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A Process of Elimination:
A Speculation on Gold and the Credit Cycle

The Speculation

Capital flows into gold under one scenario only: when the lack of investment returns elsewhere, the desire for safety, and the ascendance of a risk-averse psychology at large converge.

In other words, investors come to gold through a process of elimination. It is an odyssey of discovery and realization that investment vehicles thought to be potentially rewarding are in fact filled with hazard and adversity. The current gold cycle began with the collapse of the Nasdaq bubble. The collapse eliminated investor passion for highly speculative equities with little or no operating history trading at absurd valuations. That was five years ago and marked the beginning of a secular downturn in credit. The Nasdaq peak represented the culmination of a credit cycle that commenced in June 1982, when 30 year treasuries were priced to yield 13.92%

The high water mark of the credit cycle, in our opinion, should be measured not by the quantity of debt outstanding, as some would argue. Surely, the Fed's energetic effort to prop up the post 2000 economy has resulted in significantly more debt outstanding than before the Nasdaq crash. Instead, the apex of the credit cycle must be identified in a less quantifiable manner. It is the degree of fantasy present in investor expectations as to future returns. The fact that there is more General Motors paper outstanding than five years ago is not due to GM's improved credit standing or a heightened level of expectations for returns. Obviously, the reality is quite the opposite. A most useful objective measure of credit excess (and fantasy) is the ratio of the Dow Jones Industrial Average to the price of an ounce of gold. The DJII traded at 40x the price of an ounce of gold in 2000. Today, that ratio is 24x. At the bottom of credit cycles in the previous 100 years, that ratio was more or less 1x. A rising gold price merely anticipates future downgrades in financial assets of all stripes, including equities, debt, and currencies.

Dow Gold Ratio
Source: Ashley Ouyang

Some Recent Examples

The first half of 2005 has been noteworthy in that two important capital havens have been soundly discredited: (1) multiple categories of speculative debt instruments and (2) the euro. The demise of both is still in progress. Junk credit will be buried in due course by a global slowdown. European politics and protectionism will take care of the euro.

Investor preferences shifted towards yield instruments as a consequence of the post 2000 adversities in Nasdaq equities and the prolonged episode of zero to negative real interest rates. Having been burned in insanely valued equities, investors mistakenly equated yield with safety. Promoters of toxic Nasdaq merchandise simply reconfigured their production lines to crank out junk credit instruments. Fed-engineered forty year lows in real interest rates forced investors to reach for the sky.

The still-unfolding crack up of financial engineering in the fixed-income sector illustrates what it takes for investors to transit from greed to safety. Investors who positioned complex debt instruments thought to be insulated from volatile and unpredictable returns have learned a difficult lesson. This is especially true for Fund of Fund investors. Opaque financial structures known as Collateralized Debt Obligations (CDO) hedged with Credit Default Swaps (CDS) were promoted as "uncorrelated" yield enhancers. These were almost tailor-made for the Fund of Funds world that promised their investors steady month to month returns and low volatility (returns that were predictable enough, in fact, to be leveraged in their own right).

This obscure credit sector has enjoyed such rapid growth in recent years that it has become the world's largest non sovereign debt market, according to Mari Koi of Wolf International in a paper published April 30, 2005. She states that "In a low real interest rate environment, correlation among assets is assumed to be constant and stable. This brings us to CDO's and synthetic credit securities in particular. They are long real yields at excessively high prices, they are leveraged with little margin for error, they rely on uncertain liquidity as new complex instruments, there is some misinformation, many of the buyers do not mark these securities.. Last and most important, credit derivatives have implied negative gamma with their extreme reliance on correlation assumptions and a structure that implodes as credits move out of the mix." In other words, these core investments in the hedge fund and fund of fund sectors are misunderstood and often mispriced. Rising nominal interest rates will poison them.

Even more significant than junk credit, the euro's fall from grace marks a resounding defeat for financial engineers and technocrats. The previous high correlation between dollar weakness vs. the euro and gold illustrates the predisposition of financial markets to trust in the constructs of academics and technocrats. From mid 2002 to year-end 2004, both gold and the euro rose exactly 40% against the US dollar.

Why bother with gold, investors such as Warren Buffet must have asked, when you can invest in a far more liquid alternative to bet on a weak US dollar? The investment case for a weak dollar has not changed simply because of the exodus of speculative capital from the euro. Where does the smart money go now that the euro has been defrocked?

