Tocqueville Asset Management
Trivial Pursuit?
John Hathaway

Investor lust for hard assets has dimmed gold’s status as the world’s premier non government-issued form of money. Conventional wisdom now holds that gold, oil, and base metals are inextricably linked. For example, on October 18, the Bloomberg headline said “Gold Drops for Second Straight Day After Crude-Oil Prices Slide.” Investment strategists have recast gold into a sub species of hard assets that is to be bought or sold only according to its weighting in a commodity index such as the CRB, GSCI, or DJ-AIG. It is a fate for the yellow metal that would make any latter day central banker smile.

Gold’s recent sharp correction as well as its earlier sharp run up in the first half of this year is a case of mistaken identity. Perhaps hundreds of billions of new institutional money has flowed into the commodity sector. Proponents have billed it as an “alternative asset class,” and imply the returns would somehow be uncorrelated with financial assets. In most cases the mandates have provided for passive adherence to an agreed upon commodity index. This money flow was anticipated and front run by hedge funds and other aggressive managers.

Approximately two months ago, Wall Street fashionistas decreed that “hard assets” were out and “paper assets” were in. In the space of a few weeks, prophesies of insatiable China-driven demand for “stuff” were replaced by scenarios of a goldilocks soft landing, tame inflation, interest rate hikes on hold, and new highs for equities and bonds. The shift caused leveraged bets on commodities to unwind in a short space of time. Gold was caught in the cross fire, and suffered a steep 20% correction from its peak above $720/ounce in early May.

In a world where gold is perceived as a minor hard asset, it is easy to conclude that this relic has been once and for all time written out the script of monetary affairs. At a Sanford Bernstein conference May 31, 2006, even one time gold champion Alan Greenspan recently said in response to a question about the recent strength in the gold price: “There is only a relatively small group of investors who very seriously believe that there is a high level of risk that the (financial) system could break down. You only need a relatively small group to believe this to move the price of gold.” In other words, the metal’s price behavior reflects the trivial obsessions of a discredited fraction of investment opinion. Or, if one prefers another fair weather explanation for the strength in the metal’s price, suitable for CNBC viewers, prosperous Asians just love the stuff. The bull market in gold has become an obscure footnote to the China story.

Though recently retired, Mr. Greenspan’s insight on the bull market in gold was very likely formulated while he was Fed Chairman and likely constitutes the official party line of most central bankers on the subject. The fusion of the CNBC mind set with Fed speak on the subject of gold’s relevance is nothing less than a triumph of brainwashing and delusion. As Werner Erhardt, founder of the EST movement once stated: “In life, understanding is the booby prize.” On the matter of understanding, we prefer Emerson’s view: “The years teach much which the days never knew.”

Until gold broke above the 350 Euros/oz barrier that had contained it for four years, conventional wisdom held that the currency was a superior way to hedge dollar weakness because it had both yield and liquidity in its favor. In our March, 2005 website article, “Euro Trash,” we noted that the relaxation of the stability pact which was supposed to underpin the integrity of the currency was good news for gold. Within two months, gold broke above the supposedly impenetrable threshold, and signaled a new advance of nearly a year in which gold attained new highs against all currencies. Gold’s current identity crisis will be resolved when it breaks to new highs against a basket of commodities.

There is plenty of evidence to suggest that much of the hot money pouring into oil spilled over into gold. For example, the September 30, 2006 8-Ks filed by the hedge fund Amaranth show large positions in nearly two dozen gold and base metals stocks. It is likely that most of the Amaranth wannabes had similar exposure. Even if a relationship lacks any sound logic, since when did flawed thinking stand in the way of investment decision making? Can’t get out of illiquid positions in energy? Sell whatever you can to meet margin calls, including gold shares. While there may be something to the short term connection between the precious metals and energy, review of the chart below will show that oil and gold can and have traded in widely divergent ratios since the gold price began to float in 1971.

