Gold is a mystery to most investors. This should not be surprising. Aside from occasional poorly timed and ill-informed financial media commentary, gold has almost no presence in the daily flow of investor information. Price quotes, if any, are buried in the commodity section of the financial pages. Many desk screens do not carry commodity quotes. For traders and portfolio managers, gold inhabits a different silo than bonds, equities, and currencies. Few would know how to take a long position in gold even if the idea seemed compelling. That the dollar price of gold has been in a five- year bull market in which gold has outperformed all asset classes would come as a surprise (see chart below). These comments attempt to demystify gold and to spell out the ABC's of its investment merits.
Skepticism and ignorance are excellent breeding grounds for long-lived market trends. While the past is never prologue, history can be instructive. I suggest that gold is in the early stages of a significant bull market. The gold cycle is in reality a facet of the larger and more comprehensive credit market cycle.
The early stages of all bull markets are deceptive and surreptitious. Very few are on the gold bandwagon. When the reasons for the trend become widely known, the opportunity will have all but passed. The outline of this discussion follows an article written 18 months ago, "The Investment Case for Gold". The investment thesis conveyed at that time still appears to be on target. Moreover, much has happened over that short interval to reinforce the conclusion reached in January 2002 - that a dollar gold price of four digits or better is attainable.
Supply and Demand
Gold production has fallen short of demand since 1988. Exhibit 1 (at end of this article) shows supply and demand trends over the last 22 years. Despite the 19-year bear market in gold prices that ended August of 1999, gold production has increased steadily since 1980. Yet, mine supply has fallen short of annual demand since 1987. It makes little sense that a sustained decline in gold prices should coincide with a chronic shortfall in mine supply. It makes even less sense that supply would expand while prices were dropping.
There are two explanations. Mine supply and sector flow analysis are not the key determinants to price behavior. Instead, capital market flows rule the day. Central bank selling (a capital market related activity) combined with an absence of investment demand kept gold in the penalty box for most of the 1990's. Second, the gold mining industry has proven to be highly successful at destroying capital. Irrespective of falling prices, the industry expanded new capacity. Investment capital was provided by hedging (or forward selling), a seemingly low cost and abundant funding source. Now recognized as one of the great abuses of derivative financing, hedging linked to project debt financing provided sufficient quantities of apparently low cost capital to fund an average annual increase in mine output during the 1990's of 1.9%.
What investors and mining companies learned all too late was that 1990's expansion was based on the false economics of mis-priced capital. The penalty paid by the most heavily hedged companies was dramatic under-performance in a period of rising prices. In extreme instances, corporate viability was compromised by a rising gold price (Ashanti, Cambior). Despite an inability to generate profits, the industry plowed ahead in search of growth using the false metrics of cash cost accounting. The deception was no different than the phony benchmarks utilized in the dot com and media sectors.
The industry ran at full tilt during an extended weak profit phase when a more rational industry, take aluminum for instance, was shuttering plants. As the profit squeeze worsened, discretionary spending on exploration was sharply curtailed. The trend towards decreased exploration was exacerbated by the need to realize "synergies" during the (still ongoing) madness of industry consolidation in which shareholder interests were sacrificed to the well being of surviving and outgoing management. Consequently, the industry pipeline of new project growth has withered.
While gold industry sector flows impact the longer-term price trend for gold in a secondary way, they nevertheless provide a supportive configuration for the market. Having depleted capital and exploration pipelines, the industry will be extremely hard-pressed to maintain current levels of output, even if the price of gold were to rise by several hundred dollars in the short term. A reserve replacement ratio for the gold industry, comparable to what the natural gas industry publishes, is not available to our knowledge. We have no doubt that if such information were available, it would convey a sorry picture. It seems highly unlikely that the industry has replaced more than 50% of the 90 to 100 million ounces of annual depletion over the last three to four years. The hype over exploratory drill and discoveries conveys the wrong impression. The time lag between an initial discovery of a major gold deposit and its ultimate transformation into an operating mine has been growing as rapidly as the coffers of Green Peace and the page count of environmental regulations. Five years would be a very fast track and closer to ten years a more likely scenario for a significant new mine.
