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A Contrarians Dilemma

A Contrarians Dilemma

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Published by Scott Orn

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Published by: Scott Orn on Dec 09, 2009
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1
40
 
West
 
57
th
 
Street,
 
New
 
York,
 
NY 
 
10019
 
 
Tel:
 
(212)
 
698
0800
 
 
www.tocqueville.com
 
Tocqueville
 
 Asset
 
 Management
 
L.P.
 
A Contrarian’s Dilemma
December 2009Is gold a “bubble” because it has now become popular or is there still worthwhile upside? As acontrarian, it is more difficult to reconcile the metal’s recent popularity with the prospect of future rewards. Is the investment consensus always wrong, or can it be right for extendedperiods? Does the perceived flood of new investment mean the jig is up?The ability to remember is sometimes the contrarian’s worst enemy. Recall that Tocquevillelaunched its gold effort in 1998 when the metal was friendless. Central banks were dumping themetal in favor of dollar-denominated assets. In a moment of charity to contrarian investors, theUK dumped most of its bullion reserves at prices below $300/ounce in 1999. Mining companiesfuriously and confidently hedged their future gold production at unheard of (and unexpected)prices well above $300/ounce. The
Financial Times
published the obituary December 13, 1997:“The Death of Gold” (see Appendix). The Dow Jones Industrial Average was valued at morethan 40x an ounce of gold. Credit spreads, a proxy for risk tolerance, were the skinniest in 30years. Risk—in those heady days, investors couldn’t get enough of it. Rodney Dangerfield gotmore respect than the metal.In our May, 2009 website article: “A Surplus of Gullibility”, we concluded that “the bull marketin gold is still young, but that it has(d) crossed an important threshold. No longer laughable andobscure, broader awareness and interest among a wider circle paves the way for capital inflowsto come.” After backing and filling for most of the summer, the gold price broke through the$1000 ceiling which had held it in check for two years, and to the surprise of many, it has heldthis ground, even managing further gains.The effect of four digit gold has been magical on investment psychology. Day after day, thefinancial media publishes glowing reports on the metal’s prospects while never failing to trashthe beleaguered U.S. greenback. Hardly a day passes when I do not receive another meticulouslyresearched, solemn tome on the merits of gold written by a market strategist or hedge fundmanager. My office has stacks of them, all basically saying the same thing: paper currencies arebad so buy gold. In the parlance of the contrarian, gold is no longer a “thin file” investment idea.Barrick Gold, once the preeminent hedger of future output, has finally discovered the attractionsof gold. In a November 2009 speech, newly installed Barrick CEO Aaron Regent declared thatindustry production had peaked at the turn of the century and has begun a secular decline.Having discovered a fragment of the bullish case for gold late in the game, the company put itsshareholders’ money where its management’s mouth is by raising $6 billion of new money frominvestors to neutralize its hedge book. In so doing, the company wrote the final chapter on the
 
- 2 -most disastrous attempt at financial engineering in the history of the gold mining industry. Inperfecting the art of selling low and buying high, Barrick and other gold mining hedgersdestroyed billions of dollars of their shareholders’ capital.Not to be outdone, the central bank of India surprised the market when it bought 200 metrictonnes of IMF gold. In so doing, it shattered the long held investment assumption that officialsector selling would supply the market forever. A surfeit of low yielding dollars presents aproblem for these institutions. India’s gold at market now accounts for a less than whopping7.3%. China is 1.8%, Japan 2.8%, and Brazil 0.6% of total reserves. Still, these countries needto keep their currencies cheap in order to maintain viability for their export markets. In so doing,they accumulate ever greater quantities of dollars. Further buying by central bank institutionsunderweighted in gold seems like a good bet.For good measure, we believe that the U.S. Federal Reserve, watch dog of the dollar’spurchasing power, no longer seems displeased to see a rise in the metal’s price. Their game isreflation and they are not terribly choosy about which assets become overvalued as a result.They are happy to inflate any and all asset classes that would serve as collateral for a renewedbinge of bank lending.The Dow Jones Industrial Average stands at 9.2x an ounce of gold, down from over 40x tenyears ago. Credit spreads widened to record levels in the great credit meltdown of 2008. Theyhave since subsided, thanks to gushers of free government money to finance risky assets, butremain high. Risk avoidance has entered the investor lexicon.In short, the world’s perception of gold has changed and the pace of the bull market hasquickened. In our “Tocqueville Gold 2005 Year-End Review and Outlook” letter, dated January26, 2006, we observed that bull markets can be measured in four stages: the beginning, the endof the beginning, the beginning of the end, and the end. At that time, we remarked that the bullmarket had ended its first phase and entered into a second that would be marked by “noisy anddynamic behavior” that would attract new money flows. Gold was then trading around$550/ounce and we suggested that it would be more correctly priced at $1000. That was beforethe near death financial market experience of 2008. We believe that the crossing of $1000 marksthe end of the second phase and that we have entered the third stage, or the beginning of the end.The first two stages took a full ten years. The latter two stages will take years but we doubt a fulldecade.In our web site article, “The Investment Case for Gold,” dated January 22, 2002, we suggestedthat an eventual gold price of four digits would not come as a surprise to us, at a time when themetal was trading below $300/ounce. As outlandish as that forecast seemed then, we did notenvision how significantly a credit meltdown of the 2008 magnitude would reset the equationbetween gold and paper money. Gold seems as undervalued at around $1200 as it did in 2001 atless than $300. The outlook for the dollar and the paper currency system pegged to the dollarhas undergone drastic change.Gold is a bubble only for those who maintain faith in the ability of politicians and financialauthorities to swim against the tide of deflation. For the rest of us, it is protection against
 
- 3 -monetary damage still to come. The bull market in gold still has much going for it, even if it isno longer a contrarian’s dream. It may be overbought, as bull markets often become, but webelieve it is too soon to jump ship for the next great contrarian idea. The implications of gold’scontinuing strength remain a mystery, even to most of those who have jumped aboard thebandwagon.Once fragile, the bull market in the metal has evolved and strengthened. In our view, there arethree factors to account for this: cultural lag, impeccable fundamentals, and the persistence of misunderstanding.
Cultural lag
far outranks rational analysis in explaining valuation of asset classes. Once popularmythology and the public mood become deep seated, they acquire generational roots that becomethe “default” mode to set the context and assumptions of analysis. Investment behavior is slowto reflect fundamental change that contradicts embedded beliefs. Generational shifts in outlook and mood cause markets to overshoot within a secular, not cyclical, framework. Cultural lag isthe key to understanding why gold, ridiculously undervalued for an extended period, could be onits way to becoming an investment bubble, perhaps several years from now. In our view, publicexpectations are about to pivot in a way that will ultimately take gold to valuations that cannot beexplained by dispassionate and reasoned discourse.The expectation that investment returns are generally positive has been perhaps fatally damagedfor the current generation of investors. Nominal investment returns over the past decade havebeen puny, and mostly negative. If measured in terms of gold (see chart below) they have beendownright disastrous. The repetition of disappointing investment experience is taking hold of expectations. Cynicism is displacing optimism and trust. We do not foresee the bear market infinancial assets ending until public expectations are saturated in apathy.
S&P 500 in Terms of Gold
(Nov. 1999 - Nov. 2009)012345619992000200120022003200420052006200720082009
 
Source: Bloomberg

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