first majestic silver

Rich on Paper

CFA, Senior Managing Director, Co-Portfolio Manager
January 31, 2000

Gold is poised to make its second significant move to the upside in less than a year. Gold shares and the gold price are in a deep funk, the same as the despondency that preceded the September 1999 rally of 30% from a twenty-two year low in the space of three weeks. The catalyst for the rally was an agreement among the leading central banks, known as the Washington Agreement, to limit sales and lending activities, which were depressing gold. While pessimism still reigns, the fundamentals of the gold market have turned decidedly bullish thanks to this development. The agreement, signed by the 15 European Central Union members, fixed the level of outright sales for the next five years. More important, the banks will not increase gold loans beyond the current level. Gold loans have been more damaging to the gold price than outright sales themselves. Finally, the US, Japan, the IMF and the BIS have stated that they will abide by the spirit of the agreement. Therefore, 85% of worldwide official sector gold holdings are now either off the market or will be disposed of in a predictable manner.

This watershed event caught the overly short market by surprise. More important, it provided a fundamental basis for stating categorically that the low point in gold for the next decade is in place. The downside price risk is no longer open-ended. It is only a matter of time before additional upside materializes. How long will it take? The next strong upside move will be driven by another fundamental development, which will also come as a surprise to this excessively short market. That development will be widespread gold producer hedge book buybacks combined with high profile statements that promise to de-emphasize the importance of hedging. Buybacks are already underway. However, anti-hedging statements, which will probably come later this year, will alter negative market psychology by removing still another argument in favor of the bearish case for gold, the expectation of ceaseless and expanding producer hedging.

According to Goldfields Mineral Services’ (GFMS) most recent survey, new supply from producer hedging is likely to decline by nearly 300 tonnes in the current year to 150 from 445 in 1999. However, GFMS is understating the magnitude of the change. Gold company reserve growth dropped significantly in 1999. The raw material for hedging is not expanding. Reserve growth in 1999 will be minimal. A net buyback of the industry hedge position would not be surprising. It would suggest a much larger decline in supply than forecast by Goldfields. Combined with the Washington Agreement, reduced hedging portends a significant shrinkage in the supply of gold over the next twelve months. GFMS forecasts a 10% reduction in supply. It could easily exceed 15%, if producer hedging is zero or negative.

To recall the three reasons for gold’s protracted decline, official sector or central bank selling and lending plus producer hedging have been the most visible. The combination led to the “piling on” variety of short selling by hedge funds and other speculators. To them, gold was just a cheap source of funding, first because the borrowing costs were lower than any other currency, and second, because gold was expected to decline in value. Secular disinvestment is the third reason, which will be discussed in more depth shortly.

Because gold industry management bought into the bearish case for gold, they engaged in extensive forward sales and other hedging transactions. This activity accelerated gold supply by as much as two years’ future mine output. The sharp spike in the gold price following the announcement of the Washington Agreement blew up the hedge books of two high profile producers, Ashanti Goldfields and Cambior and threatened the solvency of the two companies. Their difficulties dramatized the risks of excessive hedging and soured both investor and management appetites for the practice.

The rationale for investing in gold stocks is the expectation of a higher gold price. It is not because a particular CFO or hedge manager happens to be a clever trader in the gold market.Nobody wants to pay for that. The valuation of hedge book enhancements to earnings cannot begin to approach those delivered by the upside in the gold price. In the words of Leigh Goehring (portfolio manager at Prudential), the industry has succeeded in re-rating itself downward by destroying the option value of the shares. At times, it has appeared that industry management does not understand gold market fundamentals. In certain cases, there was an apparent dread of higher gold prices because of potential financial damage from their hedge books. All of this appears to be changing due to a widespread reassessment of hedging.

Gold equities are exceptionally cheap at the moment. According to the respected research team at Scotia Bank, they currently trade at a discount of 18% to net present value, an unprecedented low valuation, even before the September 1999 rally. Because of the lengthy gold bear market, exacerbated by hedging and short selling, shares of gold mining companies, not surprisingly, have ranked among the worst performers over the last twenty years. The global market capitalization of the industry is less than $50 billion. The market cap of one high tech company, Qualcomm, has gained and then lost this amount in the last six weeks. Industry earnings are all but non-existent apart from hedge book profits. Financial staying power for many companies would be in doubt if the gold price remains depressed. Concerned senior executives are considering how they can engineer a reversal of fortune from a near evisceration of shareholder value.

In principle, the answer is simple: announce a change of policy on hedging. The difficulty lies in the execution. Mining companies cannot afford to bid against each other to restructure their hedge books. Nor can they tip their hand in advance, as front-runners would bid up prices. Still, once the market perceives a different industry stance on hedging, the gold price will rise even more sharply than it did in September. Equity valuations are also likely to rise once previously alienated shareholders interested in the upside play on gold return to the fold. Just as the Washington Agreement caught short sellers by surprise in September 1999, a sharp curtailment in producer hedging will trigger a rally to new highs.

