As Good as Gold. April 24, Be fearful when others are greedy and greedy when others are fearful. Warren Buffett

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1 As Good as Gold April 24, 2013 Be fearful when others are greedy and greedy when others are fearful. Warren Buffett Whenever one of our investments experiences a significant price correction, we regard the correction as a signal to test whether our original investment thesis is still valid. In some cases, we discover that our fundamental analysis was flawed. In most cases, however, we determine that our assumptions have not changed, and we use the price decline as an opportunity to add to existing holdings. In the long term, outstanding investment results are generated by taking a contrarian approach and investing against the crowd. Mr. Buffett captured this idea perfectly with his famous quote (above) about greed and fear. As of the close of the market on April 15, 2013, gold officially entered bear market territory having declined by more than 25% from its 2011 peak. Moreover, between April 9 th and April 15 th, gold s decline was particularly severe, dropping 14% in less than a week. This decline has prompted us to revisit our investment rationale for owning this asset. Our fundamental thesis for owning gold has been the following: Gold represents insurance in the event of a currency crisis. Foreign central banks are buying gold as insurance to hedge their foreign currency reserves, which today mostly consist of U.S. Treasuries. Historically, gold tends to perform well during environments when real interest rates are negative. (The real interest rate is the nominal interest rate minus the inflation rate.) With the Federal Reserve keeping interest rates low, real interest rates are currently negative and likely will remain negative for years. Central banks are expanding their balance sheets at dramatic rates. As economies remain weak due to excessive credit market debt, central banks will likely continue their strategy to reflate economic activity with money printing. The price of gold is strongly correlated with the price of oil. Oil is a scarce resource which is becoming more difficult and more expensive to produce; as the price of oil increases, so, too, should the price of gold. Overall portfolio volatility declines with gold as a component and key portfolio diversifier.

2 Let us now examine each of these investment thesis assumptions to see whether they still hold true. Gold represents insurance in the event of a currency crisis. Foreign central banks are buying gold as insurance to hedge their foreign currency reserves, which today mostly consist of U.S. Treasuries. Despite misleading articles one might read in the mainstream financial media, gold continues to underpin the international monetary system. Central banks around the world own gold in very large quantities, and their holdings continue to increase. As of the latest report, the United States owns 8,000 tons, the International Monetary Fund (IMF) owns 2,800 tons, and the Euro area (including the European Central Bank) owns 10,800 tons of gold. According to recent data from the World Gold Council, the United States has 75% of its reserves in gold, Germany 72%, France 70% and Italy 71%. The European Central Bank holds 32% of its reserves in bullion. As for emerging market countries, their gold exposure is limited but growing fast. India has just 9.6% of its reserves in gold, Russia 9.5%, Brazil 0.9%, and China 1.6%. Central bank gold ownership continues to increase as currency risks escalate. In 2012, central banks purchased another 534 tons of gold, representing an increase of 17% over 2011, with healthy buying as recently as Q If China were to take its bullion holdings to 10% of its reserves, they would have to purchase an incremental 4,000 tons at current prices. We see no reason to expect recent purchasing trends to halt or reverse. 200 Central Bank Gold Demand (Tonnes) Tonnes of Gold Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Source: World Gold Council. Furthermore, countries are beginning to form bilateral agreements so they can trade directly with their own currencies without using the dollar as the transactional currency. China has formed currency cooperation 2

3 arrangements with South Korea, Japan, Brazil, Russia, Australia, and others, just in the past two years. These agreements reduce the demand for dollars and the need for foreign central banks to own U.S. Treasuries as foreign reserves. As a result, these arrangements diminish the dollar s role as the world s reserve currency and increase the chances we likely will see major changes to the international monetary system during the coming decade. For net exporting countries, diversifying out of dollars reduces their risk. For U.S. investors, these arrangements increase currency risk. Therefore, we conclude it is not selling on the part of central banks or any kind of diminished change in the role that gold plays in the financial system that has been the cause of the recent price decline in gold. If anything, risks are increasing, which should lead to an elevated role for gold as a currency or currency substitute. Historically, gold tends to perform well during environments when real interest rates are negative. (The real interest rate is the nominal interest rate minus the inflation rate.) With the Federal Reserve keeping interest rates low, real interest rates are currently negative and likely will remain negative for years. During the 1970s and during the period between 2000 and the present, gold performed well relative to other asset classes primarily because real interest rates were negative. That this has happened is no accident; if Treasury bills do not allow investors to maintain their purchasing power, investors are more likely to invest in gold as a store of value to protect the purchasing power of their capital. Price of Gold (left scale) vs. Real Interest Rates (right scale) since 1970 Negative Real Interest Rate Environment Negative Real Interest Rate Environment 3

