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October 29, 2002

Business As Usual?
by John Hathaway

An investment allocation to gold and gold shares makes sense only if one does not expect an imminent return to the investment world of the 1990's. Many who already believe that the odds of such a recurrence are slim still hold fast to the notion that a more favorable investment climate will be created by the still elusive economic recovery. "Business as usual" might not look like the 1990's, but is there any need to think that the current morass will be sustained once a business recovery takes hold? Aren't three years of declining equity markets enough? Three successive down years in the stock market was the limit even during the 1930's.

History suggests that a return to more stable and friendlier financial markets is a distant prospect at best. Having suppressed the normal functioning of capital markets over the last two decades, the Federal Reserve and economic policy makers have set the stage for a protracted period of sub-par investment returns. Investment expectations at all levels remain excessive. The consequences of a further downshift in expectations would be to reinforce negative trends already in motion in the financial markets and the economy.

Investment expectations are central drivers of economic activity and asset values. While this observation seems almost too basic to ponder, most economic forecasts and market analysis ignore the subject altogether. Investment and credit analysis are most often viewed as quantitative in nature. Emotional and psychological factors at the individual, institutional and public levels are frequently ignored. However, at certain times, these inputs far outweigh rational calculation.

Author and MIT Professor Charles Kindleberger observes in Manias, Panics and Crashes (4^th edition-p 91) that "expectations in the real world may change slowly or rapidly, and different groups may wake up to the realization----sometimes at different rates and sometimes all at once---that the future will be different from the past. The period of distress may be drawn out over weeks, months, even years, or it may be concentrated into a few days. But a change in expectations from a state of confidence to one lacking confidence in the future is central."

Three times in the last century, the DJII traded at a low single digit multiple of the price of gold (per ounce). In 1981, the prices actually intersected. In 2000, the DJII sold at an all time high multiple of 39.6 times the price of gold. The cycles between peak and trough in this relationship endure for decades and appear independent of conventional business cycles. What is at work is the accumulation or erosion of confidence. A high valuation for gold is based on nothing more than a very low expectation for investment returns.

The investment mania of the 1990's can be explained in part by Federal Reserve intervention in financial market busts starting in 1987 and continuing through the Asian meltdown, Russia, and LTCM. By underwriting downside risk in financial market debacles, the Fed played a large part in raising investment expectations to unrealistic levels. The secular bull market lasted from 1974 to 2000, time enough for an entire generation of capital misallocation.

Bear markets that might have unfolded as early as 1987 were truncated by Fed intervention. The ensuing period of prosperity and credit growth fostered unprecedented disregard for risk. "Even if some all-knowing central bank could create a state of economic perfection----human beings would respond by overpaying for stocks and bonds. In this way, they would restore imperfection.-----The function of bear markets---is to cut short the train of error." James Grant -"The Trouble With Prosperity", p. 309.

Grant's 1996 prophesy turned out to be a precise, if not exactly timely, warning of what would be the undoing of the 90's mania. Bear markets are necessary, if unpleasant. They do the dirty work of ridding the economic system of investment mistakes. They do so by liquidating bad investments at great pain to those who made or participated in them. To interrupt the liquidation process, as the government has done repeatedly, is the equivalent of sweeping dirt under the rug. The length of the period during which the cleansing process of bear markets was aborted by government intervention will dictate to a large degree the amplitude and the duration of the corrective process necessary to restore financial stability. By preventing "mini" busts from running their course, "no fault" economic policies have set the stage for more pervasive events.

An important ideological underpinning of the investment mania was the worldwide movement toward deregulated, unfettered capital markets. The scale and presence of government in the economy diminished considerably. The government was supposed to enable superior resource allocation by just "butting out". Enthusiasm for deregulation of the banking, telecom, and other important sectors was both boundless and borderless. The triumphal message of free markets spurred wholesale privatization of state-owned businesses in formerly socialist economies. This was all wonderful as long as it appeared to work. However, the outgoing tide of three years of declining equity markets and sputtering economies has exposed enough economic malpractice to feed a host of social engineers. Finger pointing, demonizing, and witch hunting have emerged as favorite political and media blood sports. In the words of Bernard Connally, AIG economist, the bear market in big government is over.

