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The True Believer

"It certainly is possible that gold can return to its long-term equilibrium inflation price of $500 an ounce, or even take a run at its all-time high of close to $1,000. What would cause such an explosion? A steep decline in the equities market, higher inflation, or competitive devaluation of the major currencies. In a bleak world, gold could beat almost everything else."

by Barton M. Biggs, Morgan Stanley & Co.

With equity markets having fallen so sharply and the rally in high-grade bonds, our ten-year return study needs tinkering with. Nevertheless, nothing has happened that changes our long-term assumption that we are in for an extended period of mid-single-digit returns in both stocks and bonds. Large portfolios are going to have to be imaginative and unorthodox to beat 6% nominal in my opinion, and there will be bigger allocations to hedge funds, arbitrage strategies, real estate, emerging markets, and private equity. Whether all these asset classes work as advertised or the capital markets arbitrage out the excess returns is a horse of another color.

In that regard, a horse I have never believed in is gold, for all the conventional reasons, but now I am changing what's left of my mind. I think there is a plausible case that a professionally managed portfolio consisting of the metal itself and gold shares could realize returns of 15% real per annum in the difficult environment ahead. Here is the story.

I know a number of investors who are deeply, almost fanatically committed to an investment philosophy. They are the "true believers." The purest, most steadfast disciple of an asset class I know of is an old friend, Peter Palmedo, who is a gold disciple.

By definition, a true believer has to endure long stretches out there in the cold and bleak winds of the wilderness as an exile from the herd, when his or her style doesn't work and the world thinks he is both terminally wrong and crazy. Certainly in the late 1990s value investors had a very tough couple of years, and if you didn't believe in tech in the summer of 1999 you were nuts and obsolete. But other than Peter, no one I know has suffered a decade of anguish and still persisted.

Peter is a really interesting guy. Now 46 years old, he has boyish good looks, is very fit, is soft spoken, but has always had a rebellious streak. If his prep school coach told him to practice foul shots, Peter would work on three pointers. Told by authority "it's either my way or the highway," Peter instinctively heads for the highway. After majoring in economics and option theory, he joined Morgan Stanley's equity derivatives group in 1980 and did a lot of everything. In the summer of 1987 using a series of quantitative models he developed, he became convinced that dynamic disequilibrium was imminent. He persuaded the firm and certain accounts to buy deep out-of-the-money S&P 500 puts, which he demonstrated were very underpriced, and in addition bought a load for himself. Then came the Crash!

With a nest egg, Peter began to think the high stress and travel Morgan Stanley required were not his thing, when he had a wife and three young children. A skier, climber, and biker, he moved his family to Sun Valley, Idaho, and began to search for an asset class to immerse himself in. Immerse is the operative word. Peter's style has always been to focus intensely on one thing, study it, build models on it, and develop an analytical edge. He came up with gold because it was misunderstood, under-researched, and susceptible to his option-pricing theories. In 1990 he founded Sun Valley Gold.

Source: Sun Valley Gold, MSIM Asset Allocation Research

Over the next decade, Peter became arguably the most knowledgeable gold analyst in the world. He totally immersed himself in the study of gold, always applying his option-pricing theories. In time he built a four-man research team of geologists and mining engineers that probed mine sites and generated detailed inputs for cash flow and resource value models. In addition, he uses dynamic valuation modeling and warrant theory cash flow to determine accurate and consistent corporate valuations.

For the metal itself he built models that attempt to predict the effect of small changes in the variables of the supply and demand curves. Gold is an intriguing commodity to model because there is a huge above-ground stock and limited production increases. Quants tell me that Peter's models and equations are highly sophisticated and that Sun Valley Gold has the best mining research. As he studied the literature, Peter focused on a long scholarly piece written in 1988 by Lawrence Summers (later Secretary of the Treasury and now president of Harvard) and Robert Barsky entitled Gibson's Paradox and the Gold Standard. The conventional wisdom is that gold is a barbaric metal, it has a negative yield, and its only role is as a hedge against inflation and the apocalypse. By contrast, Summers and Barsky argued that the relative price of gold is driven by (and is the reciprocal of) the real rate of return from capital markets and that this relationship has strengthened since the price of gold was floated.