Source: Zeal LLC

Gold’s price behavior relative to other commodities is inherently unpredictable precisely because of its monetary nature. The linkage attributed in the current mythology has no historical basis. If the relationship between gold and oil was as deterministic as current commentary implies, gold should revert to the historical ratio of 7.2 ounces per 100 barrels of oil, or $830/ ounce. While the price action of the two commodities can influence each other from time to time, to suggest there is a strict causal relationship is nonsense.

Over the past ten years, gold has been the tortoise in the race against economically sensitive commodities:

Source: Baseline

A long term chart of gold vs. other commodities also shows a great deal of variance:

Source: Lonmin Plc

The hard asset theme rests explicitly on the notion that the rapidly growing Asian economies will consume ever greater quantities of stuff. There is also an implicit monetary rationale: hard assets offer an escape from depreciating currencies. However, this rationale has rarely been voiced during the rush into tangibles. Finally, investors in commodity baskets or indices expect uncorrelated returns.

Hard asset craze or not, an appraisal of the usual gold supply and demand plusses and minuses is decidedly robust. In fact, these factors seem more favorable than seven years ago when gold was less than half its current price. World gold production has declined since 2000 despite a more than 100% increase in the gold price.

Source: World Gold Council

Explanations include heightened political risk in host countries, substantial increases in the time between discovery and permitting, and substantial rises in operating and capital costs. Large mining companies are challenged to maintain current production, much less to achieve gains. What used to be permitted in six months now often takes six years, according to Pierre Lassonde, President of Newmont Mining. Energy is a key cost component, especially in open pit operations, and so margins have been squeezed. Despite the 140% gain in the gold price since 1999, the industry’s return on capital has improved by only 75% to 14% from 8%. Capital costs required for a new mine have more than kept pace with the higher gold price. For example, the estimated capital costs of Gold Field’s planned major new mine in Peru, Cerro Corona, have increased 18% over the past year, not atypical for the industry. Therefore, a potential glut of gold exists only in the minds of short sellers.

Source: BMO Capital Markets Research

Central bank selling has begun to abate. In the most recent twelve months, the European central banks sold only 393 tonnes against a ceiling of 500 tonnes, the first shortfall since 1999. More important, high profile sales have been offset by unpublicized central bank buying. The dollar’s role as an international reserve asset is being subjected to a level of criticism unthinkable a few years ago. Just days after newly minted Treasury Secretary Henry Paulson had returned from his trip to China, The Financial Times reported (Sept 25, 2006) that Wen Jiabao, the Chinese Prime Minister, and Zeng Qinghong, Vice President, confirmed that “the government is considering whether to buy gold, considered a hedge against the potential of a falling US dollar.” Russia, with the world’s third largest cache of currency reserves must also be considered a potential buyer. Alexei Kudrin, Finance Minister stated on 4/22/06: “We do not understand why the U.S. dollar at the moment is the universal or absolute reserve currency. The international community can hardly be satisfied with this instability.”

More powerful than all of the foregoing considerations together is the November 2004 launch and subsequent success of the gold Exchange Traded Fund (ETF) traded on the New York Stock Exchange under the ticker GLD. The World Gold Council notes in its third quarter Gold Investment Digest that there are seven new gold exchange traded funds listed on ten stock exchanges around the world, holding in excess of 500 tonnes, now ten with the secondary listing of GLD on the Singapore Exchange. This gold rests securely in the vaults of HSBC beneath the streets of London. It is gold that has been taken off the market. Demand for ETF gold has averaged 250 tonnes per year or 10% of annual global mine production. The fact that the gold underlying the ETF held steady during the recent 20% correction in the gold price suggests that the investor base is solid. (See chart).

