Excellent insight into the next move up in GOLD! John Hathaway of the Tocqeville Gold Fund -- predicts a new rally more powerful than last fall.
Rich on Paper
By John Hathaway
Gold is poised to make its second significant move to the upside in less
than a year. Gold shares and the gold price are in a deep funk, the same
as the despondency that preceded the September 1999 rally of 30% from
a twenty-two year low in the space of three weeks. The catalyst for the
rally was an agreement among the leading central banks, known as the
Washington Agreement, to limit sales and lending activities, which were
depressing gold. While pessimism still reigns, the fundamentals of the
gold market have turned decidedly bullish thanks to this development.
The agreement, signed by the 15 European Central Union members, fixed
the level of outright sales for the next five years. More important, the
banks will not increase gold loans beyond the current level. Gold loans
have been more damaging to the gold price than outright sales
themselves. Finally, the US, Japan, the IMF and the BIS have stated that
they will abide by the spirit of the agreement. Therefore, 85% of
worldwide official sector gold holdings are now either off the market or
will be disposed of in a predictable manner.
This watershed event caught the overly short market by surprise. More
important, it provided a fundamental basis for stating categorically that the
low point in gold for the next decade is in place. The downside price risk
is no longer open-ended. It is only a matter of time before additional
upside materializes. How long will it take? The next strong upside move
will be driven by another fundamental development, which will also come
as a surprise to this excessively short market. That development will be
widespread gold producer hedge book buybacks combined with high
profile statements that promise to de-emphasize the importance of
hedging. Buybacks are already underway. However, anti-hedging
statements, which will probably come later this year, will alter negative
market psychology by removing still another argument in favor of the
bearish case for gold, the expectation of ceaseless and expanding
producer hedging.
According to Goldfields Mineral Services? ( GFMS ) most recent survey,
new supply from producer hedging is likely to decline by nearly 300
tonnes in the current year to 150 from 445 in 1999. However, GFMS is
understating the magnitude of the change. Gold company reserve growth
dropped significantly in 1999. The raw material for hedging is not
expanding. Reserve growth in 1999 will be minimal. A net buyback of
the industry hedge position would not be surprising. It would suggest a
much larger decline in supply than forecast by Goldfields. Combined
with the Washington Agreement, reduced hedging portends a significant
shrinkage in the supply of gold over the next twelve months. GFMS
forecasts a 10% reduction in supply. It could easily exceed 15%, if
producer hedging is zero or negative.
To recall the three reasons for gold?s protracted decline, official sector or
central bank selling and lending plus producer hedging have been the
most visible. The combination led to the ?piling on? variety of short
selling by hedge funds and other speculators. To them, gold was just a
cheap source of funding, first because the borrowing costs were lower
than any other currency, and second, because gold was expected to
decline in value. Secular disinvestment is the third reason, which will be
discussed in more depth shortly.
Because gold industry management bought into the bearish case for gold,
they engaged in extensive forward sales and other hedging transactions.
This activity accelerated gold supply by as much as two years? future
mine output. The sharp spike in the gold price following the
announcement of the Washington Agreement blew up the hedge books of
two high profile producers, Ashanti Goldfields and Cambior and
threatened the solvency of the two companies. Their difficulties
dramatized the risks of excessive hedging and soured both investor and
management appetites for the practice.
The rationale for investing in gold stocks is the expectation of a higher
gold price. It is not because a particular CFO or hedge manager happens
to be a clever trader in the gold market. Nobody wants to pay for that.
The valuation of hedge book enhancements to earnings cannot begin to
approach those delivered by the upside in the gold price. In the words of
Leigh Goehring ( portfolio manager at Prudential ) , the industry has
succeeded in re-rating itself downward by destroying the option value of
the shares. At times, it has appeared that industry management does not
understand gold market fundamentals. In certain cases, there was an
apparent dread of higher gold prices because of potential financial
damage from their hedge books. All of this appears to be changing due
to a widespread reassessment of hedging.