The prospective lack of responsiveness of supply to rising prices is reinforced by the gold mining industry's born-again love for the metal it produces. Years of investor protest combined with assorted hedge book misadventures have caused the industry to curtail renewed hedging and to accelerate repayment of outstanding hedges. The recent triumph of Newmont Mining in buying out counter parties to the Yandal hedge book, a fiasco for the bullion dealers, will only reinforce the abstinence of miners and bullion dealers alike from this undesirable activity. By shrinking hedges, the industry is improving the optionality of share prices to gold, which is a good thing. On a supply and demand flow analysis, this change in behavior has resulted in a 15% shrinkage in supply as gold owed to lenders is repaid and never comes to market. Despite these positive changes, gold mining shares have under-performed the metal over the last twelve months due to rising costs, falling grades, and failure to replace reserves. Since 5/31/02, the gold price has increased 9% while the benchmark XAU index has declined 3%. Gold shares trade at the lowest valuations in the last five years based on enterprise value to net present value (see Chart), suggesting at least on a near term basis some constraint on new capital formation.
Central bank behavior is changing too. In the late 1990's, they terrorized the gold market with indiscriminate selling and lending activities accompanied by commentary unfriendly to gold. The European Central Banks in particular dumped significant quantities of gold reserves at the market lows. However, gold sales by the European Central Banks are now flowing at a predictable annual rate of 400 tonnes, thanks to the 1999 Washington Accord. The market for lending gold has all but dried up due to lack of demand as mining companies reduce hedges. Prospects for a renewal of the five-year agreement, expiring September of 2004, appear excellent. There has been expanding central bank buying in such areas as the Persian Gulf and Southeast Asia. Asian banks in particular are very under-weighted in gold relative to their dollar holdings. For example, the Chinese central bank has added 205 tonnes to its gold holdings since year-end 2001.
In short, the threat of central bank sales has largely dissipated. Will they intervene from time to time to cap the market? Perhaps, but only within the context of a rising price trend, for the official sector is incapable of setting longer-term direction. In selling at the lows, central banks revealed that their ranks are composed of fallible, trend following human beings. In a world of huge currency blocs, the majority of these institutions are little more than quaint anachronisms. Hence, management of central bank reserve assets has evolved into a quest for performance as bankers attempt to justify their existence to their respective constituencies. Having sold substantial quantities of their best asset at the end of a twenty-year bear market, in order to diversify into low-yielding and depreciating dollar assets, it would be hardly out of character for them to become bullish on gold at higher prices.
On the horizon is the Gold Exchange Traded Fund (ETF), to be launched by the World Gold Council this summer. This and similar instruments will liberate gold from its archaic market structure. For the first time, capital will be able to flow freely to and from the capital markets into the metal. The ETF will enable gold to perform as insurance for portfolio managers unwilling or unable to deal with the risks of short selling or the costs of buying puts. In time, as these non-speculative attributes of gold are recognized, billions of investment capital will flow into the physical metal. A more extensive discussion of this can be found at "The Gold Equity Share-An Idea Whose Time Has Come."
Pension funds, foundations and other institutions that would never have considered gold because of transaction complexities will discover gold's merit as financial insurance. The chart below illustrates gold's negative correlation with various asset classes over the past ten years. A small percentage allocation has demonstrably positive attributes as a way to reduce risk, especially in periods of stress. In the past, gold bull markets were fueled by speculative bets on financial turmoil. While the vulture contingent is present in the current bull market, it will be joined by non-speculative buyers of risk protection. A small allocation by such investors to physical gold will have a dramatic impact on demand. A hypothetical 1/10th of 1% allocation from global financial assets to gold would easily absorb two years' of newly mined gold, a quantity that could not be satisfied within several hundred dollars of today's price.