Source: World Gold Council,,, Bloomberg

The gold ETF is a trust instrument in which shares are created or redeemed on a daily basis. A network of dealers, known as “authorized participants,” have the right to buy or sell gold in exchange for GLD shares from the trust. If the price of GLD (the ETF) is above the price of physical gold, the dealers will short GLD, buy gold, and deliver it to the trust in exchange for shares to cover the trade. If the price is below, they will short physical and deliver shares of GLD to cover. GLD shares are created only if the dealers deliver gold to the trust in exchange for the shares. Shares are redeemed (and the underlying gold of the GLD trust shrinks) when the dealers have shorted physical and cover by delivering shares back to the trust. Under normal circumstances, there is substantial liquidity in the shares and the process of share creation or redemption doesn’t come into play. However, the day to day profits from trading the shares are identical to the same skimpy margins as on any other exchange traded security. The financial incentives for the dealers lie in the arbitrage profits to be gained from share creation or redemption.

While conventional supply and demand factors strongly influence market perceptions, gold is above all a capital market asset. As the chart below depicts, annual supply and demand factors are dwarfed by the amount of above ground gold. For example, a 10% increase in new mine supply, or 250 tonnes, would represent an increase of .00016% to the global stock of +/- 150,000 tonnes.

Source: GFMS Ltd.

For centuries, gold has been all but inaccessible to the investment public. Available alternatives included commodity accounts, coins, bars, and arrangements with bullion banks, none of them mainstream options. To the financial media, COMEX futures represent the principal expression of capital market interest or disinterest in gold. What ignorance! Notoriously volatile, futures markets simply do not have the capacity to transform capital inflows or outflows into a potential $100 billion market capitalization asset. While trading volume on futures contracts is much greater than the ETF, futures contracts are paper bets with underlying gold coverage of only 25%. The current COMEX figures (October 30) indicate warehouse stocks of 7.6 mm oz. against open interest 32 mm oz. In contrast, the gold ETF is 100% backed by gold bullion. While price action in futures contracts makes all the media noise, a clearer picture of investment interest in gold emerges in the details behind the ETF.

The ETF has become the bridge between the capital markets, central banks, and the souks. It has emerged as an omnibus financial vehicle for obtaining protection, reflecting uncertainty, and hedging bets. In our opinion, the market cap of GLD will one day approximate that of the global gold mining share sector or $100 billion. Our reasoning is that GLD taps a different investor base than those attracted to mining shares or commodity futures trading accounts. The core group of GLD investors appears risk averse and focused on the underlying metal’s insurance value, not the pyrotechnics of day to day price action. The demand for gold based on risk protection seems potentially far larger and deeper than speculative demand as expressed by gold mining shares or commodity futures.

During shakeouts in the gold market, the gold ETF has demonstrated stability that is not apparent in other gold investment vehicles. Much, and probably most, of ETF gold is in very strong hands such as pension funds, endowments and individuals who are thinking in generational terms. Despite the 20% decline in the gold price since its 2006 high in early May, holdings of the gold ETF have increased from 11.5 mm ounces to 12.4 mm oz. at the end of September. In contrast, the net long position represented by futures contracts declined 36% in the third quarter.

The World Gold Council recently published an academic study titled: “Gold as a Strategic Asset.” ( The study was authored by New Frontier Advisors, LLC, an institutional research firm “specializing in the development and application of state of the art investment technology.” The study concludes that “gold is not a substitute for other assets but adds diversifying power across much of the risk spectrum.” While commodity indices also can provide diversification, the report notes, there is no reason to believe “that they have superior return.” We would add that investment in commodity indices are essentially a paper, institutional arrangement, and cannot offer physical commodity backup comparable to the gold ETF. The study goes on to say that gold provides strategic diversification benefits in allocations of 1%-4% in long term institutional portfolios. It is worth noting that a mere 1% allocation to physical gold by a significant percentage of long term institutional portfolios through the ETF could only be accomplished through a gold price that is well into four digit territory. The chart below shows that an allocation of this modest magnitude would require over 38,000 tonnes of gold, or roughly 25% of all the gold that has ever been mined. Note that gold has been correctly positioned by the World Gold Council study as a sober, rational, and conservative instrument to protect capital. It would undoubtedly disappoint Mr. Greenspan to learn that there is no mention of financial Armageddon in the study.