Gold equities are exceptionally cheap at the moment. According to the
respected research team at Scotia Bank, they currently trade at a discount
of 18% to net present value, an unprecedented low valuation, even before
the September 1999 rally. Because of the lengthy gold bear market,
exacerbated by hedging and short selling, shares of gold mining
companies, not surprisingly, have ranked among the worst performers
over the last twenty years. The global market capitalization of the
industry is less than $50 billion. The market cap of one high tech
company, Qualcomm, has gained and then lost this amount in the last six
weeks. Industry earnings are all but non-existent apart from hedge book
profits. Financial staying power for many companies would be in doubt
if the gold price remains depressed. Concerned senior executives are
considering how they can engineer a reversal of fortune from a near
evisceration of shareholder value.
In principle, the answer is simple: announce a change of policy on
hedging. The difficulty lies in the execution. Mining companies cannot
afford to bid against each other to restructure their hedge books. Nor can
they tip their hand in advance, as front-runners would bid up prices. Still,
once the market perceives a different industry stance on hedging, the gold
price will rise even more sharply than it did in September. Equity
valuations are also likely to rise once previously alienated shareholders
interested in the upside play on gold return to the fold. Just as the
Washington Agreement caught short sellers by surprise in September
1999, a sharp curtailment in producer hedging will trigger a rally to new
highs.
The third, most important, and least discussed reason for the gold bear
market has been the twenty-plus year bull market in financial assets. It
has banished gold to investment Siberia. Interest has vanished for all but
a few diehards with long memories. However, long dormant investment
demand seems ready to awaken in 2000. If so, it would provide the basis
for a sustained, much higher price level that would destroy all hope for
shorts to cover at a profit. Investment demand is the most potent of all
forces that could drive gold higher, but has been absent for twenty years.
For this reason, analysts have modeled supply and demand factors based
on newly mined gold, scrap, and net sales or purchases by the official
sector versus consumption for jewelry and industry and bar hoarding ( a
form of investment, primarily in Asia ) . Little attention has been paid to
investment demand, which has been treated simply as a residual of the
balance between the foregoing supply and demand factors. In their just
published numbers, GFMS projects investment demand for the year 2000
at a negative 418 tonnes vs. a positive 203 tonnes in 1999. Investment
demand appears to be negative in the GFMS model in order to balance
the numbers. Not to pick on GFMS, but these numbers simply don?t
make sense. I believe that investment demand will be positive in 2000,
and will begin to crowd out jewelry consumption.
Gold Supply/Demand Balance ( tonnes )
1999
2000
Estimated
Mine Production
2,569
2,650
Official Sector Sales
441
250
Old Gold Scrap
623
650
Producer Hedging
445
150
Total Supply
4,078
3,700
Jewelry
3,069
3,350
Other Fabrication
603
618
Bar Hoarding
203
150
Total Demand
3,875
4,118
Balance = Net Investment
203
-418
Source: Goldfields Mineral Services
Investment demand will awaken because of macro-economic factors that
are not within the province of GFMS-type statistical surveys. The world
is not awash in gold, it is awash in dollars. The run rate of the US trade
deficit exceeds $300 billion per year. 40% of US debt is now held by
foreigners. Interest rates are in a rising pattern across the yield curve.
The monetary base grew at the highest rate in 50 years during the fourth
quarter of 1999. While inflation numbers as measured by the Labor
Departments PPI and CPI still appear tame, the precursors of higher
inflation numbers are impossible to ignore for anyone not caught up in
market mania. According to a recent ISI Group commentary, ?inflation
still looks tame, at the same time every core measure... has been
starting to creep up over the past few months including US core PPI,
CPI, and import prices as well as German and French core CPIs.
The Atlanta Fed finished prices index has increased sharply and the
Euro PPI increased much more than expected in November. In this
context, it should be remembered US average hourly earnings gains
also appear to have bottomed out in recent months.? Expect the
sanguine low inflation, goldilocks economy, ?Greenspan is a genius?
mentality to be severely challenged in the current year.