The supply and demand equation has improved substantially relative to its already strong posture 18 months ago. Hedging is on the wane, the pipeline for new projects is in bad shape, production is falling, reserve replacement is poor, central banks are re-evaluating their sales and lending activity, some mining companies are becoming more rigorous in their analysis of new capital projects, and the Gold ETF raises the prospect of increased capital flow into physical metal. As long as gold continues to trade in a sub $400/ounce environment, the supply and demand fundamentals for gold will continue to strengthen.
Bubbles and Their Aftermath
Gold will benefit whether the post bubble outcome is inflationary or deflationary. The only scenario unfriendly to gold would be a return to the euphoric credit expansion of the 1990's. When expected returns on financial assets are favorable and rising, investor interest in safety diminishes, gold included.
Short of a crisis, the post bubble environment promises to linger for years. Neither a stock market rally nor a business cycle upturn will undo the damage of previous credit excess. What is required is the passage of time measured in approximate proportion to the previous credit expansion. Time is needed to liquidate bad investments, clear markets, and alter behavior patterns of consumers, businesses, policy makers, and investors to adjust to new realities. In a recent commentary (FT-5/27/03), Martin Wolf noted that: "During bubbles people make huge mistakes. Investors pay too much; companies invest too much; households spend and borrow too much; and the government believes temporary fiscal surpluses are permanent." He goes on to add that the root cause is "that the real interest rate (was) too low and monetary policy too loose, given the over-optimistic view of prospective returns on capital." Years of artificially low and mispriced interest rates deposited a residue of excess of debt and manufacturing overcapacity. For this malady, which exists on a global scale, there is no quick fix.
The cornerstone of the 1990's credit binge was the overvalued US dollar. By ushering in a flood of cheap imports, a billowing trade deficit kept US inflation low by shifting manufacturing capacity offshore. Low reported inflation was instrumental in the decade-long decline in interest rates, which in turn pumped up equity valuations. The rising exchange rate of the US currency whet non-US investor appetites for dollar financial assets. The circularity of the process, the mechanisms of credit transmission and the mythology supporting expected return on investment were on a global scale and steeped in remarkable self-deception.
Pricing power, pent up demand, returns on new investment, positive real interest rates, and currency stability are absent in the post bubble environment. Let economists and academicians decide whether these conditions are precursors to inflation or deflation. Global employment is weak because labor cutbacks are viewed as a prerequisite for profit improvement. The boom in mortgage refinance sated consumer appetites, and eliminated the potentially stabilizing cyclical influence of pent up demand. Returns on business capital spending are negligible because over-capacity means low operating rates. Real interest rates are negative and will stay so, forcing fixed income investors to assume increased risk in the scramble for yield. Because currency strength translates quickly into domestic economic weakness, it's every man for himself in a replay of the competitive devaluation of the 1930's. =
The dollar based mechanism for credit expansion is all but broken. Yet, the prescription for economic lethargy is more credit. Record issuance of government and corporate debt lacks the substance of real credit creation. If a flood of new paper could repair credit, the benefit would show up in narrowing credit spreads. Instead, credit spreads are on the rise:
What matters for gold is dramatic interplay between the threat of inflation and deflation, not the outcome. Fed Governor Ben Bernanke, the patron saint of monetary debasement, reminded the markets in November 2002 that government printing presses were in good working order if needed to combat deflation. Greenspan and other high-ranking Fed officials have expressed similar thoughts since then. The May '03 "how to" text issued by Evan Koenig, Vice President, and Jim Dolmas, Senior Economist, of the Dallas Fed (Monetary Policy in a Zero-Interest-Rate Economy), is one of the most provocative trial balloons in the history of monetary policy. The cheerful ("what, me worry?) essay articulates the reality of current monetary and fiscal policy when it states: "By coordinating with fiscal policy, the Fed could even implement what is essentially the classic textbook policy of dropping freshly printed money from a helicopter. In this case, the Fed would monetize government debt that had been issued to finance a tax cut…Though trite to say, it is nonetheless true that extreme times could require extreme measures." In other words, the Fed might expand its balance sheet at an even greater rate than the 15% joy ride of the last six months.
