A New Chapter for Gold

CFA, Senior Managing Director, Co-Portfolio Manager
August 31, 2007

The general meltdown in credit is the ideal macroeconomic scenario to launch gold into all time high territory. While those same conditions have been disruptive for gold and gold shares in the short term as investors sell whatever they can to meet margin calls, it is important to understand that this is a necessary passage to higher ground. Gold must shed the perception of recent years that it is just another "run of the mill" tangible asset and emerge as the premier way to escape financial havoc.

Government spokesmen and analysts who say the economy remains strong and, therefore, no extreme measures are called for, are looking at coincident indicators. If they believe what they are saying, they are either complacent or ignorant of the laws of basic economics. Whatever happened to economic forecasting? It is credit, and credit alone, that makes the economic world turn. Shrinking credit is a bad omen for future economic activity. A soft economy or, more likely, a recession in an election year, is a recipe for gold well above $1000. It is ludicrous to think that a rate cut here and there or daily injections of liquidity by the Fed will make any difference. This market-induced tightening of credit is a deflationary threat to asset values that will prove to be long lived and resistant to traditional policy measures.

In short, the rationale for a commitment to the gold sector is supported by a meltdown in credit. While it seems that the fuse has been lit for gold, the duration of the burn is unknowable. We must wait for investors to connect the dots. Discomfort with the sell off in gold and gold shares will probably be short lived, but only time will tell. Historically, tests such as these shake out weak hands ahead of significant advances. It is encouraging that the bullion holdings of global gold ETF's (Exchange Traded Funds) have quietly climbed to all time highs during this crisis. This has happened against a backdrop of high profile panic liquidations by hedge funds, proprietary trading desks, and COMEX speculators. Gold has, therefore, been very well bid during the recent market panic and it appears that weak hands (leveraged momentum players) have been flushed out.

Within the space of a few months, the mode of the financial markets has shifted from greed to fear. Just as irrational extremes in greed were necessary to set the stage for the emergence of fear, investor appetite for risk is unlikely to return until all phobias have been exhausted. The psychic energy of crowd emotion is too powerful for central bank or government actions to harness or redirect. Attestations of public officials as to the underlying health and strength of the economy seem hollow and unconvincing. The danger of markets driven by the desire for safety is not limited to the damage they inflict on financial asset values. It extends to the impact on the real economy. Recognition of this potential is what can and will panic public policy makers.

This credit crunch is the most serious financial market event since the 1970's bear market, and perhaps the depression. The NASDAQ crash was mere foreplay by comparison. The internet bubble was just a playground for high rolling investors. Housing has deep roots in everyman's and every politician's psyche. It is a sacred cow. The prospect of declining values, foreclosures, and hard times for American homeowners could put Iraq on the back pages. The potential for collateral damage far exceeds the troubles of those foolhardy investors brought down by the internet bubble.

The political and economic ramifications extend beyond US borders. America has been busily exporting risk to unsuspecting foreign investors. According to Kyle Bass of Hayman Capital Partners in a letter of July 30, 2007, most of the bad mortgage debt issued since 2003 was purchased by foreign investors who had vast pools of dollar liquidity to recycle, and had insatiable and indiscriminate appetites for any dollar denominated instruments. He concludes: "I think the world is going to begin to decouple from the US and realize that currency appreciation coupled with the globe's best growth is an attractive alternative to fraudulent ratings, US dollar depreciation, and financial interventions used to export risk."

There is no politically viable way to counter the threat of general insolvency, other than to devalue debt burdens through inflation. As this dilemma becomes increasingly apparent, I expect that money will flow into the gold sector at an unprecedented clip. The Fed will have to cut interest rates, expand its balance sheet and start to print money. So will other governments, at first reluctantly, and then they all will try to outdo each other. It will come as no surprise when politicians also get into the act with deficit spending measures and debt relief proposals.

The page has turned for gold. In the previous chapter, the metal was just another hard asset and a laggard at that. It was outperformed by base metals, energy and all manner of tangible assets. It was an also ran and an afterthought in the commodities derby driven by the expectation of unstoppable growth in the emerging sectors of the global economy. In the current chapter, I expect gold to outdistance its tangible brethren as its unique monetary traits become more widely understood. Unlike dollars, euros or yen, it cannot be printed. In comparison to these suspect contenders for safety seeking capital, it is scarce and difficult to produce. Companies who mine the metal have nothing but complaints about rising costs and barriers to building new mines. Despite the eight year advance in gold prices, mine production continues to stagnate and returns on capital are mediocre at best.

Our March 5, 2007 Website article "Today's Avalanche Forecast" concluded: "Nothing would be more congenial for gold than a global recession and a liquidity squeeze, which few anticipate. Forgetting timing and immediate causes, however, what is the likelihood of such an event in the next few years? Has the modern Fed gained such mastery over the economic system that it just can't happen? The tight credit spreads of today are indicative of investor complacency and explain why the appeal of gold is lost on so many. Let's see whether that complacency continues when the unexpected leads to mushrooming credit defaults and a meltdown in asset values."

As of this writing, credit spreads have widened but they have not approached the post NASDAQ level of stress. (See chart below.) Only time will tell whether the current meltdown has been successfully contained by liquidity injections by the Fed. It would be surprising to us if this were the case, but it is possible that this is just another mini panic that will blow over as quickly as it appeared.

However, there are a number of reasons to think that the current credit meltdown is more serious and pervasive than the NASDAQ crash. The magnitude of the dollar overhang is far greater than in 2000. Geopolitical concerns are heightened relative to 2000. The psychic impact of the dot com bust was bad, but not as potentially pervasive as declining house prices. A simultaneous decline in house prices and financial assets is a double whammy that we haven't seen post WW II. As in the dot com bust, liquidity has dried up (and we don't know for how long), but it is doubtful that the leverage employed by institutions, hedge funds, and consumers was on the same scale back then. Finally, the extent of the damage in 2000 was readily apparent on a timely basis. Given the complex credit and derivative structures that now are prevalent, the process of discovering where one stands could be more protracted.

If gold investors are squirming these days, what about the overleveraged quant hedge fund geniuses who were instrumental in bringing all of this about? Warren Buffett said that finance is too important to be left to really, really smart people. Gold may be simplistic, but it is understandable to most ordinary folks. If you are not a worried investor these days, you must be a Nobel Laureate. At least gold is a viable strategy to address global credit concerns, and based on historical precedent, it should prove rewarding. Should gold begin to trade in earnest above $700, gold mining shares should also revive and head towards new highs.

John Hathaway, CFA, Senior Managing Director, Co-Portfolio Manager

Mr. Hathaway is a co-portfolio manager of the Tocqueville Gold Fund, as well as other investment vehicles in the Gold Equity Strategy. Mr. Hathaway also manages separately managed accounts for individual and institutional clients.  He is a member of the Investment Committee and a limited partner of Tocqueville Asset Management (www.tocqueville.com). Mr. Hathaway began his career in 1970 as an Equity Analyst with Spencer Trask & Co. In 1976, he joined investment advisory firm David J. Greene & Co., where he became a partner. In 1986, he founded Hudson Capital Advisors and in 1988 became Chief Investment Officer of Oak Hall Advisors. He joined Tocqueville as a Senior Partner in 1998. Mr. Hathaway has a BA degree from Harvard College and an MBA from the University of Virginia.  

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