Gold demand has three components. These are fabrication for jewelry and
industry, potential demand from short covering, and investment demand.
Fabrication demand has grown steadily, especially for jewelry. Without
it, gold would have collapsed under the weight of the short selling binge.
It has counterbalanced the extremely negative investment sentiment of
recent years. At 3,700 tonnes in 1999, it exceeded new mine production
by over 1,000 tonnes. Without central bank sales, producer selling, and
speculative short selling to fill this deficit, the equilibrium gold price
would have to be several hundred dollars higher than where it stands.
However, fabrication demand by itself does not hold the key to higher
gold prices. Instead, it will be pushed aside by panic short covering and
renewed investment demand.
There are two reasons to expect the next rally in gold to be more
explosive than the 30% run up in September 1999. First the short
position still remains very large ( for more information, see The Golden
Pyramid ) . It stands at 5,000 to 10,000 tonnes, or two to four years? mine
production. Lending appears to have expanded during the fourth quarter,
despite the Washington Agreement, as Kuwait, the Vatican, and other
stragglers were recruited to put out the October short squeeze fire. Since
mine production is more than absorbed by fabrication, short positions can
only be covered by new borrowings, or by central bank sales subject to
the 400 ton per year limit under the Washington Agreement.
Bullion dealers appear to shoulder the bulk of the risk that central banks
might grow reluctant to provide liquidity. In our conversations with
mining executives, it appears that bullion dealers were so eager to sell
hedging instruments that they provided very lax margin provisions. This
situation has not changed since the Washington Agreement rally. In a
startling disclosure, Ashanti recently announced that its hedge book had
changed for the worse since their difficulties began. Although the
quantity has declined slightly to 9 mm ounces, the breakeven point has
declined to $262 from around $285. The notional loss today is $270mm,
whereas four months ago, it would have been zero. The company?s
balance sheet has shown no improvement. Ashanti?s bullion bankers
appear to be at equal or greater risk than when this fiasco first came to
light. Ashanti is just one of a number of specific situations that could
motivate bullion dealers to manipulate the gold price at the high end of its
trading range or at specific chart points closely watched by traders. It is
safe to say that Ashanti, one of the most active hedgers, will be a
non-entity this arena for some time to come.
Beyond Ashanti, the bullion dealer/mining industry aggregate hedge
position remains as vulnerable as ever to a gold rally. Complacency has
settled in following the twelve-week retracement in the gold price from its
October 1999 peak. Few participants in the outstanding short position
contemplate another sharp rally in gold. Many of the shorts do not
appear to understand the degree to which they, or the institutions they
represent, are at peril. The fallacious argument that gold in the form of
mining reserves to be delivered, in some cases, at distant future dates, is an
effective long to offset the dealer short, is still a foundation of this
complacency. What this view fails to take into account is the financial
stress that would result from a substantial rise in the gold price, which
does not retrace, for deliveries scheduled several years in the future.
Keep in mind that bullion banks operate on a high degree of leverage.
There is an ongoing mismatch between paper and physical gold. A given
flow of physical gold can be multiplied by a factor of 5x or greater in the
paper market. Any reduction of physical provided by the industry at a
future date implies increased leverage and an expanded aggregate short
position among the bullion dealers. Compared to the diamond industry,
which enjoys gross margins of 50% or more, the gold industry has done
a poor job of marketing. By turning over much of the distribution
function to bullion dealers, the industry has amplified its own supply by
whatever leverage factor bullion dealers wish to apply. Over the longer
term, the gold industry would be well advised to explore ways in which it
could avoid giving over control of physical flows to these intermediaries.
The second reason to expect a sharp, sudden rise is that markets do not
adjust slowly to changes in psychology. Complacency built upon the
assumption of tame inflation, the new paradigms of e-commerce, and
masterful Fed leadership is overripe. We live in an age of unprecedented
financial euphoria. The dollar is considered to be unassailable.
