Today’s Avalanche Forecast

CFA, Senior Managing Director, Co-Portfolio Manager
March 6, 2007

For more than the past four years, both gold and financial assets have performed well.  From October 18, 2002 through February 28, 2007 gold rose 112% and the S&P 500 Index rose 59%. The question we wish to pose is: why has gold risen during an extended period when financial assets have also done well? It has typically performed inversely to financial assets. One answer is that gold remains securely entrenched in a secular bull market that started in August of 1999 when the metal dipped to $252/ounce or less than 40% of the current price. The fact that it could and did rise during a halcyon period for the equity and bond markets can be taken as a sign of strength.

A second and more meaningful answer is that gold discounts the future more than it responds in knee-jerk fashion to current headlines. There are unmistakable signs that the metal is moving from weak hands to strong hands. The weak hands are central bank sellers and commodity speculators, ignorant of or indifferent to the metal’s long term strategic merits as a portfolio diversifier. The strong hands are investment interests who believe that there are risks to the continuation of the status quo for the economy, the financial markets, and the global political situation. Adverse outcomes for any or all of these would unleash powerful capital market flows that would drive the metal’s price much higher, and thereby protect and preserve capital with appropriate exposure.

The steady growth in global gold ETFs (exchange traded funds), all backed by physical metal which is taken off the market, is visible evidence of the strength of the global bid for gold. The NYSE listing is GLD, but gold ETFs also trade on nine important exchanges in other financial capitals. Despite the sharp correction in the gold price from early May 2006 through the beginning of October (-22.4%), global holdings of the ETF rose 7.8%. (See Chart 1.)  During the same period, net long non-commercial positions of futures only on the Comex (weak hands) declined 48.2%. (Chart 2.)  The ETFs now absorb more than 10% of new mine supply.  During February, the GLD added 31 tonnes of physical metal which equates to an annual rate of 360 tonnes, a pace which exceeds that of the first two years by 50%.

In time, this instrument will command, in my opinion, a market cap equal to or greater than the global gold mining sector of +/-$100 billion, and why not?  ETF investors are primarily interested in the safety that gold can provide, especially during periods of financial adversity.  For this, they do not desire or need to undertake the risks embedded in gold mining shares.  The demand for safety is inherently risk averse and far greater in magnitude than the risk tolerant demand for the capital appreciation and leverage to gold that is possible in the shares. Today, the collective market cap of all gold ETFs is $14.2 billion. Its growth to $100 billion will be an important driver of the gold price.

What does the small percentage of investors who have steadily moved into gold foresee that seems to have escaped the vast majority? It would be fair to say that there is a litany of worries that have not yet come to pass.

Our friend Craig Drill of the hedge fund bearing his name asks an interesting question:  What would cause an avalanche in financial asset values?  In answer, most would cite one or more of the many concerns voiced frequently in the pages of the financial press: a bear market in equities and bonds, a collapse of the dollar, a deep recession, a collapse in housing, rampant inflation, uncontrollable deflation, worst case geopolitical outcomes, avian flu, or nuclear proliferation.  One can worry about all of these things and more, but who is qualified to take a stand on the likelihood of any particular scenario?  Moreover, these answers would be incorrect.

Craig illustrates with his avalanche analogy..  Mankind is preoccupied with activity in the valleys beneath the mountain peaks.   Troop movements, the comings and goings of dignitaries, pitched battles, and the pronouncements of oracles are the focus of commentary and analysis.  The build up and condition of the snow pack in the mountains receives scant attention.  Is the proximate cause of the avalanche the proverbial canon shot?  Or is it the warming of the snow pack on a sunny day, when, from a human perspective, things couldn’t seem better?

Avalanches could not occur without an unsustainable buildup in the snow pack above the valley, or systemic risk.  Neither geopolitical events, nor earnings disappointments, nor Bernanke’s testimony can topple the markets without the entrenchment of unseen risk.    Investor attention is devoted almost exclusively to the goings on in the valley below, such as the massaging of inconsequential and meaningless government statistics, the parsing of official Fed pronouncements, or the endless scrutiny of irrelevant quarterly earnings data.  From these deliberations, a set of beliefs and mythology eventually emerge to justify and project the status quo. The condition, even the existence, of the snow pack is at best an afterthought. 

The relevant question that trumps all of the day to day concerns of the valley is whether risk in general is accurately priced in today’s markets. One does not have to be a visionary or even a CNBC reporter to discern the abandonment of critical investment thinking in nearly all corners of the financial markets. Complacency and the lust for yield have displaced common sense.

Record low credit spreads between junk and higher grade corporate debt are but one illustration of endemic recklessness. The spread between triple C grade credit and B grade is the narrowest in ten years, according to Martin Fridson of Leverage World, as quoted in the 1/12/07 issue of Grant’s. Signs of recklessness can also be seen in the mortgage sector, where money center banks and brokerage firms repackage the ugliest of sub prime credits into indecipherable instruments called CMO’s (collateralized mortgage obligations) which are cosmetically appealing to credulous investors. 

All myths, manias and distortions of this sort must have their apologists. For example, the esteemed Bank Credit Analyst recently opined: “the combination of a steady world economy and low interest rates has compelled investors to squeeze out any yields in the global market place.”(Weekly Bulletin s5-134187) The volatility index (“VIX”) is low and credit spreads are tight because “volatility in the real business cycle has dropped and, as a result, equity prices have become less volatile.” In other words, everything is fine as long as nothing changes. And by the way, it’s different this time.