Dollar devaluation is suddenly in vogue. It is in the interests of American consumers, a.k.a. voters, and their government to thwart deflation. Key policy makers are coming to understand this reality and are searching for ways to deliver such an outcome. The dilemma is that devaluation against other paper currencies would achieve only limited and transitory benefits because it weakens the economies of our trading partners. The devaluation of paper therefore must be against tangible assets including plant, equipment, real estate, and commodities, including gold. Debt burdens that are throttling economic activity must be extinguished. The slate must be wiped clean of bad investments and frozen markets.
Foreign private investors are losing their appetite for US financial assets, especially Treasury and Agency debt. The change of heart became noticeable in the fourth quarter of 2002 and coincided with heightened expressions of concern by Fed officialdom regarding deflation. The chart below shows that official sector accumulation of US Treasury and Agency debt accelerated sharply at that time, after six years during which private sector demand for US assets seemed insatiable. The coincidence of pronounced dollar weakness with accelerating official sector purchases suggests the potential for a much more precipitous decline if official sector support falters. For example, the Bank of Japan purchased $33 billion of US Treasuries in May, an annual rate of $400 billion. For another, Asian central banks hold 20% of Freddie Mac's outstanding debt.
Accelerated purchases of US paper by foreign central banks to prop up the US currency amount to little more than a holding action. They signify a breakdown in the dollar credit mechanism. When in high gear, this mechanism distributed US sovereign debt to a diffuse array of non-US private sector purchasers. Unwilling to commit hara-kiri, foreign private sector buyers have turned their backs, leaving their respective central banks to shore up the dikes. A serious break in the dollar would create significant funding issues for the US government. A glut of paper is masking a potential shortage of credit.
Policy makers are stalling for time while searching for answers. A review of post bubble Japan provides an analogue for the current dilemma. After the initial stock market break of 61% (1989 to 1992), there were four significant rally attempts, three of which lasted for at least a year. These occurred over nine years, and were followed by a further three-year break of 57%. From Nikkei 38,957 in 1989 to 7603 on April 28, 2003, a buy and hold long-term investor, following the advice of the Japanese equivalent of CNBC, would have lost 80.5%. In the ten years following the initial break, Japan enjoyed 6 years of positive GDP growth (see chart). Japan illustrates the disconnect between financial market and business cycles.
It has been only three years since the break in the global market bubble. Could it be the equivalent of 1992 in Japan all over again? Or is it 1970? Market observer and historian Richard Hanley observes that the precursor for the Nasdaq bust was the 90%+ losses cranked out by the hot money mutual funds of the late 1960's. Loaded with illiquid "letter" stocks and over-priced conglomerates, the three Freds (Carr, Mates and Alger) and their imitators did more than their share to give stock market investing a bad name.
Certainly there are distinctions but the common ground between 1970 in the US, 1992 in Japan, and 2003 globally is the overhang of debt and the litter of investment folly. The only quick fix for such an ailment is a financial panic, which financial authorities in Japan and the US have proved adept at avoiding. The DNA of post bubble dementia is saturated with longevity. It seems prudent to prepare for a long workout by adjusting investment expectations accordingly.
Investment Expectations and the Credit Cycle
Investment expectations and popular perceptions change slowly and lag events that shape them. Developments and changes in expectations are barely noticeable in the short term and therefore receive little attention in the financial media, which prefer to report on every meaningless twitch in daily market action. Yet, they are powerful determinants of economic behavior ranging from investment and capital decisions to consumer spending patterns. Emotions and psychology have as much if not more influence on economic outcomes than rational calculation of finite quantities. The Fed campaign to revive inflationary expectations dramatizes the grip of psychology on economic outcomes.
Shifting expectations for financial assets returns explain the periodic rise and fall in preferences for paper vs. tangible assets. The long-term cycles (see chart below) which depicts the DJII vs. the gold price, measure the secular expansion or contraction of credit. Expectations for strong and rising returns on capital tend to be associated with an expansion of credit while disappointment and declining confidence triggers credit contraction.