Since January 1st, 2005, gold has risen 10% against the euro. With traders overwhelmingly bearish on the euro, a decent rally is most likely around the corner. Despite the recent bad news, the euro is most likely here to stay for longer than the bearish trading view anticipates. As noted by Dan Norcini in a June 7, '05 dispatch, the NYBOT speculative position (net short) is the largest in four years. In the previous instance, the speculators were net long (and wrong) when the trade-weighted dollar touched the low end of its trading range (80):

US Dollar Index
Source: Dan Norcini

However, a euro rally will not erase its considerable flaws (see our web site article "Euro Trash, March '05). Where will the euro trade if Italy becomes the Argentina of Europe? To project a complete demise of the euro would be a stretch. However, we are comfortable in asserting that the esteem in which it is held is likely to slip further with the euro price of gold having pierced the top of a three year range bounded by 350 euros/oz. The current price of 358 euros/ounce is a positive sign that dollar bears are beginning to look beyond the euro.

Euro vs. Gold Price
Source: Bloomberg

What we have is a horse race between the euro and the dollar as to which can first attain full investment dishonor. After all, both are core components of "the so-called international monetary system... in fact, an elaborate exercise in price-fixing... ...a giant pool operation" manipulated by the Asian Central Banks. (Grant's June 3, '05) The shift in the global balance of power is perhaps reflected in the futile calls by US officials for Chinese revaluation. With deaf ears to the administration, the Chinese will act according to their own timetable. If our administration's influence on the matter of dollar valuation is as scant as it appears, then what is our currency really worth? In fixing the value of the renminbi, the Chinese control the terms of the relationship. It is not the place of the debtor to dictate terms to the lender. The end game is clearly a significant devaluation of the US currency, but against what and when?

The advance of the gold price signifies more than investor disenchantment. The debris field of financial instruments is the evidence of progressive credit deflation. Nasdaq securities priced at infinity, CDO's, CDS's, derivatives and fiat currencies are or were conduits for credit, resource allocators essential to economic activity. Their impairment threatens economic shrinkage.

A credit squeeze shows up as widening spreads between higher and lower quality debt (see chart). It is also depicted by a falling Barron's Confidence Index (see chart).

Quality Spread
Source: Fred Kalkstein

Confidence Index
Source: Fred Kalkstein

Perhaps this is why the Fed is showing signs of abandoning its "less accommodative" stance. While still talking a tough game on inflation, Dallas Federal Reserve Bank President Richard Fisher stated (June 1st on CNBC) that "we're clearly in the eighth or ninth inning of a tightening cycle." The Fed has significantly augmented its balance sheet over past eight weeks in what has been a conditioned reflex to financial problems going back to 1987. Since the recent GM downgrade, Fed holdings of Treasuries have risen by more than $7 billion, after a lengthy period of no growth (see chart):

Fed Holdings
Source: MacroMavens, LLC

Regardless of whether there are one or two more 25 bp increases in the Fed Funds rate, real interest rates throughout the yield curve will remain at historically low levels, whenever the Fed declares victory. Monetary policy is hemmed in, as has been amply demonstrated elsewhere, by the consumer's vulnerability to rising interest rates. This is especially pertinent now that the residential mortgage market, propped up by inflated collateral value and perverse credit standards, has become a preferred avenue for credit expansion. The gap between what the Fed is saying and what it is doing is attracting considerable attention. As noted by columnist Bill Jamieson, "Apprehension over the health of the US credit market has been heightened by talk of a further development. This is that the Federal Reserve has been pumping huge amounts of liquidity. This brought back anxious memories of a feared liquidity shortage just before the collapse of Long Term Capital Management in 1998." (Financial Times 6/9/05)

Expanding credit spreads, a declining Barron's confidence index, the flight to quality, the Fed response of liquidity creation all add up to a credit squeeze. More paper, perhaps, but less credit. The recession in credit that began in 2000 has many years to run and will eventually expose all misallocated capital. The process is self-reinforcing. The tipping point for confidence will be the moment when Fed liquidity injections are recognized to be ineffectual and even damaging.

What comes next after the Nasdaq, CDO's, junk debt, and the Euro? There are plenty of candidates including hedge funds, housing and a still overvalued stock market. These overvalued asset classes can and will continue to levitate and attract capital flows as long as real interest rates remain at historic lows. Low real interest rates are the foundation of financial market speculation, and the lubricant of global economic growth.

