Investment Success and the Long-Term Gold Bull
Below are extracts from a commentary posted at www.speculative-investor.com on 24th June 2004.
Investment Success = Knowledge + Conviction + Risk Management
The main reason that most investors in the stock market don't make much money over the long-term is that they find it impossible to move in the opposite direction to 'the herd'. What tends to happen is that they become very optimistic after prices have already gone up a long way and very pessimistic after prices have plunged. The result is that the average member of the investing public ends up doing most of his/her buying at relatively high prices and most of his/her selling at relatively low prices.
The public can even find ways to avoid making large profits when everything is in its favour. For example, Peter Lynch was one of the world's most successful mutual fund managers between the mid 1970s and the mid 1990s, a period during which the stock market was in a powerful long-term upward trend. However, according to Mr Lynch the majority of people who invested in his funds did not end up making much money because they would tend to get drawn into the funds FOLLOWING periods of very strong performance and then exit FOLLOWING periods of weak performance. In other words, many of the people who invested money with one of the world's best money-managers during one of the greatest bull markets of all time STILL found a way to achieve sub-par returns.
Based on our own experience and on what we've observed, investment success over the long-term requires three attributes; two of which are knowledge and conviction. Without conviction you won't be able to buy or hold when 'the herd' is panicking and without the right knowledge any conviction you have will probably be misplaced. To put it another way, in the financial markets conviction without knowledge (blind faith) is dangerous while knowledge without conviction is useless.
As far as the gold market is concerned, we have a lot of conviction that a long-term bull market is in progress and this conviction is based on knowledge (many thousands of hours of research). There is, of course, always a possibility that we could be wrong, and that's why we employ risk management (the third prerequisite for investment success). For us, risk management involves such things as scaling out of some positions into strength, maintaining substantial cash reserves at all times and, regardless of what we THINK the markets are going to do in the future, always reducing our exposure to the markets if the total value of our portfolio falls by more than 10% from its high water mark.
The sharp corrections in the gold market that happen from time to time (we usually get one per year) are NEVER a reason for us to worry as far as our long-term view is concerned. Instead, we constantly check our thesis as new evidence becomes available and as long as the drivers of the long-term bull market in gold remain in place we will assume that every sharp correction is simply another buying opportunity. And during a long-term bull market the cost of missing a buying opportunity will, with one exception, be MUCH greater than the cost of missing a selling opportunity. This is because every sell-off except for the last one (the sell-off that follows the ultimate peak) will be followed by a move to new highs. Another way of saying this is that there will be many great buying opportunities along the way but only one great selling opportunity. And in gold's case we are confident that the great selling opportunity lies at least 5 years and potentially as much as 10 years into the future.
Earlier in today's report we said "...we constantly check our thesis as new evidence becomes available and as long as the drivers of the long-term bull market in gold remain in place we will assume that every sharp correction is simply another buying opportunity". So, what are the long-term drivers of the gold bull?
The long-term drivers of the 'gold bull' are the same as the long-term drivers of the 'dollar bear'. In no particular order they are:
1. Low REAL interest rates.
The below chart shows the real Fed Funds Rate (the Fed Funds Rate minus the median CPI) from 1969 to the present. Notice that apart from some short-lived exceptions the real FFR spent the 1970s below 1% and the period from 1980 through to 2000 above 1%. Not coincidentally, gold was in a long-term bull market during the 1970s and in a long-term bear market during the 1980s and 1990s. Also notice that the real FFR has spent the past 3.5 years below 1%.
Not surprisingly given what had happened over the preceding 30 years, the start of a new gold bull market coincided with the Q4 2000 downward reversal in the real FFR.
The extremely high debt levels in the US make the US economy acutely vulnerable to higher real interest rates, so it's a good bet that the Fed Funds Rate will be kept at a low level relative to the inflation rate over the next several years. In other words, this particular driver of the gold bull market is likely to remain in place.
2. Sub-par REAL returns on US$-denominated assets
The below chart shows that the decline in the US$ over the past 2.5 years is yet to reverse the course of the US quarterly current account deficit. This, in itself, would not guarantee additional weakness in the dollar and additional strength in the anti-dollar (gold) if the US were able to attract enough new investment each quarter to offset the current account deficit. The crux of the matter, therefore, is whether or not the US stock market and other dollar-denominated assets will be able to generate sufficiently-high real returns in the future to attract enough new investment to counteract the out-flows on the current account. You know what our views are on that.
3. A rising yield-spread
The gold bull market that began 3-4 years ago has been associated with a widening of the gap between long- and short-term interest rates, either because long-term rates have risen relative to short-term rates or because short-term rates have fallen relative to long-term rates. This makes sense because the yield-spread will tend to rise when the expected inflation rate rises.
The Fed has no direct control over long-term interest rates but it exerts a lot of influence on short-term rates. Therefore, the Fed has the ability to affect the yield-spread.
As mentioned in item 1 above, the debt situation in the US is almost certainly going to mean that the Fed continues to err on the side of inflation over the next several years. So although there will be multi-month periods every now and then -- the past few months, for example -- when the markets discount a less-stimulative Fed and the yield-spread contracts, a major trend reversal in the yield-spread (from up to down) is unlikely in the foreseeable future.
4. Sub-par REAL returns on all financial assets
Items 1-3 above all but guarantee a continuation of the long-term upward trend in gold in terms of the US$, but in a secular gold bull market gold should rise in terms of ALL currencies. The desire of the other major central banks to prevent their currencies from getting too strong relative to the US$ SHOULD ensure that the Fed's inflation policy is embraced throughout the world and, therefore, that all currencies will depreciate relative to gold. Furthermore, the goings-on of the past two years give us reason to be confident that this is what WILL happen.
29 June 2004
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