John Hathaway, manager of the Tocqueville Gold Fund (TGLDX), looks at what is required to restore investor interest in gold, concluding that “a prolonged bout of financial-market adversity would suffice.”

Hathaway believes that “the roof above the dollar gold price has been built brick by brick from confidence in central bankers,” and “nothing would serve better to undermine confidence in central bankers than a bear market in bonds and equities.”

Hathaway concludes his letter:

“History instructs us that it is common for politicians of all stripes to rely on overvalued currency to achieve policy goals. We believe gold-price suppression to be a natural adjunct of this predisposition. Paul Singer believes that shorting low-yielding sovereign debt represents an excellent opportunity to profit from the fallacies of “money that is backed by nothing but promises.” We agree. However, in our opinion, the even greater opportunity, and certainly the more accessible one for most investors, is a long position in gold and gold-mining shares. At the very least, it offers protection against potential bear market downside for equities and bonds. At best, and despite the requirement for substantial patience and fortitude to question the wisdom of the investment consensus, it may prove to be an opportunity of generational proportion.”

Tocqueville Gold Strategy Investor Letter: Second Quarter 2015 – Part II

What is required to restore investor interest in gold? In our opinion, a prolonged bout of financial-market adversity would suffice. After all, the cornerstone of coordinated central-bank policy since 2008 has been the levitation of financial assets via Zero Interest-Rate Policy (ZIRP) and Quantitative Easing (QE) by forcing investors into risky assets. We believe that nothing would serve better to undermine confidence in central bankers than a bear market in bonds and equities. The roof above the dollar gold price has been built brick by brick from confidence in central bankers.

In our Q12015 Gold Strategy letter, we stated:

We believe that confidence in central banking is the principal explanation for the current lofty valuations of financial assets and the corresponding low esteem for gold. That confidence, in our opinion, will dissipate if the investment gains of the past five years begin to turn into losses.

We believe that such a reversal is long overdue, and that the vast majority of investors are ill prepared for this eventuality. The demise of the most notable recent bubbles in dotcoms and mortgage-backed securities also seemed to take forever to coalesce. The current bubble in government bonds, supported in our opinion by confidence in central banking, seems to be taking its time to deflate as well. Inflection points in markets take longer to occur than most can imagine, especially when authorities spare no effort to defer the inevitable. Paul Singer of Elliott Management states in his most recent investor letter:

Sometimes inflection points take a while to actualize, even when they are long overdue…. All it would take at the present time for a collapse in developed-country bond markets to begin is a loss of confidence in paper money, central bankers, or political leadership…. The ingredients for a renewed financial crisis are in place, as a possible ‘surprising’ transformation of money debasement into highly visible inflation.

In our opinion, we stand at the threshold of such a shift. Will the shift take weeks, months, or years? There is unfortunately no way to be certain on timing a shift of such potentially epoch magnitude, but several important clues suggest that the timing is sooner rather than later.

The Greek financial crisis: a precursor to the deflation of the bubble in sovereign debt

While Greece is small in relation to the European and global economies, it is emblematic of the disease: excessive money-printing to fund promises to voters that are not financially viable. In our view, the Greek (and the Puerto Rican) drama is reminiscent of the blowup of the two Bear Stearns mortgage-backed securities hedge funds in 2007. Shrugged off by the financial markets at the time, that fiasco was the first sign of trouble to come in the housing/MBS sector that led to the global financial meltdown of 2008. As with the Bear Stearns hedge funds, the Greek episode may well foreshadow a deflation of the bubble in sovereign debt.

It is counterintuitive that gold has weakened in conjunction with the events in Greece. For example, Bitcoin prices have reacted much differently than gold to these circumstances:

Tocqueville Gold Strategy

Source: Bloomberg

The potential withdrawal of Greece from the euro at the very least emboldens left wing/nationalist factions in Spain, Italy, and France, who see the results of the Greek referendum as legitimizing rebellion against the diet of austerity imposed by Brussels. Are the events in Greece a prelude to greater instability in the entire Eurozone? The small size of the Greek economy and banking system makes it easy for market bulls to pass it off as a sideshow. Greece has not by itself engendered the sort of fear that would generate massive capital flows into gold. Impatient gold investors may have overemphasized the short-term potential of this skirmish to ignite a rally. However, voter repudiation of fiscal austerity imposed by remote bureaucratic elites seemed to play well in Athens, and there is reason to think that it may catch on in other parts of the globe.

Warnings from former central bankers and the BIS

– According to the most recent annual report of the Bank for International Settlements (BIS):

…central banks have backed themselves into a corner after repeatedly cutting interest rates to shore up their economies. These low interest rates have in turn fueled economic booms, encouraging excessive risk taking. Booms have then turned to busts, which policy makers have responded to with even lower rates…. In some jurisdictions, monetary policy is already testing its outer limits, to the point of stretching the boundaries of the unthinkable.

– Claudio Borio, head of BIS economic research, recently observed, “It’s hard to believe that interest rates that are so extraordinarily low are consistent with a fully rational allocation of resources.”

– At the 2015 Peterson Institute Fiscal Summit, Alan Greenspan stated, “We’re not getting like Greece, we’re getting like Illinois.”

– Former Fed Governor Larry Lindsay: “Unfunded Social Security and Medicare/Medicaid liabilities when added together to US Federal debt take US obligations closer to 300 percent (of GDP) v. 100 percent, which is more than Greece’s debt.”

– And according to former Fed Governor Richard Fisher:

Imagine the political turmoil if you have to cut payments to those you promised and say we still have to pay interest. Both the US political right and left will ask – well, who owns our debt? It’s China, Japan, etc. This is a political train wreck that is about to happen.

Overvalued financial assets

In our 1Q2015 letter, we noted that equity-market valuations were at dangerous levels by three different measures: the CAPE ratio, the Q-ratio, and the Buffett indicator, which are discussed at length in our last letter. Through June 30, the S&P Index struggled and was basically flat, while the NASDAQ rose slightly. The Dow Jones Transportation and Utilities averages are down for the year. Beneath the surface, there has already been significant deterioration. According to Stan Weinstein, the popular averages are misleading

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