The mother of all bubbles is US Treasuries, where pricing is driven not by crowd psychology, but rather by the policy dictates of our Asian trading partners. As noted by Jim Bianco (Arbor Research), "There seems to be little to no talk that the bond market might be in a bubble. Real estate, Google, the dollar and many other markets are being deemed 'bubbles'..Maybe the bond market is the bubble." (6/10/05) A bubble without an accompanying mania seems implausible and without precedent. The most recent "commitment of traders" number suggests sentiment is neutral, with commitments of large speculators at 68% of the 52 week high. For the US treasury bubble, the missing manias are to be found in markets and economic sectors linked by their dependence on mispriced capital

It is worth noting that the foreign central banks were net sellers of US Treasuries in March. It was short covering by hedge funds that provided the bid to offset dispositions by foreign central banks. Over the past two months reported (March and April), foreign buying failed to cover the trade deficit. Since April of 2002, according to Arbor Research, foreign central bank buying has been insufficient to cover the budget and trade deficit on a cumulative basis.

Bridgewater Daily Observations notes that "at current prices there is net more than 8% of Chinese GDP flowing into China via the private sector." (Waiting on the Inevitable, June 7, 2005) "This type of BoP imbalance is essentially unprecedented. The BoP imbalance is due to the massive labor arbitrage between China and the rest of the world. Everyday that China holds their currency below market value they have to do more to keep it where it is, because the investment into China makes their labor more productive (factories open in China but close elsewhere) at the same time that the price essentially does not change." Bridgewater goes on to note that "there are virtually no cases (in history) of one improperly pegged exchange rate being repegged at another improper level (i.e. that which doesn't rectify the BoP imbalance) and sticking for long." Bridgewater found that the average devaluation in 56 cases since 1930's was 25%.

A Few Fundamentals to Consider

The notion that capital will flow into gold is a speculation on macroeconomic events external to gold. It is helpful to this speculation that the goings on in the world of gold itself are quite supportive of a substantially higher gold price. In brief, the metal is very tight.

Even though trading houses in New York and Europe seem to find plenty of paper gold to trade in a knee jerk fashion according to the news of the day, the real stuff is hard to come by. It is hard to mine and it is hard to buy in any large quantities. Just ask managers of the Swiss precious metal refineries. Their daily run rates are 30% above year ago levels and their managers are not above making urgent but discrete inquiries for gold in quantity. They are running seven days a week when they can get their hands on metal, less when they cannot. According to one contact, there is almost no metal in storage. The turnaround time for incoming metal, whatever the source is 4 to 5 days at most.

Gold is tight based on the CFTC numbers indicating that speculators are sufficiently bearish to be short 757 tonnes (gross) as of June 7, 2005, or one third of annual mine production. The net large speculative trader position ranks in the 22nd percentile of the past 52 weeks. Gold becomes "toppy" when they approach the 90th percentile. It is tight because mine production declined 4.9% in 2004 and appears likely to decline over the next three to five years. Mining companies continue to generate poor returns on capital and are struggling to replace reserves. It is tight because central banks disposing gold under the Frankfurt agreement (500 tonnes per year) have already sold 384.7 tonnes throught the first week of June, an average of 10 tonnes per week. Over the remaining 14 weeks of the fiscal year ending in September, they will be limited to 7.6 tonnes per week, a 24% decline from the average pace, and an even sharper decline from the recent three weeks' pace of 12.2 tonnes. Finally, gold is tight because total end user consumption, as tabulated by the World Gold Council, rose 9.5% in 2004, and 25.8% in the first quarter of 2005 vs. '04.

An important reason, but by no means the only one, for the jump in consumption is the success of the gold ETF, particularly GLD (listed on the NYSE) sponsored by the World Gold Council. GLD and related series listed in London and Australia represents 1/10 oz of ounce of physical gold and is now backed by 236 tonnes (includes all listings) which has been taken out of the market. By capital market standards, GLD is tiny, with a market capitalization of only $3.2 billion. For example, if the market cap of GLD were to grow to $30 billion, still modest by capital market standards, it would require gold purchases equal to 90% of annual global gold production at today's prices. Unlike mining or internet stocks, share creation is not a simple matter of investment banking fees and printing capacity. Share creation requires incremental purchases of physical gold. In this sense, the ETF is a dynamically reflexive investment structure, a potential time bomb for short positions.

The global market cap of mining shares is about $100 billion. Investing in shares is subject to a long list of risks including geopolitical, cost pressures, labor disruptions, mine accidents, and environmental lawsuits to name a few. However, the greatest risk by far is share dilution by financially unsophisticated managements. Over the last two years ending December 31, 2004, the share count for the entire industry rose 33%. Is it any wonder that the shares and share indexes have lost some momentum in light of the additional supply? We wholeheartedly support the scathing comments of Graham French speaking at a mining conference in April of this year: "This industry is so blasé that 90 percent of capital raising is done without consulting shareholders." We would add that the industry consumes huge quantities of capital on which it generates poor returns. It cannot afford to take its shareholders for granted.