The third, most important, and least discussed reason for the gold bear market has been the twenty-plus year bull market in financial assets. It has banished gold to investment Siberia.Interest has vanished for all but a few diehards with long memories. However, long dormant investment demand seems ready to awaken in 2000. If so, it would provide the basis for a sustained, much higher price level that would destroy all hope for shorts to cover at a profit. Investment demand is the most potent of all forces that could drive gold higher, but has been absent for twenty years. For this reason, analysts have modeled supply and demand factors based on newly mined gold, scrap, and net sales or purchases by the official sector versus consumption for jewelry and industry and bar hoarding (a form of investment, primarily in Asia). Little attention has been paid to investment demand, which has been treated simply as a residual of the balance between the foregoing supply and demand factors. In their just published numbers, GFMS projects investment demand for the year 2000 at a negative 418 tonnes vs. a positive 203 tonnes in 1999. Investment demand appears to be negative in the GFMS model in order to balance the numbers. Not to pick on GFMS, but these numbers simply don’t make sense. I believe that investment demand will be positive in 2000, and will begin to crowd out jewelry consumption.

Gold Supply/Demand Balance (tonnes) 1999 2000
Mine Production 2,569 2,650
Official Sector Sales 441 250
Old Gold Scrap 623 650
Producer Hedging 445 150
Total Supply 4,078 3,700
Jewelry 3,069 3,350
Other Fabrication 603 618
Bar Hoarding 203 150
Total Demand 3,875 4,118
Balance = Net Investment 203 -418

Source: Goldfields Mineral Services

Investment demand will awaken because of macro-economic factors that are not within the province of GFMS-type statistical surveys. The world is not awash in gold, it is awash in dollars.The run rate of the US trade deficit exceeds $300 billion per year. 40% of US debt is now held by foreigners. Interest rates are in a rising pattern across the yield curve. The monetary base grew at the highest rate in 50 years during the fourth quarter of 1999. While inflation numbers as measured by the Labor Departments PPI and CPI still appear tame, the precursors of higher inflation numbers are impossible to ignore for anyone not caught up in market mania. According to a recent ISI Group commentary, “inflation still looks tame, at the same time every core measure... has been starting to creep up over the past few months including US core PPI, CPI, and import prices as well as German and French core CPIs. The Atlanta Fed finished prices index has increased sharply and the Euro PPI increased much more than expected in November. In this context, it should be remembered US average hourly earnings gains also appear to have bottomed out in recent months.” Expect the sanguine low inflation, goldilocks economy, “Greenspan is a genius” mentality to be severely challenged in the current year.

Gold demand has three components. These are fabrication for jewelry and industry, potential demand from short covering, and investment demand. Fabrication demand has grown steadily, especially for jewelry. Without it, gold would have collapsed under the weight of the short selling binge. It has counterbalanced the extremely negative investment sentiment of recent years. At 3,700 tonnes in 1999, it exceeded new mine production by over 1,000 tonnes. Without central bank sales, producer selling, and speculative short selling to fill this deficit, the equilibrium gold price would have to be several hundred dollars higher than where it stands. However, fabrication demand by itself does not hold the key to higher gold prices. Instead, it will be pushed aside by panic short covering and renewed investment demand.

There are two reasons to expect the next rally in gold to be more explosive than the 30% run up in September 1999. First the short position still remains very large (for more information, see The Golden Pyramid). It stands at 5,000 to 10,000 tonnes, or two to four years’ mine production. Lending appears to have expanded during the fourth quarter, despite the Washington Agreement, as Kuwait, the Vatican, and other stragglers were recruited to put out the October short squeeze fire. Since mine production is more than absorbed by fabrication, short positions can only be covered by new borrowings, or by central bank sales subject to the 400 ton per year limit under the Washington Agreement.

Bullion dealers appear to shoulder the bulk of the risk that central banks might grow reluctant to provide liquidity. In our conversations with mining executives, it appears that bullion dealers were so eager to sell hedging instruments that they provided very lax margin provisions. This situation has not changed since the Washington Agreement rally. In a startling disclosure, Ashanti recently announced that its hedge book had changed for the worse since their difficulties began. Although the quantity has declined slightly to 9 mm ounces, the breakeven point has declined to $262 from around $285. The notional loss today is $270mm, whereas four months ago, it would have been zero. The company’s balance sheet has shown no improvement.Ashanti’s bullion bankers appear to be at equal or greater risk than when this fiasco first came to light. Ashanti is just one of a number of specific situations that could motivate bullion dealers to manipulate the gold price at the high end of its trading range or at specific chart points closely watched by traders. It is safe to say that Ashanti, one of the most active hedgers, will be a non-entity this arena for some time to come.

Beyond Ashanti, the bullion dealer/mining industry aggregate hedge position remains as vulnerable as ever to a gold rally. Complacency has settled in following the twelve-week retracement in the gold price from its October 1999 peak. Few participants in the outstanding short position contemplate another sharp rally in gold. Many of the shorts do not appear to understand the degree to which they, or the institutions they represent, are at peril. The fallacious argument that gold in the form of mining reserves to be delivered, in some cases, at distant future dates, is an effective long to offset the dealer short, is still a foundation of this complacency. What this view fails to take into account is the financial stress that would result from a substantial rise in the gold price, which does not retrace, for deliveries scheduled several years in the future.