Gold is a highly durable asset, and thus, as stressed by Levhari and Pindyck(1981), it is the demand for the existing stock, as opposed to the new flow, that must be modeled. The willingness to hold the stock of gold depends on the rate of return available on alternative assets. We assume the alternative assets are physical capital and bonds"

Peter gave me a copy of the Summers-Barsky thesis, and it's too dense a thicket for me. He has written a succinct paper that is comprehensible.* In it he points out that this relationship to the capital market's real return and particularly to the stock market has proved stunningly consistent since that paper was written (Exhibit 1). Since 1988 the price of gold has had a negative 0.85 coefficient of correlation with the S&P 500 and an R squared of 72%. As things got crazier since 1994, the negative correlation rose to 0.94, with an R squared of 88%. In other words, the stock market explains 88% of the weekly price fluctuations of gold over the last eight years. The long-term correlation with Treasury bonds is not as high but still very significant.

As he explains it, the so-called "problem" with gold, which causes its erratic price behavior, is that the elasticity of a positively sloped investment demand function overwhelms the inelasticity of supply. Only 18% of the gold mined throughout history is held in investment form, or slightly more than $200 billion. The investable capital markets of the world are estimated to be about $60 trillion. In a lowreturn cycle for stocks and bonds, monetary and investment demand for gold turns positive, and there is a dramatic shortage of available metal. This large differential can only be solved by much higher prices.

The point is that it is not inflation or deflation that is the principal driver of gold, but the return from other long-term financial assets, particularly equities. Here is Peter's model of this relationship.

Source: Sun Valley Gold

Peter maintains that the long-term equilibrium or inflation-adjusted price of gold in today's dollars is about $500/oz, as compared to the current price in the low $300s. Summers and Barsky also say that there is a secular trend toward a higher real and nominal price.

Population and income growth exceed the constrained growth of the physical stock of metal, which has been a mere 1.75% over the centuries. In addition, in the modern world, monetary growth far exceeds economic growth.

However, gold was not a happy place to be in the 1990s. Gold was still correcting the excesses of its huge bubble of the late 1970s, so the market price was in the process of not only reverting to the mean but dramatically undershooting. The best company-specific research and the most sophisticated models were for naught in a secular bear market. Peter was viewed as "that guy who used to be smart that went crazy and became a gold bug." However, he didn't care because he was convinced double-digit real returns on financial assets were unsustainable. He was a true believer, and meanwhile his family grew up in Sun Valley, he climbed every mountain in sight, and waited for his time to come.

This piece is a summary of much longer discussions Peter and I had. You need to read his paper. But my point is that if we are in an extended low-real-return period for financial assets, there is a place for a gold investment program in both large and small portfolios.

Peter runs portfolios where the benchmark is gold bullion and gold shares, each at 50%, in a range from 70% to 30%. Allocation can add a couple of hundred basis points a year to gold's return. Gold shares tend to have twice the volatility of the base metal because of their inherent operating leverage. Sun Valley Gold's record is that active management of a gold shares portfolio can add 800 to 1000 bp a year to the return of the gold shares index. This strikes me as optimistic, but the gold shares market is very inefficient, and analytical resources can make a huge difference. The optimum size of a managed gold stock portfolio is probably around $200 million.

So if you believe this story and think the real return from capital markets over the next decade is going to be 4% per annum, the real return from a managed gold portfolio is going to be around 15% real (+7% metal, +1% allocation, +14% gold shares, plus 8 percentage points of alpha). I don't need to tell you that returns of this magnitude would be spectacular, but I strongly suspect that the returns would be highly volatile given the history of gold. How much should a large fund have in professionally managed gold? I say 5%.

It certainly is possible that gold can return to its long-term equilibrium inflation price of $500 an ounce, or even take a run at its all-time high of close to $1,000. What would cause such an explosion? A steep decline in the equities market, higher inflation, or competitive devaluation of the major currencies. In a bleak world, gold could beat almost everything else.

*Gold 2002: Can the Investment Consensus Be Wrong? The Summers Barsky Gold Thesis. Sun Valley Gold LLC (208 726-2327) or Peter@SVGold.com

Excerpt from Morgan Stanley US Investment Perspectives ­ July 17, 2002
by Barton Biggs, Morgan Stanley
July 17, 2002

The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated ("Morgan Stanley").

Copyright © Morgan Stanley 2002. All Rights Reserved.

Reprinted by USAGOLD with permission of the author. Further use without consent is prohibited.

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