While we favor gold shares in most instances over the metal because they offer leverage to the gold price, we can understand why risk-averse investors looking for the protection of gold without the risk of mining would prefer the metal itself. Gold entails no business risk, only the possibility of overpaying. In our view, the potential pool of risk averse investors is considerably larger than the share oriented risk tolerant investor group. Physical gold comprises an asset class at least 10 times that of the mining shares. Therefore in time, it seems reasonable to expect the ETF and similar initiatives to have a market cap proportional in size to the underlying disparity.

The recent weakness in the gold shares is a good proxy for investor sentiment. It is at rock bottom. This is confirmed by the Hulbert Gold Newsletter Sentiment Index which has recently matched record low readings. The May 23rd Market Vane sentiment gold barometer was 61% bulls, the lowest since 57% on May 13, 2004 when gold was $379. The bullish consensus was in the 40's in April '03 when gold was $320. The peak recent reading was 83% in October of 2004 when the gold price was slightly below $430.

The dollar price of gold bullion is trading within 3% of a seventeen year high, despite negative sentiment. Over the past five years, the dollar gold price has increased 50% vs. a 16% decline in the S&P 500 and a 18% decline for the trade weighted dollar. Swooning sentiment while gold trades within a few percentage points away from a seventeen-year high? Sounds like a bull market to us. It is the nature of every bull market to take along as few as possible. The recent shakeout, which began in earnest in early March, has done an excellent job of chilling investment sentiment. The early stages of all bull markets are characterized by widespread skepticism. Gold remains in a multiyear bull market that will last another decade. The deflowering of the euro represents a major milestone along the way.

Whenever it happens, the demise of the bubble in US Treasuries will take down the many related bubbles based on a mispricing of risk free capital. Problematic fundamentals, notwithstanding the near term "Laffer Curve" improvement to the federal budget deficit, will eventually gain the upper hand. Foreign central banks will eventually decide to move towards the exit. First they will buy less, later on they will sell outright. Timing the tipping point is problematic for most, including us. Those who feel able to predict the precise moment when foreign central banks turn their backs on the dollar should wait until then to position gold. All others are advised to start now.

In his 1871 treatise entitled The Origin of Money, Carl Menger demonstrated that money was a social institution long before governments adopted and enforced legal tender laws. Precious metals were universally adopted by all societies because they offered, among all other commodities, superior liquidity, scarcity and portability: "Money has not been generated by law. In its origin it is a social and not a state institution." Governments did not adopt gold as monetary backing until the 1840's when England and France held 40 tonnes. This is not to suggest that state issued currency cannot function for a time as a satisfactory medium of exchange. However, over generations, it has proved to be a poor store of value.

We believe that the divestiture of gold reserves by central banks (at a measured pace, of course) offers the possibility of the eventual privatization of gold. There could be no better monetary outcome for the private sector than for all gold to be removed from central bank vaults. Citizens would then be free to choose how to hold their wealth, as they did before legal tender laws became the standard. We have no doubt that sufficient buying power exists through the exchange of questionable paper assets to support a bid much higher than the current dollar price. Would it be possible for gold instruments such as the ETF and Bank Receipts to coexist with fiat currencies? We may be witnessing the dawn of just such an outcome. In a free market for both, gold would offer the superior alternative for capital preservation, while fiat currencies may periodically offer a more convenient medium of exchange.

Nearly sixty years ago, Beardsley Ruml (Chairman of the New York Fed) wrote: "The necessity for a government to tax in order to maintain both its independence and its solvency" is no longer true because of the "vast new experience in the management of central banks" and "the elimination, for domestic purposes, of the convertibility of currency into gold." (American Affairs, Jan. 1946) These few phrases foreshadow the sixty year evolution of the Federal Reserve from a traditional central bank into a central planning agency. (See our web site article "Beardsley Ruml's Road to Ruin," November 2004) Convenient though government sponsored currencies such as the dollar and the euro may be, they are first and foremost tools of government policy and serve the interests of the private economy as an afterthought. The dichotomy of monetary interest between the public and private sector will be exposed as the current secular credit contraction runs its course. It will culminate in a grass roots mandate for sound money, and will be expressed as a dollar gold price well into four digits.

John Hathaway

© Tocqueville Asset Management L.P.
June 30, 2005

The views expressed by the portfolio manager in this article are current as of the date of this article, and are subject to change at any time based on market and other considerations.

This commentary is not an advertisement or solicitation to subscribe to The Tocqueville Gold Fund, which may only be made by prospectus. This material must be preceded or accompanied by the Fund's prospectus. For more complete information, please order a free prospectus by calling 1-800-697-3863, or visit www.tocquevillefunds.com

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