The Fed's new "open mouth" policy, to borrow a phrase from Paul McCulley of Pimco, is directed at influencing widely shared grass roots beliefs and expectations. The message leaves little room for misinterpretation, dissection or rumination by an intermediate layer of academics, theoreticians and media analysts. The blitz of anti-deflation commentary over the last six months seems intended to speed up the normally slow process of changing expectations. The apparent urgency is telling. The Fed wants to influence the course of consumer and business decisions directly and promptly, before deflationary winter settles in. In the lead column of the 6/20/03 Wall Street Journal, Greg Ip wrote: "Fed officials … broadly agree that no unconventional monetary policy is effective unless it convincingly shapes investor expectations about the future path of interest rates."
Governor, (formerly Professor), Bernanke was recruited by the Fed in part because of his academic (Princeton) expertise in the field of deflation. Among his books is "The Great Depression", a collection of essays, which explains why the depression was protracted and severe. The Dallas Fed handbook on deflation fighting was written on a level so colloquial that it could be subtitled "Deflation for the Mentally Challenged". It is an overt attempt to shape public attitudes and behavior. Will the Fed excursion into the business of shaping expectations bear fruit? If so, can those new expectations be tamed or will they get out of hand? The whistle-stopping Fed bears little outward resemblance to the once remote and inscrutable institution whose pronouncements had to be interpreted by a handful of anointed Fed watchers. Unchanged, however, is a central planning culture rooted among academicians and bureaucrats who share a deep disrespect for market outcomes.
Core social beliefs, attitudes and expectations underpin the current low momentum economy. They fall into two categories: those that the Fed would like to change and those it would like to see stand. Candidates for change are:
(a) inflation will remain dormant
(b) a corollary of (a), prices of consumer items will remain "on perpetual sale"
(c) the economy will remain stagnant
(d) manufacturing can be outsourced to China indefinitely
(e) a corollary of (d), workforce reductions are an excellent way to boost profits.
Candidates for retention are:
(a) the Fed will promote economic well being in one way or another
(b) the financial system, aside from a few rocky patches, is basically sound
(c) financial crises are an aberration
(d) the dollar, current weakness aside, will remain the global currency of choice
(e) stock market and economic weakness is related primarily to distractions and concerns related to Iraq
(f) the stock market is a good place to invest
(g) the modern economic cycle can be managed
Bond market investors seem unaware that the Fed is hard at work undermining the foundations of their twenty plus year bull market. If successful, the destruction of capital will rival the dot com bust. How can the Fed manipulate inflationary expectations with any precision, when it has demonstrated no ability to create an amount of credit appropriate to the circumstances? Instead, it has responded to all financial market dust ups and mini panics with the same formula, credit and promises of more where it came from. The Fed is fighting history as well as its own poor record. In the words of market observer and investor Bill Fleckenstein (6/19/03), "The Fed is so panicked that it's resorting to mad experiments to get its own way, i.e., make the economy do as it commands."
Tinkering with expectations fails to address the root causes of the debt hangover. Worse, such efforts work at cross purposes with attempts to patch up a stagnant economy through the accelerating issuance of consumer, corporate, and government debt. Under Volcker, the Fed drove real interest rates to a level that would be unimaginable today considering the fragility of credit. Still, those harsh measures illustrate what was necessary to restore credibility to the dollar. The Greenspan Fed's response to the deflating equity bubble has been to cushion the fall with a bond market bubble. Aggressive easing has encouraged the assumption of even more debt. The same lubrication has attracted investment flows, as the record issuance of sovereign, agency, corporate, convertible and sub investment grade debt attests. The campaign to regenerate inflationary expectations contradicts and clashes with the policy of aggressive easing in the most dangerous way. It is a high-risk gamble to resuscitate pricing power through monetary levers just enough to improve profit margins but to stop short of triggering a return of debilitating inflation. Any overshoot resulting in significant inflation would do more than discourage the investment flows that Fed actions had so arduously courted. It would provide grounds for widespread revolt in the financial markets and foster a level of disrespect and cynicism unseen since the end of the 1970's.
