Year End Gold Review

January 12, 2004

Dear Shareholder:

The past year marked the fourth in the secular bull market in gold, which commenced August 1999. The milestone passed with little fanfare as the recovery in global equity markets transfixed investors. The persistent decline in the US dollar also received little attention, as did the growing US Federal budget and trade balance deficits. The crossing of the $400/oz. price threshold by the metal in December merited no special news coverage. Gold is in the early stages of a stealth bull market. Stealth augurs well for potential longevity and magnitude.

There are two reasons to invest in gold. First, there is the simple and obvious prospect that it may rise in price and thereby create positive returns for those of us who hold it or gold mining shares. The second reason is not quite so obvious, but it is more powerful. It is the fact that gold's behavior is uncorrelated to other financial assets including bonds, stocks and currencies. When expected returns on financial assets are low, money flows in the direction of gold. It is also true that gold, being uncorrelated as opposed to inversely correlated, can rise while financial asset prices are also rising. It is these characteristics that qualify gold as a form of financial insurance.

One might speculate that with lofty valuations, investors ought to worry that future returns on financial assets might be sub par. However, that does not appear to be the case. Even though the S&P is trading at more than 30x trailing 12-month earnings, ten-year bonds at 4.2%, and Federal Funds at 1.00%, investor expectations remain high.

Beneath the complacent surface of the financial markets at year-end, those investors who are thinking beyond the next six months are detecting reasons for concern. Awareness is spreading that the Fed's excursion into extreme liquidity has been little more than a band-aid to deal with the aftermath of the bubble. The Fed has purchased near term euphoria with a flood of debt issuance and unsustainably low interest rates. Those who can see through the fog are beginning to exit the dollar and look to safe havens such as the Euro, gold or tangible assets. Despite record low inflation readings, the future purchasing power of the dollar has never been in greater jeopardy. The Fed's barrage of liquidity is nothing less than an attack on savings. For those who wish to preserve the value of their liquid assets over the next decade or more, and do not wish to speculate in overvalued financial assets, recourse to gold is inescapable.

Gold at $400 is one of the few remaining bargains in a financial world that is a minefield of risk. Investors owe thanks to the central banks. Their repeated sales of the metal have kept a lid on the price. Without such sales, the price would already be several hundred dollars higher. Those with vast pools of wealth to protect, including institutional and private investors, can only hope that these outdated bureaucracies, managed by financially ignorant civil servants, continue their divestment process to facilitate acquisition of meaningful gold positions at attractive prices.

An important milestone for the gold market was the 2003 launch of gold exchange traded funds (ETF's). These instruments link physical gold to the financial markets for the first time in history. Two versions trade in Australia while launch of an ETF on the London stock exchange took place on December 9th. We expect more to follow. Gold ETF's will, over time, actuate a flow of capital into physical metal. They will legitimize and demystify gold and thereby broaden its acceptance as a risk management tool for conservative investors. (For background, please see our website article-The Gold Equity Share: An Idea Whose Time Has Come.)

Despite gold's 20.8% rise in 2003, and more than 60% rise since 1999, professional sentiment is negative. The Hulbert Digest of gold timing newsletters recorded extremely low sentiment readings at the end of December. According to Hulbert, "You will rarely see a more perfect textbook illustration of a bull market climbing a wall of worry…" Consider also the January 6th comments of a well-known market strategist: "Gold is 'blowing off' on the upside right here, just as the U.S. Dollar is 'blowing out' to the downside. I'm expecting a reversal imminently..." In December, Barron's carried an article titled "Gold's Bugs: If you're a fan of the precious metal, buy it, not the stocks." Bull markets are born in skepticism and die in euphoria. Based on this current survey of sentiment, the gold bull market is alive and well.

Along the same line, we were most encouraged by the January 4th comments of Federal Reserve Governor, Ben Bernanke stating that "gold prices … respond to geopolitical tensions; these tensions have certainly heightened since 2001 and, in my view, can account for the bulk of the recent increase in the real price of gold." These comments were included in a lengthy defense of the Fed's very accommodative monetary stance. The speech by this highly influential Fed governor suggests that the Fed is unconcerned about the rise in the gold price and rules out the possibility that it is discounting a renewal of inflation, a dollar crisis, or the bursting of the most recent equity market bubble that the Fed has engineered.

Pullbacks and corrections are a fact of life for any bull market and in this respect, gold is not exempt. We will take advantage of such opportunities to add to positions. While we will attempt to defend against them, we do not want to find ourselves in the position of the sold-out bull who, having grasped the opportunity, missed out because of hyperactive trading strategies and other sins of micromanagement.

Since the gold bull market commenced in August, 1999, gold has increased 66%, while the euro has increased 19% against the US dollar. However, over the past year, they have increased by roughly the same amount, leading many to think that gold is just another play on the weak dollar. Once the weak dollar creates sufficient stress among our trading partners in Europe and Asia, central bankers will figure out ways to reverse the trend, at least temporarily. Investors will then begin to realize there is little to differentiate among paper currencies, and that gold represents the only real alternative to the dollar based system of international credit. At this stage, we expect gold's rate of appreciation against all paper currencies to accelerate.

The bull market in gold is well underway. While it will suffer periodic setbacks, it will not reach its completion until world governments restore integrity to financial instruments beginning with paper money. There is little to suggest that such a moment is within view.

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.  

In 1792 the U.S. Congress adopted a bimetallic standard (gold and silver) for the new nation's currency - with gold valued at $19.30 per troy ounce