Once upon a time, in the days before the Greenspan Fed, the notion of investment risk was generally considered to be the possibility of adverse outcomes. Examples would include dividend reductions, a bond default, or a declaration of bankruptcy.  In today’s world, however, the essence of risk is price volatility, which is capable of generating margin calls and forced selling of assets held in highly leveraged structures. As opposed to adverse experience, risk equates to the possibility of an ephemeral shift in the opinion of the marketplace as to the merits of a particular investment.  The altered state of risk is a symptom of investment horizons that coincide with the reporting of monthly results to hedge fund investors.  The low tolerance for volatility that pervades today’s capital markets would not exist in the absence of delicately balanced pyramids of leverage that finance illiquid and sometimes incomprehensible assets.

Over the past fifty years, credit spreads have shown a positive correlation with gold, albeit with some lag (see Chart 3). During periods of tight credit spreads, gold has been depressed or at least absent from the headlines.  The simple reason is that the price of gold is a proxy for risk perceptions. The fact that risk perceptions in today’s world have been muted until the last few days suggests that gold is undervalued. In this respect, gold has little company in the spectrum of asset classes.

Chart 3 -- Quality Spread

Source:  Fred Kalkstein, Janney Montgomery Scott LLC

It is unfortunate that real interest rates, a formerly reliable measure of gold’s attractiveness, have been irretrievably debased by the politicization of the CPI (Consumer Price Index).  High real interest rates have been poison for gold as Fred Kalkstein’s chart below illustrates. Myriad changes introduced during the Clinton and Bush administrations have rendered this benchmark of inflation all but useless.  If computed in the same manner as it was before the Clinton administration, measured inflation would currently exceed 5% or twice the official rate and real interest rates would be zero.  These changes have been painstakingly tracked by John Williams, an economist who has specialized in dissecting the entrails of government economic reports.  His very useful website  Note the implications for real interest rates, which relate inversely to the gold price if the pre-Clinton CPI is substituted for the present day official CPI on Fred Kalkstein’s chart below:

            Chart 4:  Gold & Real Rates, January 1970 – January, 2007

Source:  Fred Kalkstein, Janney Montgomery Scott LLC


Chart 5: Alternative CPI Measures

Source:  John Williams, Shadow Government Statistics

Tinkering with benchmarks, information series and indices has become fashionable in recent years, perhaps in direct correlation to the proliferation of economic quants our educational system seems to be producing.  Even the venerable CRB (commodities research bureau) index underwent a radical revision in 2005, according to Adam Hamilton of  During its first 48 years of existence, the index was calculated by the geometric averaging of equally weighted components.  The new index, CRB-10, was revised so that oil and two refined products account for 33% of the index which consists of more than twenty items.  The breakdown of the oil complex in the summer of 2006 therefore had an exaggerated impact on the chart pattern, creating the impression the boom in hard assets was finished.  However, a glance at the little-known CRB-9 (see below) that existed before 2005 suggests that the boom is intact:

                        Chart 6:  CCI and CRB Indexes 2005-2007

Source:  Adam Hamilton, Zeal LLC

The hyperactive manipulation and revision of popular data, indices, and information series undermine whatever guidance and insight they may have once provided for analysis of the past, present and future.  Yet such data is regarded as holy writ in most of the financial media, and helps explain the state of profound ignorance and gullibility among most investors and business leaders as to the condition of the economy,and the significance of economic policies (especially the Fed). The measured inflation number, hedonically adjusted, geometrically weighted, and stripped to the core indicates that the dollar is sound, notwithstanding Chairman Bernanke’s  fretting and posturing over looming inflation risks. The bond market, taking these numbers to heart, demands a return of no more than 4.68% (thirty year Treasuries-2/28/07) as sufficient compensation for events unknown until decades from now.  On the other hand, the near doubling in recent years of scarce items including art, gemstones, antiques, premier cru Bordeaux, and gold, to name a few, are passed off as minor and irrelevant curiosities.  The steady progress of financial markets in recent years is the only confirmation needed that risk is overrated.  In short, the weather seems perfect but the avalanche forecast is less sanguine.

One still useful indicator which no think tank of econometricians has figured out how to revise, improve, debase or recalculate is the price of gold, as quoted in  the paper currency of one’s choice.  Instead, Fed governors and mainstream economists alike have trivialized gold as an instrument of public policy and economic discourse (see our previous website article: “Trivial Pursuit?,” 10/31/06).  Still, we suggest that if financial returns were to be benchmarked or restated against gold, they would appear anemic.  The same would be true for the prices of homes, coops, and the list of exotic, scarce items noted above.  The sense of well being and satisfaction conveyed by financial information expressed in nominal currency terms would be recognized by a few as the evil magic of the money illusion.  What it means is that bad information leads to bad decision making.  In the current world, this has amounted to the ill-advised assumption of risk.

Nothing would be more congenial for gold than a global recession and 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.

Today’s avalanche forecast is basically the same as the one for yesterday, the day before and the day before that.  In fact, it has not changed much for quite a few years, except that with each passing day, the odds of an occurence seem to improve in an ever so slight, but less than newsworthy manner.

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.  

China has only 2% of its Total Foreign Reserves in gold.

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