Keep in mind that bullion banks operate on a high degree of leverage. There is an ongoing mismatch between paper and physical gold. A given flow of physical gold can be multiplied by a factor of 5x or greater in the paper market. Any reduction of physical provided by the industry at a future date implies increased leverage and an expanded aggregate short position among the bullion dealers. Compared to the diamond industry, which enjoys gross margins of 50% or more, the gold industry has done a poor job of marketing. By turning over much of the distribution function to bullion dealers, the industry has amplified its own supply by whatever leverage factor bullion dealers wish to apply. Over the longer term, the gold industry would be well advised to explore ways in which it could avoid giving over control of physical flows to these intermediaries.

The second reason to expect a sharp, sudden rise is that markets do not adjust slowly to changes in psychology. Complacency built upon the assumption of tame inflation, the new paradigms of e-commerce, and masterful Fed leadership is overripe. We live in an age of unprecedented financial euphoria. The dollar is considered to be unassailable. Valuations that have never been seen are considered reasonable. Recently, Paul MacRae Montgomery, a noted student of the financial markets, observed that the ratio of triple-A bond yields to the S&P yield is 7.5 times. The only other examples in history where this relationship even approximated this number was the Weimar Republic in Germany, probably not a useful parallel, and Japan in 1989, most likely a valid parallel. Montgomery also prepared a chart, carried by Barron’s, showing the ratio of mergers to GNP, reproduced below. It speaks for itself:


Strange as it may seem, gold has a corner on euphoria. Overvalued stocks, short positions in gold, and foreign holders US dollar instruments occupy the same space. They are hostage to the stale incantations of the bull market. The financial markets at large are conceptually short gold.



The climate of opinion in the investment market is that inflation will never, ever reappear. This credo, repeated ad nauseam by investment gurus in all the media, is the foundation of financial euphoria. What if we couldn’t resort to this mantra? The year 2000 will provide the answer.

Perhaps the most unsuspecting of the potential victims are foreign holders of US debt. A major reason for low inflation is the willingness of our trading partners to accept our paper for their goods. The rosy inflation picture would quickly sour if their high opinion of dollar-denominated debt faltered. The US has been importing the rest of the world’s over-capacity. For years, the US economy’s strength was matched by weakness among our trading partners. Economic recoveries are now underway in the rest of the world. Over-capacity is being absorbed, and the flood of dollars necessary to finance our record trade gap may become less welcome. A change in sentiment would lead to sharply higher US interest rates.

The gold market has reached a point where conventional supply and demand models offer little guidance. Macro economic forces, which have been gestating for what seems like forever, will become impossible to ignore. The positive fundamentals, which formed the underpinnings of the twenty-year bull market in financial assets, have withered. Only the façade remains.Once market participants wake up to the change, gold will benefit to an extent that is inconceivable to those who are short.

Paper wealth has become a state of mind, even a fantasy, regardless of whether it is represented by shares of overvalued high tech companies or foreign holdings of overvalued US dollars. Vying for the title of the greatest fools are the central bankers who have systematically divested their gold through outright sales and lending in order to increase their holdings of higher yielding dollars and other paper currencies. Nouveau central bankers parrot the values and beliefs of the paper asset bull market. They disdain gold and couldn’t be more negative.Their supposed prescience is one of the unfathomable myths of our time. Look for them to change their minds and turn into panic buyers of gold when paper currencies lose value.

Vast quantities of present-day paper wealth, held in the form of inflated stock market equities, will never be converted into lasting wealth. For most, this imaginary wealth will die along with the prevailing market mania. Only a few high tech millionaires will transform their and similar paper into lasting wealth. As in all major market turns, surprise will be a major factor.No advance warning signals for a privileged or clever few will be flashed. Manias exist because a popular point of view becomes over-exploited. A willingness to act in advance, when the negative catalysts are still unclear, and risk leaving money on the table, is the only certain escape. Our suggestion: sell a little while it is still possible to sell. Risk derision and buy gold or gold shares, the pariah of all asset classes. When investment confidence falters, gold will be the leveraged play. A small commitment will preserve and protect some of the paper wealth that would otherwise disappear.

Most holders of equity shares are unable to move their wealth efficiently between alternative asset classes. Gold is the important exception. It is liquid, and currently happens to be depressed which to our mind is one of the benchmarks of value. Gold, almost alone at this point in time, stands out as a more than reasonably priced insurance policy against an undiversified portfolio of high tech and equities. A small investment will translate into enhanced buying power following a serious upset in the financial markets. To feel rich on paper these days is commonplace. To convert these paper riches into lasting wealth will be the exception.

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 ( 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.  

Nevada accounts for 75% of U.S. gold production.
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