Tocqueville Asset ManagementIs Gold Still In a Bull Market?
John Hathaway
Portfolio Manager and Senior Managing Director ©
Since the Bear Stearns bailout at the end of the first quarter, the backdrop for gold has unfolded
in a more positive way than almost any of its proponents could have imagined. The government
takeover of the GSEs, the Lehman Bankruptcy, the disappearance of blue chip investment banks,
and continuing intense credit market stress despite the Paulson bailout of the financial system
have generated successive new highs in the climate of fear overhanging the financial markets.
These successive highs in stress can be measured objectively in the shrinking yields of short
dated government securities and escalating credit spreads of all descriptions.
In light of all of this, why hasn’t gold done better? Year over year, gold bullion is up 25.9%, but
is well below its peak price above $1000/ounce six months ago. Gold shares have not
participated in the flight to safety and have in fact provided disappointing returns over the past
six months, during one of the most intense financial market panics of recent history.
Is gold still in a bull market? On the face of it, the question seems absurd. It is tantamount to
saying that paper currencies have bottomed out and that the coast is now clear for financial
assets. Still, a quick look at gold’s chart shows why the question is pertinent. From viewing this
chart, one could argue that when gold traded briefly above $1000/ounce around the timing of the
Bear Stearns rescue, it had already fully discounted subsequent, albeit even more dramatic
events in the financial markets. At the very least, according to this hypothesis, even though gold
might remain in a very long term bull market, for the time being it is not a “good trade”. Asking
this question another way, if these horrific financial market developments have been insufficient
to drive gold to new highs, what will it take?
As we dissect the internal market developments since the Bear Stearns demise, we can discern
(with 20-20 hindsight) a confluence of unusual factors leading to the breakdown in gold’s multi
year advance. Our hypothesis is one of mistaken identity. Gold was caught in the cross fire of
the unwinding of faux safe haven anti-dollar trades, namely the euro and commodities. The
various iterations of anti-U.S. dollar trades leading up to Bear Stearns were undeniably
overcrowded. Market Vane sentiment in favor of commodities and the euro and against the
dollar were at extreme levels, an accident waiting to happen. On March 17, Market Vane’s
bullish consensus was 93 for gold, 73 for copper, 96 for the euro, 82 for light crude oil and 17 for
the U.S. dollar index.
The catalyst for a reversal of the anti-dollar trade was news of high level meetings between the
U.S., European and Japanese monetary officials to draw up plans to defend the dollar should it
crater in response to the Bear Stearns news. These meetings were reported in the press by
William Pesek of Bloomberg on August 29, 2008: “Many were equally attentive to how the
dollar’s drop was helping to boost oil prices…..The quickest solution is to stop the dollar from
falling, a dynamic that might reverse the increase in oil prices.” It would not be surprising if
word of these discussions was disseminated to selected financial institutions and their clients
well before the press coverage of a dollar defense strategy, originally reported by of Nikkei
News.
The prospect of a possible line in the sand translated into a brick wall for the euro. The exchange
rate has declined from 1.60 to 1.35 or 15.6% in the space of a few months. Unwinding of the
long euro-short $US began in earnest in mid July ’08 and reached panic proportions by early
September. Related trades including commodities and especially oil were also collapsed.
Covering dollar shorts created the illusion of a strong dollar. Given the tight correlation in recent
years between the euro and gold, long gold positions held by hedge funds were dumped. The
swings in Comex positions depicted by the Ned Davis chart are consistent with interpretation of
a panic liquidation. The one month swing from July to August for gold was the fifth largest four
week drop in net speculative positions over the last twenty-five years.
Comex futures are paper contracts typically settled for cash. Little physical gold changes hands.
For example, Tocqueville holds nearly 100,000 ounces of physical gold at a Comex warehouse.
While our gold is counted as part of the underlying physical metal to support the trading of paper
contracts on Comex, it is not for sale and cannot be hypothecated. During the recent meltdown,
bullion dealers inquired whether Tocqueville wished to sell its gold to take advantage of record
premiums for converting Comex good delivery bars into coins. The U.S., Austrian, and South
African mints report that they have had to ration or suspend sales of gold coins due to shortages
of metal. Accounts of shortages in physical gold trading centers are numerous: “Wealthy
Investors Hoard Bullion (Financial Times 9/30/08).” Jeremy Charles, chairman of the London
Bullion Market Association, is quoted in the article as saying “There is an enormous pick-up in
investment demand. I have never seen a market like this in my 33 year career.” To add to the
conundrum, physical holdings of gold ETFs have climbed to all time record levels.