4 The end of the last gold bull market occurred in 1981 when Federal Reserve Chairman Paul Volcker raised the Fed Funds rate to 20%, well above the inflation rate. His goal was to reduce inflation, even if his actions caused a severe recession (which they did). Once investors realized that Chairman Volcker wasn t kidding, his policies kicked in, inflation declined, and the gold price plunged; it took nearly a quarter of a century for the gold price to reach its previous highs. Real interest rates were negative only 6% of the time between 1980 and 2000, and gold lost its luster during that period. In checking our investment thesis, we ask, Where are we today with short term interest rates, and where will we be tomorrow? Currently, one month Treasury bills are paying 0.04%, while the Consumer Price Index (CPI) is at 1.48%, which suggests that the real interest rate is officially negative at 1.44%. The Federal Reserve recently announced that it plans to keep short term interest rates near zero until unemployment falls below 6.5% or inflation exceeds 2.5%. This suggests to us that the plan, for at least the next several years, is to keep short term interest rates well below inflation. Our conclusion is that this should be an environment conducive to a higher gold price. Furthermore, it seems highly unlikely that Chairman Bernanke or any other Fed Chairman would hike interest rates today the way that Chairman Volcker did in There is simply too much debt outstanding which requires cheap financing, from auto loans to floating rate mortgages to obligations of the U.S. government itself. A significant hike in interest rates would cause widespread bankruptcies which would have adverse consequences for the economy and for the banking system. Today s Federal Reserve has far less flexibility to raise rates as compared to the Federal Reserve of thirty years ago. Central banks are expanding their balance sheets at dramatic rates. As economies remain weak due to excessive credit market debt, central banks will likely continue their strategy to reflate economic activity with money printing. While there is a relatively fixed supply of gold, the monetary system is being deluged with an increasing supply of dollars and other fiat money. As the supply of dollars increases over the long term, it should require more dollars to purchase a monetary commodity, such as gold or silver, whose supply is more or less fixed. If we saw signs that central bank balance sheets were about to contract, or that money printing efforts were near their end, we would reconsider our ownership of gold. However, what we are seeing, if anything, is an acceleration of reflationary efforts. Just within the past six months, the Federal Reserve committed to an ongoing program of printing $85 billion per month, while the Bank of Japan more recently committed to nearly doubling its monetary base by the end of

5 We also note that the current value of gold relative to various measures of the U.S. monetary base and the world s monetary base looks inexpensive compared to history. While gold has gone up in price since 2000, so, too, has the world s monetary base. The current value of the 8,000 tons of gold stored in Fort Knox is still less than one fifth of the United States monetary base, which is a striking difference versus 1981 when the last gold bull market ended and the value of gold exceeded the United States monetary base. These measures support our view that gold remains inexpensively priced. 140% U.S. Treasury Gold Holdings as a % of U.S. Monetary Base 120% 100% 80% 60% 40% 20% 0% Source: Federal Reserve, World Gold Council. 5

6 The price of gold is strongly correlated with the price of oil. Oil is a scarce resource which is becoming more difficult and more expensive to produce; as the price of oil increases, so, too, should the price of gold. It is no accident that oil production has expanded to difficult and expensive to explore areas such as the Gulf of Mexico, Canada s tar sands, and the Bakken area of North Dakota. If oil were priced at $50 per barrel, none of these areas would see the development currently underway. However, at $80+ per barrel, production in these areas can generate attractive returns. The fact that oil continues to be priced so high is not just a sign that oil production is declining; it is also a sign that easy and inexpensive to find oil is declining. The oil being produced today has a far higher marginal cost of production. Indeed, the International Energy Agency (IEA) forecasts that conventional oil production from existing projects will decline dramatically over the next two decades. Replacing those production declines are barrels of oil that are likely to be more expensive to pursue than existing projects. The ongoing shift in oil production from conventional to unconventional sources should continue to drive oil prices higher. Price of Gold (left scale) vs. Price of Oil (right scale) The price of gold has historically demonstrated a high correlation with the price of oil for numerous reasons. First, a higher oil price drives the price level of many goods higher, and gold is purchased by many investors as a hedge against inflation. Second, higher oil prices weaken the global economy, which usually results in more expansionary monetary policies. Third, many oil exporting countries use oil revenues to invest in gold. Fourth, the energy costs related to gold mining increase when the price of oil rises. 6

7 It is our view, then, that the gold price rise, beginning in 2001, coincided with a similar increase in the price of oil. Similarly, a flat gold price over the past two years has coincided with a flat oil price. The ratio between gold and oil has averaged 15 barrels/ounce historically, although the ratio can fluctuate away from that average for short periods of time. Today, the oil/gold ratio is 14.1 barrels/ounce, which is fairly close to the historical average. No factor has arisen to alter this relationship today. Because increasing oil supply constraints should continue, oil prices will likely move up considerably during the next ten years, although not in a straight line. Similarly, gold prices will likely rise along with oil prices, although not in a straight line. Overall portfolio volatility declines with gold as a component and key portfolio diversifier. The price of gold tends to be inversely correlated to the dollar and largely uncorrelated to stocks and bonds. As such, we believe gold can provide an important role in investment portfolios by reducing overall volatility. The upside to this low correlation to stocks and bonds is that in markets such as 2008, when gold actually appreciated in price, investment portfolios with significant stock and corporate bond allocations were partially protected from the weak financial markets. The downside for using gold strategically as a diversifier in a portfolio is that gold can reduce portfolio returns when stocks are appreciating sharply, such as what occurred in the six months ended 4/15/13. 7

8 From a risk management standpoint, a diversified portfolio of bonds, stocks, gold, and cash (with the mix of each tailored to each client s financial situation) makes the most sense for investors. Risks In our opinion, the primary risk of owning gold is a significant and permanent decline in the price of oil or a significant and permanent increase in the value of the dollar, or both. These outcomes are unlikely for the reasons discussed. Nevertheless, we remain vigilant in tracking all of the fundamental factors which could cause our investment thesis to be incorrect (with gold, as with all of our investment positions). Investing Opportunity Current investor sentiment related to gold is as bearish as we have seen since first taking a position for clients in 2006, and that contrarian indicator gives us some level of comfort that we may be at or near a bottom. Longterm, we believe the price of gold will rise considerably. Having said that, we do not have a strong opinion as to when Mr. Market will agree with us. We are viewing the current gold price correction as an opportunity that Mr. Market has provided to purchasers of gold, and, in some cases, we are using this opportunity to add to existing positions. As famed investor Ben Graham once said, In the short run, the market is a voting machine but in the long run it is a weighing machine. This truism applies to gold just as it does to all investment assets. 8