scenario unfolds, in whatever variation, we will experience the "next time down." The realization that the market is going down again, and with it the economy, will force people to come to grips with the fact that the interlude of the last year was just that. This will deal a crushing blow to confidence, causing the public to finally comprehend that the Fed can't save them. Once the business of clearing away the excesses begins again in earnest, your guess is as good as mine as to how ugly it all gets.


Though I run a short fund and recently became fully invested for the first time since 2002 (as I was fortunate enough to see last year's rally coming), my specific idea to capitalize on the debacle I see brewing is a long -- not a short. I decided to go with a long idea for three reasons: (1) Managing a short position requires a lot of monitoring. (2) While you may make 50% to 70% on a short, you can make 200% to 300% on a long.  (3) This long idea should also protect you when the dollar weakens.


My idea to protect yourself, or to profit from the potential damage I have just described is -- buy silver or silver equities. One month ago, I was struggling to come up with an idea to suggest today. But the recent 35% collapse in the silver market created a topic for me, and an opportunity for you, as silver's downside from the $5.50 level is small and manageable.


The fundamentals of the silver market are briefly as follows: About 600 million ounces, or $4 billion worth of silver, are produced each year, while 800 million ounces are consumed. The market has been in deficit for 13 years in a row now, reducing above-ground stocks by some 1.35 billion ounces. (These stocks are currently estimated to be approximately 500 million ounces, or $3 billion.) Photographic demand comprises about 25% of consumption and has remained fairly stable, in spite of digital cameras, thanks to other photographic uses. In fact, Photofinishing News projects that more silver will be used in 2008 than in 2000!


However, the supply and demand data are not reason enough to own silver, though they do suggest what could happen to the silver price if investment demand picks up. The price rise could be truly explosive, especially when one considers the inelasticity of silver supply. Pure silver mines are rare, as roughly 70% of the silver produced is a byproduct of other mining. The bottom line: If demand heats up, there will be only a limited amount of new silver for quite some time -- and, the central banks don't have any, unlike gold.


So what will create the investment demand? A change in psychology regarding the superiority of paper assets, precipitated by the ramifications in the financial markets of "the next time down." The demand for paper assets and dollars that we have witnessed in the last decade or so has been an expression of total confidence in the central planners at the Fed. If that confidence cracks, as I expect, and the dollar begins to be viewed as the Bernanke confetti it has become, demand for silver and gold will increase. Warren Buffett has eloquently articulated his bearish point of view of the dollar (and backed it up with $18 billion), so there is ample reason to be concerned about the dollar, even without the change in psychology precipitated by "the next time down."


Okay, so how can a guy who doesn't want to buy silver itself implement this idea? Since silver is a small market, and silver mining has been so difficult for so long, your investment choices are limited to about five companies, which all have different characteristics. One has serious base-metal exposure, one has serious gold exposure, one is pretty speculative, one has the most horrendous management I have ever seen, and then -- bearing in mind that everything I have to say is 100% biased -- there is Pan American Silver.


Since I am a director, it is not appropriate for me to be as opinionated as I otherwise would like to be. What I will say is that after being on the board for seven years, I believe it is an extremely well-run company. I don't know how many of you know Michael Larson, who manages Bill Gates' money, but he has been on the board for five years now, and he shares my opinion of management. John Doody, the best independent mining analyst, says that PAAS is the "best pure silver producer; with six mines soon, its profits will benefit most from a silver rise, as all others need two to three years to build a mine."


Earlier, I promised an idea for those who disagree with my analysis. For those of you, I would suggest shorting CDE, of which John Doody has written: "CDE stayed alive, issuing shares for debt, but despite diluting original holders by 90%, the company still cannot make a profit. Management continues self-aggrandizing ways, as 2003's corporate overhead works out to 87 cents an ounce produced! No wonder management owns few shares."


I thought I would conclude this brief analysis by comparing a few data points about PAAS and CDE (but for anyone wishing more detailed information, read John Doody at, or listen to Pan American's most recent conference call at 877-519-4471. The pin code  is 472 6403.)


If all goes as planned, by the end of next year, both companies will produce in the neighborhood of 15 million ounces of silver annually. In eight years' time, Coeur d'Alene's production will have grown 60%, Pan American's about fivefold, with shares outstanding having increased nearly tenfold at Coeur d'Alene, versus 2.5 fold at Pan American. In other words, Pan American will have delivered almost nine times the growth in production, with about one-quarter of the dilution.


Meanwhile, the chairman and founder of PAAS owns almost 10 times as much stock, while getting less than 25% of the salary received by CDE's chairman. Yet, Mr. Market has valued PAAS at 50% less than CDE ($800 million, vs. $1.2 billion). For all you market-neutral people in the audience, perhaps a pair trade is in order. The next time down for stocks may be the next time up for silver. But even if you disagree with that, then you know what to do.