Tocqueville Investor Letter – Year End 2014
It is a little-known fact that gold outperformed all currencies in 2014, except for the US dollar. In dollar terms gold declined 1.7 percent, but as the table below shows, it posted solid gains against all other currencies. While the dollar price of gold was essentially flat in 2014, highly negative media coverage created the impression that gold was a disaster. Negative sentiment weighed heavily on the performance of gold-mining shares, with our benchmark XAU index down 17.3 percent. Meanwhile, dollar bulls appear dangerously overcommitted to the greenback, with open interest at an all-time high. The dollar’s strength relative to other currencies has camouflaged the strength of gold. Both dollar and gold strength in our opinion portend trouble ahead for financial assets (click here). It seems to us that with financial assets at all-time highs and red flags proliferating, this is an opportune moment to acquire cheap wealth insurance in the form of physical metal and precious-metal mining shares.
We share the view of many contrarians that the six-year bull market in equities has been powered in large part by the Fed’s policy of zero-interest rates and quantitative easing, which has driven investors into risky assets. As noted by Fred Hickey in his January 4, 2015, newsletter (High Tech Strategist), “The market’s price to sales ratio is at an all-time high, the market capitalization to GDP ratio (Warren Buffett s favorite indicator) is the second highest in history…. The Shiller Cyclically Adjusted P/E Ratio for the S&P is 27. That level has been exceeded only two times before – in 1929 and 2000.”
It seems to be the consensus view, and it is certainly the party line of the Fed, that the money printing of the past six years is history. As Hickey points out, if the fuel for the market advance has been spent, what is there left to support lofty equity valuations? Numerous factors point to spreading economic weakness for the global economy. These include the weakness of foreign currencies relative to the US dollar (which increases the debt load of dollar-denominated debt, fueling the growth of emerging market economies), falling commodity prices, widening credit spreads, and a broad assortment of feeble economic reports that market bulls choose to ignore. If we are correct in our view, corporate earnings are set to decline, undercutting a key pillar of the bullish case for equities.
We believe that a serious market correction, or the onset of a bear market, would exert extreme pressure on the Fed to reverse course and resume money printing. The Fed, most likely aware that their credibility is at stake, would probably resist this option at all costs. Capitulation to market weakness by the Fed at this juncture would in our opinion lead to the evaporation of confidence in all central banks, since investors would be forced to accept the proposition that money printing, once started, can never be stopped.
A return to quantitative easing would be transformational for the perception of gold. We believe the transformation would happen suddenly. As noted by investment luminary Paul Singer in a letter to his clients, confidence, especially when it is not deserved, is a thin veneer. When confidence falls apart, the consequences can be quite severe. In a recent interview, Jeffrey Gundlach, CEO of investment giant DoubleLine, commented, “It is interesting how you have been beginning to see signs of investor concern around the edges about the health of the economy and about the financial system. Historically, when junk bonds give up the ghost and treasuries remain firm, it is a signal that something is not right.” In our view, the hidden strength of gold during 2014 is another sign that investors are starting to sense that something is not right.
We believe that capital is beginning to scramble towards higher ground in anticipation of a monetary crisis. To us, this explains the relative strength of the US dollar. The same concern is reflected in the less obvious strength of gold. As of this writing, the euro price of gold has surpassed the 1,000 level. The downtrend of the past three years seems to have been broken in euro terms. Investment flows from Asia continue strong. China and India now buy as much gold as the mining industry produces. While the Chinese central bank remains secretive, not having updated gold reserves reporting since 2009, the sharp decline in purchases of US Treasuries (see below) implies a step up in gold purchases.
Central bank buying, led by Russia, is robust; central banks have added gold bullion to reserves for 14 straight quarters. Political pressure to repatriate gold bullion has also been on the rise. Countries considering or successfully repatriating gold include the Netherlands, France, Belgium, Austria, and Germany. As noted by Casey Research, repatriation has led to the biggest drawdown in gold held at the NY Fed in more than 100 years.
We believe that a breakdown of trust in financial intermediaries – including bullion banks, “synthetic” gold substitutes such as ETFs, and derivatives, as well as the integrity of central-bank custodial relationships – is behind the growing clamor to repatriate physical gold bars owned by sovereign states. Ebbing confidence is not limited to the official sector. Gunvor, the world’s fifth-largest commodity trader, decided to discontinue gold trading in part “because of difficulties in finding steady supplies of gold where the origin could be well documented” (Bloomberg, 12/12/14). Grant Williams, of Vulpes Investment Management, explains, “Because of the mass leasing and rehypothecation programs [the use by financial institutions of clients’ assets, posted as collateral] by central banks, there are multiple claims on thousands of bars of gold. The movement to repatriate gold supplies runs the risk of causing a panic by central banks.”
Loss of trust is the genesis of bank runs. Bullion banking is a fractional reserve system in which large amounts of credit are extended based on a relatively small quantity of physical metal. Sovereign gold bars are a major component of the credit base. We believe this is a story to watch very closely in the coming year.
It seems to us that that the circle of those disparaging gold has dwindled to a rear guard of hard-core, dollar-centric addicts still hooked on a monetary policy designed to herd investors into risky assets. In a truly Orwellian transposition, gold, the safest asset in history, is maligned by the financial media as risky, while financial assets at near-record valuations are viewed as compelling. In the simplistic logic that passes for financial wisdom, if equities are good, then gold must be bad. If there has been a Greenspan/Bernanke put for equities, why not a Yellen cap for gold?
Such a notion might explain the fearless manner in which gold has been periodically trashed. A skidding $US gold price confirms that all is well. “Synthetic” gold, created by bullion banks for propriety-trading desks, high-frequency traders, and commodity traders, is dumped (often following Fed policy pronouncements) onto