Valuations that have never been seen are considered reasonable. Recently,
Paul MacRae Montgomery, a noted student of the financial markets,
observed that the ratio of triple-A bond yields to the S&P yield is 7.5
times. The only other examples in history where this relationship even
approximated this number was the Weimar Republic in Germany,
probably not a useful parallel, and Japan in 1989, most likely a valid
parallel. Montgomery also prepared a chart, carried by Barron?s,
showing the ratio of mergers to GNP, reproduced below. It speaks for
itself:
Strange as it may seem, gold has a corner on euphoria. Overvalued
stocks, short positions in gold, and foreign holders US dollar instruments
occupy the same space. They are hostage to the stale incantations of the
bull market. The financial markets at large are conceptually short gold.
The climate of opinion in the investment market is that inflation will never,
ever reappear. This credo, repeated ad nauseam by investment gurus in all
the media, is the foundation of financial euphoria. What if we couldn?t
resort to this mantra? The year 2000 will provide the answer.
Perhaps the most unsuspecting of the potential victims are foreign holders
of US debt. A major reason for low inflation is the willingness of our
trading partners to accept our paper for their goods. The rosy inflation
picture would quickly sour if their high opinion of dollar-denominated
debt faltered. The US has been importing the rest of the world?s
over-capacity. For years, the US economy?s strength was matched by
weakness among our trading partners. Economic recoveries are now
underway in the rest of the world. Over-capacity is being absorbed, and
the flood of dollars necessary to finance our record trade gap may
become less welcome. A change in sentiment would lead to sharply
higher US interest rates.
The gold market has reached a point where conventional supply and
demand models offer little guidance. Macro economic forces, which have
been gestating for what seems like forever, will become impossible to
ignore. The positive fundamentals, which formed the underpinnings of
the twenty-year bull market in financial assets, have withered. Only the
fa‡ade remains. Once market participants wake up to the change, gold
will benefit to an extent that is inconceivable to those who are short.
Paper wealth has become a state of mind, even a fantasy, regardless of
whether it is represented by shares of overvalued high tech companies or
foreign holdings of overvalued US dollars. Vying for the title of the
greatest fools are the central bankers who have systematically divested
their gold through outright sales and lending in order to increase their
holdings of higher yielding dollars and other paper currencies. Nouveau
central bankers parrot the values and beliefs of the paper asset bull
market. They disdain gold and couldn?t be more negative. Their
supposed prescience is one of the unfathomable myths of our time. Look
for them to change their minds and turn into panic buyers of gold when
paper currencies lose value.
Vast quantities of present-day paper wealth, held in the form of inflated
stock market equities, will never be converted into lasting wealth. For
most, this imaginary wealth will die along with the prevailing market
mania. Only a few high tech millionaires will transform their dot.com and
similar paper into lasting wealth. As in all major market turns, surprise
will be a major factor. No advance warning signals for a privileged or
clever few will be flashed. Manias exist because a popular point of view
becomes over-exploited. A willingness to act in advance, when the
negative catalysts are still unclear, and risk leaving money on the table, is
the only certain escape. Our suggestion: sell a little while it is still
possible to sell. Risk derision and buy gold or gold shares, the pariah of
all asset classes. When investment confidence falters, gold will be the
leveraged play. A small commitment will preserve and protect some of
the paper wealth that would otherwise disappear.
Most holders of equity shares are unable to move their wealth efficiently
between alternative asset classes. Gold is the important exception. It is
liquid, and currently happens to be depressed which to our mind is one of
the benchmarks of value. Gold, almost alone at this point in time, stands
out as a more than reasonably priced insurance policy against an
undiversified portfolio of high tech and dot.com equities. A small
investment will translate into enhanced buying power following a serious
upset in the financial markets. To feel rich on paper these days is
commonplace. To convert these paper riches into lasting wealth will be
the exception.
John Hathaway
January 2000
¸ Tocqueville Asset Management L.P. |