In a recent article (New Republic, Sept. 12, 2002), George Soros conveys a sense of the media and political environment that could lie ahead: "Misconceptions or flawed ideas are generally responsible, at least in part, for most boom/bust sequences. Analyzing what went wrong in the '90's, we can identify two specific elements: a decline in professional standards and a dramatic rise in conflicts of interest. And both are really symptoms of the same broader problem: the glorification of financial gain irrespective of how it is achieved.. .Correcting these deficiencies will require stronger government intervention."

A less indulgent view of the business sector by politicians and media will lead to lower equity market valuations. Even a business upturn and an earnings recovery, if and when they commence, may be unable to offset the impact of shrinking multiples. Putting this into perspective, Bill Gross (Pimco-September '02) wrote: "The two primary components of (stock market returns during the 20^th century) were 1) a beginning dividend yield of 4.2% and 2) rising valuation (P/E's going up). Real earnings growth, or its twin, real dividend growth, comes in a poor third. Over those same 100 years, dividends managed to grow at only 0.6%."

The current P/E on the S&P is 33.3x (trailing) and the dividend yield is 1.8%. Poor returns on capital invested in the stock market will eventually compel investors to require higher yields. In the 1970's, it was not uncommon for shares of quality companies to trade at multiples and yields of 6x and 6%. It is impossible to know the sequence of events that would lead the market to value equities with this degree of skepticism. The headlines and background music will most assuredly differ from the '30's and the '70's. However, the precise path, excuses, and explanations are almost irrelevant. What matters is the secular trend in confidence and investment expectations. Almost all one needs to know is that overpaying for an investment leads to adverse consequences. Repeat this pattern often enough, and the most exuberant investor or lender eventually becomes a tightwad.

The transformation from exuberance to stinginess occurs at the individual, institutional and social level. There are two useful ways to measure this transformation. First, spreads or yield differentials between credit instruments of varying quality are highly instructive. For example, the spread between Aaa and Baa corporate bonds (see below) indicates that investors are becoming more risk averse. Since the end of last year, this spread has remained stubbornly in excess of 120 basis points, the highest level in nearly a decade. However, the spread is well below the peak of 280 bps reached in the early 1980's. The second indicator is the price of gold. It is interesting that the previous 1981 peak in gold prices and the quality spread roughly coincided. The narrowest spread since 1979 coincided with a twenty-year low in the price, the second half of 1999. Since then, the spread and the gold price have been trending higher.

The shorthand history of the price of gold is the love or hatred of risk. As explained by Sam Hewitt, Ph.D., in a 1996 paper "The Behavior of Gold Under Deflation" ^© Sun Valley Gold LLC, "Because individual objectives change from capital growth to capital preservation in a deflationary spiral, currency hoarding begins. Hoarding simply reflects the manifestation of an increased desire for safety." He goes on to explain that when currency is suspect, investors move up the safety ladder to gold. For example, the black market price of gold rose 50% above the official price in the 1930's, as investors began to anticipate or fear that extreme policy measures that would eventually be undertaken by the Roosevelt administration. The chart of Homestake (see below), a leading gold producer of the time, also depicts market anticipation of a flight to gold in the midst of global deflation.

Just what will motivate investors to climb up the safety ladder to gold? Many would argue that investors have "forgotten" about gold because the modern financial system provides so many more sophisticated ways to deflect risk. The worst bear market in 25 years, corporate scandals, accounting heresy, and all too evident geopolitical risks have caused only a modest rise in the gold price. This sort of skepticism is reassuring and supports our expectation that significantly higher gold prices lie ahead. The core safety nets that have absorbed the tide of risk-averse capital instead of gold are government bonds, real estate mortgages, and credit derivatives. Only 25 years ago, bonds were dubbed "certificates of confiscation," an allusion to the theft of returns via inflation. While memories may be short, the instinct to preserve capital is eternal. Over centuries, man-made currencies erode while gold maintains value. The story will be no different for the dollar, the dollar based system of credit, and rival currencies.

