Another Volcker Moment at Hand? An Appraisal of $1500 Gold – Tocqueville
May 2, 2011
Tocqueville Asset Management L.P.
In any given market, it is essential to ask “what is reflected in the price?” This admonition is as true for gold as it would be for any particular stock, interest rate, credit default swap, junk bond, or farm acreage. Market prices are the sum total of known facts, opinions, sentiment, and expectations. The point of investing on the basis of contrary opinion is to take advantage of unexpected change.
With respect to gold, the question of unexpected change is far more complex and controversial than it was over ten years ago, when the metal was the object of universal derision. The only observation necessary then was that this high quality asset had fallen into intense disfavor, a classic low risk entry point. There was no need to forecast the successive busts in the dot com, housing, and credit sectors. The revealed truth in 1999 was that the metal had been in a twenty year bear market and that returns in financial assets had been compelling over the same period. How could the gold price ever rise when central banks were divesting their bullion as fast as possible, and the major mining companies were piling on by hedging production as far as ten years into the future?
The ridicule once reserved for gold at the bottom of its twenty year march downward has recently moved on to paper currencies of all stripes. At $1500 gold, one must ask how many investors harbor expectations that redemption lies ahead for the likes of the euro, yen and dollar. Do the downgrade of U.S. debt by S&P and short sales of U.S. treasuries by PIMCO sound like the pealing of bells for dollar bears? When it comes to bull and bear market cycles, the characteristics of incipient and terminal stages are identifiable to contrarian scrutiny based on sentiment, sponsorship, participation and valuation. The middle innings, however, tend to be muddled affairs. Sentiment vacillates but never seems decisive. Sponsorship is broader but not unanimous. Ownership, the acid test in our opinion, is more widespread but not universal. That seems to be the case for gold right now.
The best assets in bull markets always seem too expensive. One can never say in advance how overpriced or underpriced an asset can become at its peak or nadir. With respect to gold, normal valuation exercises offer no help since the metal lacks intrinsic worth. For gold, price is simply the exchange rate expressed in a specific currency, which says more about the valuation of the currency in which it is quoted than it does about the metal itself. Gold does not become more expensive. Instead, the paper needed to buy it has been cheapened.
The middle innings of a bull market can be prone to scary shakeouts. Investor enthusiasm must be punctured from time to time to extend the cycle. Despite several shakeouts since 1999, gold has appreciated more than six fold over the past twelve years, and has managed to advance in each and every year in dollar terms. Gold’s progress reflects cumulative damage to the dollar and other paper currencies since the turn of the century inflicted by central bankers and the fiscal policies they have felt compelled to finance.
It is readily apparent that investor disenchantment with paper money also extends broadly to financial assets. The chart of the DJII in terms of gold (below) measures the devaluation of paper money not captured by conventional measures of inflation. Nominal investment returns, disappointing as they have been over the past ten years, do not begin to tell the story. The causes for the general deflation of paper assets are widely known: money printing by central banks, possible sovereign debt defaults, and vexing fiscal issues in Western democracies. In that sense, much news that was unimagined twelve years ago seems widely disseminated and priced into $1500 gold, good or bad, depending on one’s viewpoint.
A superficial glance suggests that the contrarian argument for gold has been played out. Front page proclamations of the dangers of paper currency and the incompetence of politicians are the norm. Ten years ago, Federal Reserve Chairman Greenspan was anointed “maestro” of the financial universe. Today, monetary cognoscenti snicker at the mention of his successor. Still, there are two reasons to think that $1500 gold represents a mid-point and not a final destination for the gold price in this bull market. First is the tendency of fiat currency hostage to the democratic process to self-destruct. Second, and equally important, economic vitality is incompatible with a flawed and chronically failing medium of exchange. The prognosis for the dollar is terminal, in our opinion, short of political sea change. In that sense, our view, right or wrong, is at odds with the consensus view. Hope that the political battles over the debt ceiling and the future of government spending will result in fiscal sanity and that, pending such an outcome, normal economic progress will resume, to us seems misplaced.
Welfare state democracy is incompatible with sound money, in our opinion. As just one example, we refer to a recent research study flagged by Pimco: “The Liquidation of Government Debt”, by Carmen Reinhart and M. Belen Sbrancia. It concludes that “the annual liquidation of debt via negative real interest rates amounted on average to 3% or 4% of GDP per year …which quickly accumulated (without compounding) to 30% to 40% of GDP debt reduction in the course of a decade.” In other words, an essential mechanism for servicing sovereign debt has been the devaluation of investor claims by capping interest rates. That amounts to outright theft of wealth by government from its citizens and more recently non-U.S. investors. Negative real interest rates, less obvious than CPI inflation, are the stealthy pillar of welfare state finance. Gold prices correlate inversely with real interest rates, as we have been suggesting for the past decade. This relationship is one of the most reliable indicators of the macro climate for gold. Negative real rates ought to be a flashing green light for capital to seek out gold.