Over the past few months, the price of gold has not been set by the physical markets, however. It
is set on the Comex platform where gold can be shorted naked. Unlike the process of shorting a
stock, requiring a borrow prior to the execution of a short sale, funds trading on the Comex can
short paper contracts that typically settle in cash and do not require possession of physical gold.
According to one bullion trader we spoke with recently, there is only very light volume trading at
the London fixes, where physical metal changes hands. All of the action has been on the Comex,
and even there the volumes are light. Most of the recent trading appears to be linked to
movements in the euro by relatively small players in a thin market.
It seems that the likely source of the glut of paper gold was momentum driven hedge funds that
had been massively wrong footed in an overcrowded trade. The 2008 summer gold panic was a liquidation of paper that never translated into the physical deliveries to satisfy record demand.
At the end of the day, the paper shorts represented by hedge funds, banks and their clients fell
into a bear trap of their own making. There was no physical with which to cover. This explains
the unprecedented 17% short covering rally in the space of only two days (September 17 and
18). The only similar episode in recent memory was the short covering rally in 1999 triggered
by the Central Bank agreement to limit gold sales. Chart patterns back then were less favorable
than today. At the very least, it is premature to declare an end to the bull market in gold and the
bear market in paper. It is more likely that this massive shakeout has set the stage for a dynamic
advance.
What will drive a further advance in gold? Let’s start with the implausible assumption that the
worst of the credit crunch had been already discounted when gold scaled $1000. Let’s also
assume, an even greater stretch, that the Paulson bailout succeeds in restarting the wheels of
lending and commerce. Finally, let’s toss in an end to the decline of asset prices and the
commencement of a bull market in equities. The unequivocal precondition for these felicitous
events would be the transformation of the dollar and other paper currencies as we know them.
The socialization of credit in the U.S. may well work the miracles as its proponents claim, but
not without stiff costs. We suspect that two inescapable costs will be inflation and negative real
interest rates as far as the eye can see. Both of these outcomes are friendly to gold. Neither is
likely to improve the credit rating of the dollar or increase the desire of non U.S. investors to
increase their holdings of U.S. treasuries.
We believe that a future downgrade of U.S. sovereign credit is a strong possibility. It would
defrock U.S. treasuries of their safe haven status. In the late 1970’s, they were dubbed
“certificates of confiscation”. We fully believe they will once again be referred to in a similar
manner as a direct result of current and still to come interventions by the government to shore up
financial markets. On September 16, 2008, The People’s Daily, which is the official newspaper
of the Chinese Communist Party, commented: “The world urgently needs to create a diversified
currency and financial system and fair and just financial order that is not dependent on the
United States.” There is similar commentary from other major foreign investors in U.S.
treasuries.
The experience of the past six months has unmasked other faux safe havens. Paramount among
these are the euro and economically sensitive commodities such as base metals and oil. While
we view the euro as perfectly capable of rallying to new highs versus the dollar in the coming
months, we believe it is even more likely to disintegrate than the U.S. dollar. A euro
permanently above 1.60 would be catastrophic for euro land and would be politically intolerable.
Finally, we note that there is nothing automatic regarding the correlation between the euro and
the U.S. dollar gold price. The last period of prolonged dollar strength versus the euro coincided
with strength in both the dollar and euro gold price.
Economically sensitive commodities have multiple shortcomings as safe havens against
economic turmoil. First, economic turmoil undermines demand for them. Second, rising prices
in real and even in nominal terms are economically disruptive and, by the way, cause economic
turmoil. Third, they are impossible for most investors to take physical possession of. As the chart
below shows, gold is cheap relative to oil. There is no rule that states that gold must revert to a
more normalized relationship. However, gold trending higher against oil would signify that
investors had rediscovered its monetary traits and are in the process of revaluing the metal versus
economically sensitive commodities.