Pay careful attention to yield spreads, the share prices of money center banks (particularly large derivative players such as JP Morgan Chase), the trade weighted dollar index (DXY), the share prices of housing related GSE's (FNMA and Freddie Mac), the share prices of mortgage insurers such as MGIC, and the shape of the yield curve. Mortgage refinancing, the most important prop to economic activity during the last three years, could be the next source of concern for the financial markets. The refinancing boom intermediaries include the GSE's, the mortgage insurance companies, and the money center banks that have provided interest rate swap coverage to mortgage investors. A yield curve inversion would pose great risk to these entities. "According to the Comptroller of the Currency, 96 percent of the US swaps market was accounted for by seven dealers. So a great deal of rate risk, once dispersed throughout the economy and through millions of enterprises... is dependent on the superhuman skill and foresight of seven risk management committees…The numbers involved in a US dollar interest rate swap market seize-up would be at least one order of magnitude larger than the LTCM problem." John Dizard "Swap Talk" AIG World Markets Advisory Summer '02.

The possibility that mortgage refinance activity might sputter in the absence of renewed strength in capital spending seems quite plausible. In this scenario, policy makers would be called upon to prescribe measures that might be considered drastic or even "out of the box" to those that had sought refuge in bonds, mortgages, and artifices of abstract calculus otherwise known as derivatives. The road map for gold is that its price will rise substantially when these safe havens are defrocked.

A sharp fall in the dollar exchange rate, a sudden rise in interest rates, or an inverted yield curve are interrelated possibilities which would reduce the derivative positions of money center banks to financial market ground zero. In a recent speech, Greenspan commented that the derivatives market is not "without its weaknesses". By virtue of its size, complexity and proclivity to "speculative excess", it carries "greater potential for systemic risk". He added that some of this risk "must be absorbed, as a last resort, by central banks." (Macro Mavens-"Recalibrating the Greenspan Put" 10/15/02) The socialization of counter party risk might be the last straw. As interventions and bail-outs increase in scale, they become more obvious and therefore increase the risk of spooking the markets.

Both the fundamentals and the supply and demand outlook for bonds appear dubious well before investors begin to sense that policy makers will cast aside their remaining shreds of integrity to deal with deflationary emergencies. Bond market funds have been the fastest growing mutual fund sector, rising to 50% of the total from just 33% in 2000 (Macro Mavens-"Seeking Shelter In the Lion's Den" 8/21/02). Single family mortgages have been the most rapidly growing class of debt, bid up in price by yield-starved investors. Real estate loans have risen to 48% of total bank loans outstanding, up from 37% in 1990. In addition, banks now hold mortgage backed securities equal to 10% of total assets. The CRB's assault (Commodity Research Bureau index of commodity prices) on a 5 year high seems incongruous at best in the context of miniscule yields. The rate of government borrowing stands at an all time record seasonally adjusted rate of $451 billion. The same is true for the balance of payments deficit. Record issuance of government paper caters to a market stampede, despite weak fundamentals. The scenario recalls the dot-com bubble.

These days, it is hard to identify whatever it is that represents business as usual. Norms go out the window during turbulent markets. Most would admit that the '90's mania was an aberration. However, few appear to be ready for the mania's aftermath. Business cycle upturn or not, the credit cycle is on the wane. The mechanisms, institutions, and economic policies that misallocated capital are still functional but under siege. They are under siege because markets are balky, economies flaccid, and faith shaky. The Fed can continue to intervene to affect market behavior to achieve a desired effect for a brief period, but it cannot make lenders lend, consumers spend, or businesses invest. The bubble's aftermath will progress at whatever pace and to whatever extent is necessary to liquidate the preponderance of bad investments. Based on history, the pace will be measured in years and perhaps decades.

John Hathaway
© Tocqueville Asset Management L.P.

This commentary is not an advertisement or solicitation to subscribe to The Tocqueville Gold Fund, which may only be made by prospectus.

The Gold Fund is subject to the special risks associated with investing in gold and other precious metals, including: the price of gold/precious metals may be subject to wide fluctuation; the market for gold /precious metals is relatively limited; the sources of gold/precious metals are concentrated in countries that have the potential for instability; and the market for gold/precious metals is unregulated. In addition, there are special risks associated with investing in foreign securities, including: the value of foreign currencies may decline relative to the US dollar; a foreign government may expropriate the Fund's assets; and political, social or economic instability in a foreign county in which the Fund invests may cause the value of the Fund's investments to decline.

Nothing herein constitutes investment or any other advice and should not be relied upon as such. This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication.

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