Proposals for a return to the gold standard are gaining support. Steven Forbes predicts that this will happen by mid-decade. Other noteworthy and influential proponents include James Grant and Lewis Lehrman. In our opinion gold based currency would be a vast improvement over a dollar anchored only to a political agenda. Resumption of the gold standard would require a significant re-pricing of the metal upwards. However, the small but elite constituency for a gold backed dollar is embryonic, and, so far, politically marginal. That seems likely to change with the next financial crisis. Only then would the merits of a sound currency become apparent to the most ignorant of politicians.
What of the current struggle between Republicans and Democrats to craft a credible fiscal policy? A plan demonstrating political resolve to shrivel federal deficits, even over a multi-year span, is most likely not reflected in $1500 gold. The existential question for gold versus paper currency is whether or not the political will can be summoned to take the necessary actions.
The budgetary nuts and bolts of tax policy, entitlements, and discretionary items in our opinion are secondary to the ideological question of the proper and desired scope of government in contemporary democratic society. 175 years ago, Alexis de Tocqueville warned that democracy would eventually demise into a “soft tyranny” in which the primary purpose of government would be to provide for the welfare of its citizens. He observed that the power of such a government is
…absolute, minute, regular, provident, and mild. It would be like the authority of a parent, if, like that authority, its object was to prepare men for manhood; but it seeks on the contrary to keep them in perpetual childhood: it is well content that the people should rejoice, provided that they think of nothing but rejoicing. For their happiness such a government willingly labors, but it chooses to be the sole agent and the only arbiter of that happiness……It is in vain to summon a people, which has been rendered so dependent on the central power, to choose from time to time the representatives of that power; this rare and brief exercise of their free choice (voting to choose their leaders), however important it may be, will not prevent them from gradually losing the faculties of thinking, feeling, and acting for themselves …. (from Democracy in America)
According to the Tax Foundation, in 2008 the bottom 50% of Federal tax returns accounted for less than 3% of income tax receipts. Transfer payments plus income of government employees at all levels represent about 26% (37% including health benefits) of all consumer spending (BEA). In other words, the constituency for smaller government and restraints on entitlements fights an uphill and ever steepening battle. Paper money is an instrument of state policy having no life or utility external to the financial system in the way that gold does. Likewise, the dollar seems destined for the financial tar pit of the welfare state, being permeated with the DNA of democracy so presciently identified by Tocqueville.
The Reagan revolution interrupted, but did not reverse, the downward march of the dollar. Paul Volcker’s attack on inflation began when he was appointed as Federal Reserve Chairman in 1979. His policy of super high interest rates and tight credit resulted in a three year recession and double digit unemployment. This harsh medicine enjoyed the tacit support of the Reagan administration. Despite the usual backbiting by political underlings in the administration, Reagan himself did not publicly criticize the stance of the Fed. The popularity of Reagan, elected by landslide in 1980, fell to G.W. Bush-like approval ratings by the 1982 mid-term elections. Whenever asked to describe the final act of the bull market in gold, we invariably respond: “The second coming of Paul Volcker.” Fed policies in those first few years of Volcker’s leadership restored credibility to the U.S. dollar, which was universally scorned in the late 1970’s. The result for gold was a nearly two decade long bear market, lasting from 1980 to 1999. The dollar became respectable, financial assets of all descriptions commenced a historic bull market, and the economy prospered.
It is understandable that the eleven year advance in the U.S. dollar gold price has momentarily hesitated, marking time as investors attempt to discern whether coherent long term fiscal measures will be implemented. As to the timing of this interlude, we would be surprised if the upcoming debate over raising the debt limit will yield decisive answers. That debate seems more likely to be a preliminary skirmish leading into the 2012 election. The presidential campaign could well turn into a national referendum on opposing world views: those who believe that shrinking government outweighs all else, and those who believe the purpose of government is to insure social welfare. History would suggest that there is little in the way of middle ground for sound money.
Still, in theory, the institutions of the American government and its political inhabitants could surprise all skeptics and provide solutions of substance that would restore credibility to the dollar and provide footing for sustained economic growth. We strongly doubt the likelihood of such an outcome. The predicament of the 2011 dollar seems more onerous than that of 1980. The pain the electorate would have to endure from an application of “Volckerian” austerity could be measured in decades rather than years. The implication of austerity in a setting where the economic well-being of so many depends on government seems starkly deflationary. American government is dominated by a generation of politicians who have made careers of redistributing wealth and battling austerity. An outcome against long odds that turns into another “Volcker moment” would be bad for gold. On the other hand, anything less will in all likelihood send gold to dramatic new highs.
Portfolio Manager and Senior Managing Director
© Tocqueville Asset Management L.P.
May 20, 2011
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