Note: Assumes 1) No price impact and 2) Based on the 12 month average gold price to September 22, 2006 of $569.29/oz.
Source: World Gold Council.

The future direction of the gold price depends less on whether mine production takes an unexpected upturn or nose dive, than on whether capital markets decide to demand greater risk protection. The most important thing an investor needs to know about whether to commit to gold is the answer to this question. Considering a stock market flirting with record highs and a VIX index hovering near record lows, there seems to be ample room for a mood change. Buyer’s remorse may lurk just around the corner. Advance knowledge of the precise trigger is impossible to divine, but a casual reading of the pages of the New York Times might prompt a few suggestions. For those with more time, we recommend the Bank for International Settlements web site which contains extensive commentary on the matter of risk and financial markets: “The search for yield can lead to serious distortions, and the potential for future instability, as investors both purchase inherently riskier assets and use increased leverage to do so.” We could not have said it better ourselves.

What we can and do know is that, should fear revisit the financial markets, buying power for gold is without precedent. While the gold mining industry struggles to produce 2500 tonnes per year, an amount that would increase the above ground stock of gold by a paltry 1.7%, the financial system continually spews out a blizzard of new financial assets, all of which represent potential claims for liquidity and safety.

In the bleak days of 1935, the market cap of above ground gold equaled 15% of US financial assets. In 1980, when bonds were dubbed “certificates of confiscation” and good quality equities traded at 6x earnings and 6% dividend yields, that same percentage was 29%. In today’s carefree world, that percentage is only 3%. The price of gold can double or triple in the absence of catastrophic outcomes simply as more investors attempt to position the ETF.

The chart below shows the above ground stock of gold marked to market in 1935, 1980 and year end 2005 as a percentage of US financial assets. However, in today’s world of globalized financial markets, is it enough to use only US financial assets as the denominator for this exercise? According to the BIS, global debt outstanding is $62 trillion as of June 30, 2006. To this one must add some figure for global equity. It does not seem to be a stretch to come up with an estimate approaching $100 trillion.

The foregoing analysis makes the assumption that all above ground gold is available to capital flows. In reality more than half has been consumed for high end jewelry, art, or simply lost. Gold prices at less than $600 are a gift to any investor who can discern the difference between the precious metal and all other commodities. Nobody buys a gold Rolex to stave off doomsday. Therefore, the market cap of above ground gold is not $3 trillion, but most likely half of that. Gold is precious because it is scarce, compact and impossible to dilute through the mischief of government. Its monetary qualities are conferred not by government decree but by the acclamation of history. Governments can write gold out of the script as legal tender but they are powerless to remove the metal’s monetary qualities. The defining difference between gold and oil lies in gold’s dual role as an alternative to paper money and as a luxury object of conspicuous consumption.

The idea that all “hard” assets provide a safe haven from depreciating currencies is a dangerous one. It might seem valid for a while based upon the power of common belief to generate capital flows, but it will inevitably fall apart during periods of severe economic distortion caused by monetary imbalances. Efforts to trivialize gold’s monetary significance are a key to the present day money illusion, that more paper equals more prosperity. It is far more palatable to the political and economic establishment to explain away the strength in the price of gold as a consequence of growing Asian prosperity or the reflection of an extreme fringe of investment thought (as suggested by Greenspan) than to read it as a reflection of flawed economic policies, archaic conventions, and corrupt institutions. A rise in the price of gold is equivalent to a fall in the value of financial assets. The strength in the metal is a sign of distrust in the ability of present day financial instruments, including paper currencies, to preserve capital over time. The global bid for physical gold is potentially immense. It will be generated not by ephemeral and flaky speculative interests seeking instant gratification, but rather by the considered actions of capital interests with a long term perspective driven primarily by the desire to convey present day wealth to future generations.

John Hathaway
© Tocqueville Asset Management L.P.
October 31, 2006

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.