The campaign to devalue the dollar is likely to be successful, mainly because it is so ready to happen. The intellectual premise for a strong dollar is no longer tenable. The world is stuffed with greenbacks while the chief promoters of this over indulgence, the Fed and the US Treasury, are working overtime to build the scaffold. The aftermath will surely be a world contracting credit, high nominal and real interest rates, capital market illiquidity, stagnant business conditions, and of course, higher inflation.
Is the demise of the international system of credit and cross border investment built upon the dollar at hand? Political expediency on the one hand and deflationary fears on the other undermine any remaining pretext for a strong dollar. The capital destruction of the last three years restored the investment objective of safety to its rightful place. Unfortunately, the scramble for safety has created a bubble in safe havens including: treasury instruments, which offer return free risk; high yield bonds, which offer the serious possibility of capital loss; and foreign currencies which will be forced to devalue in conjunction with the dollar. The process of climbing the ladder to safety set in motion by the collapse of the Nasdaq bubble is still in its early stages. The next few years will redefine perspectives on what constitutes a safe haven. Gold will be discovered by process of elimination.
Investor expectations and psychology are shaped by random, largely uncontrollable events and cannot be molded in such a way as to achieve policy objectives. Gathering market forces stand ready to override whatever further delay and meddling the Fed, Treasury, and foreign policy makers choose to employ. Such intervention is capable only of postponing a reckoning which more enlightened policies might have moderated or never fostered in the first place.
The inception date for the Tocqueville Gold Fund was June 30, 1998. The rationale to start the fund originated with a contrarian view of the stock market, which our partners viewed as being dangerous and overvalued. Conversely, gold was as disrespected as equities were celebrated. At the time the opportunity that we perceived as having value and upside potential lacked a particular time frame or magnitude. As a matter of interest, a slide from an early (1998) presentation for the Tocqueville Gold Fund is attached (Exhibit 2-page14). As contrarian investors, we profess: (1) that it is possible to assess the potential for risk or reward in a given market without forecasting the precise twists and turns that will bring other investors to the same conclusion; (2) that the recognition of (1) yields little in the way of clues as to timing, and; (3) it is preferable to be early and alone than late with lots of company.
Investing is a marathon, not a sprint, and bears no entitlement for happy outcomes. The 25-year bull market in financial assets was born in deep pessimism. The experience of the 1970's spawned a generation of investors who harbored negative expectations for investment returns. By most counts, however, the equity bull market commenced in 1975, five years before pessimism peaked. As with gold today, the progress of the equity bull market during its initial stages was a well kept secret.
The explanation for the lag in perception is that the repetition of success or failure predisposes expectations well after important turning points. Psychology at the individual, corporate, and social level simply becomes entrenched. The investment success of the 1990's is still a recent memory. This explains the prevalence of wishful thinking and the inability of most to recognize the inception of a secular bear market in equities. The 1990's will surely be recorded in subsequent texts as the all time caricature of investment insanity. The dot com mania and the South Sea bubble will be forever synonymous.
Positive or negative expectations become ingrained and self-fulfilling until markets become priced for perfection or for the worst possible outcome, until there is nobody left to buy or to sell. The investment cycle from sobriety to lunacy and back again is a crowd phenomenon. It must be measured in generations and viewed in conjunction with the credit cycle. No amount of interference by government policy makers can divert what is essentially the playing out of human nature. Attempts to intervene and control can only prolong the process and increase the amplitude of the cycle. The predisposition to do so is grounded in the failure to understand these elemental facts as well as the intellectual arrogance core to all social engineering.
Our original outlook for gold has been reinforced by the events of the last five years. The clarity of the opportunity is greater today than five years ago, but there is still more to unfold. As an order of magnitude, the possibility of reaching 4-digit gold in dollar terms does not seem daunting. It may prove conservative. The cycle will terminate only when the integrity of paper credit instruments has been restored. There is little to suggest this moment is at hand or within view.