The remaining “safe haven” to be unmasked is U.S. treasuries which sport yields significantly
below nominal rates of inflation. For now, safety seeking investors prefer to lose money slowly
in treasuries than in supposedly riskier assets. Should the bailout and whatever other extreme
measures the government undertakes meet with success, the safety of treasuries will be exposed
as were the euro and economically sensitive commodities as investors rush for the exits. We
believe there is pain ahead for those hiding in treasuries. As the table below shows, gold is
cheap relative to financial assets and that there is plenty of room for gold to be reassessed even in
a more favorable economic climate.
As the table below shows, there is a paucity of physical gold to receive capital flows from failed
safe havens. The magnitude of the upside potential is expressed rather eloquently in the
proposition that the estimated float of physical gold (45,000 – 50,000 tonnes) is roughly equal to
the buying that would be generated by a mere trickle of slightly more than 1% of global pension
fund assets in its favor. In our view, gold trading steadily at $2500 is not unthinkable. Gold at
$2500 would not be economically disruptive but result instead from disruption itself. Until trust
is restored in the mechanisms and instruments of government, namely paper money and, more
recently, large swaths of the financial system, we like the metal’s chances to reside comfortably
in four digit territory. We believe that gold mining shares, which have provided very
disappointing returns over the past six months, are due for a significant revaluation once
investors view the $1000/ounce threshold as a floor rather than a ceiling.
The answer as to whether or not gold remains in a bull market should not overly depend on the
pessimism currently rampant in the financial markets. While worst case outcomes may still be in
the cards, as contrarians, we suspect they are close to being fully priced into the mix, at least for
the time being. A better test for investing in gold is on what basis a case can be made in a more
favorable climate for financial markets. That scenario might include declining risk spread, a
bottom in housing, and some hope for resolution of the credit crisis. The linkage of gold to the
euro is a temporary fact of life. We fully expect both the dollar and the euro to lose value against
gold. From time to time they will take turns leading the race to the bottom but we have little
doubt the gold price expressed in either currency will be significantly higher within a reasonable
time frame. In our view, nothing could be better for gold than for European investors to lose
faith in the euro in the same way that investors have lost faith in the dollar, the financial system
and financial assets in general. If dollar strength against the euro restores some semblance of
stability to the financial scene, as ludicrous as the thought might be, gold is not automatically the
loser.
Long lines of investors buying physical gold, even though they may not have affected the price
near term, signify a widespread loss of trust. In our article “The Investment Case for Gold”
written 1/22/02, we described three factors that would drive the gold price to all time highs:
supply and demand, macroeconomic, and metaphysical. Of these three, the most important is
metaphysical because it represents a shift in widespread social and institutional belief structures
and thought patterns. The events of the past six months have all but destroyed faith in the
competence of political leadership, government and financial institutions and the expectation that
expert financial professionals can produce satisfactory returns. Gone too is the belief that
housing prices will rise forever and that taking on debt is a good idea.
The bleak climate of opinion that has settled in will not easily be whisked away by new
government policies. It will not be dislodged by cheery reports on CNBC, a positive set of
government statistics, or encouragement from bullish gurus. A preference for risk avoidance is here to stay for quite a while, even after the markets find their ultimate lows. This was the case
in the 1970’s following the bear market bottom in December, 1974. Cultural lag is a powerful
force and can influence behavior long after the worst has been seen. Once expectations and
beliefs become imbedded and are reinforced by experience, the swing of pendulum back towards
a full appetite for risk taking might take half a generation. For this reason, we expect the price of
gold to continue its rise against all paper currencies for several years to come.
Given gold’s disappointing behavior thus far as the credit crisis unfolds, it is understandable why
so many investors appear to remain on the sidelines. The bull market in gold is intact. The
dynamics of the ongoing financial crisis can be summed up in the escalating tension between
inflation and deflation. The market-induced deflation of asset values and income streams comes
at a time when debt relative to GDP is at all time highs. The options for government policy are
stark: either let the burden of debts further crush economic activity, or crank up the printing
presses to devalue paper currencies so as to relieve debt burdens. The question for anyone on the
sidelines contemplating gold is whether it is possible or necessary to time perfectly a strategic
commitment to the one asset class that will survive and most likely benefit under either outcome.
John Hathaway
Senior Managing Director, Portfolio Manager
© Tocqueville Asset Management L.P.www.tocquevillefunds.com
October 2008
This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or opinion will be realized.
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