David Tice feels an acute sense of déjà vu. “This is like the late 1970s,” says the founder of Dallas-based investment firm David W. Tice & Associates ($900 million in assets) and manager of Prudent Bear mutual fund, up 30 percent a year since the Nasdaq composite index cracked in 2000. “Financial assets are doing poorly, the dollar is falling, and everywhere I go people are talking about the debasement of currencies. It’s no surprise that gold is rallying.” The precious metal currently trades at about $350 per troy ounce, roughly 40 percent higher than its 2000 low of $250. Of course, that’s still a far cry from its all-time high of $850 in 1980. But Tice believes that the relatively low price only gives it more room to run. “I see no reason why we shouldn’t see gold at $800 an ounce, even $1,000 an ounce,” he says. “There are times when financial assets are held in high regard and times when they aren’t. When the switch occurs, the price movement in gold can be dramatic.”
While Tice is especially bullish on bullion, many other investors see a place for gold in their portfolios as well. The classic case for the hard asset: It’s a hedge against inflation, and its performance tends to correlate inversely with those of stocks and bonds. “Gold is a great hedge in times of uncertainty. Even gold mining shares tend to be uncorrelated in times of high volatility and market anxiety,” says Ian Henderson, who runs natural resources portfolios at J.P. Morgan Fleming Asset Management in London.
To Tice and other gold bugs, several forces are converging to create the ideal environment for a run-up in gold prices. The most notable factors include a weak dollar, which has historically coincided with rising gold prices; a U.S. Federal Reserve Board concerned about the threat of deflation; a projected $455 billion U.S. budget deficit; a shifting balance in supply and demand for the commodity, with fewer sales by central banks; and an unwinding of hedging strategies by gold mining companies, all of which are leading to increased demand for the precious metal.
“The supply-and-demand dynamic is very healthy at the moment. Gold is in a sweet spot compared to conventional financial assets,” says Evy Hambro, a director in the $2.4 billion natural resources group of Merrill Lynch Investment Managers in London.
Since institutional investors have a limited opportunity to gain exposure to gold -- capitalization of the world’s gold mining companies is a mere $60 billion -- more and more pension funds looking for a hedge against inflation are turning to commodities indexes, which offer the same negative correlation with financial assets as gold. Commodity indexes hold futures positions in the underlying commodities, which are then collateralized with Treasury bills. Collateralizing the futures with Treasuries enables a fund to earn yield from the bonds, even if the commodities index does not rise. The commodities underlying the best-known indexes -- the Dow Jones-AIG commodity index and the Goldman Sachs commodity index -- represent more than $1 trillion of annual global production.
Among the large pension funds betting that commodities will work as a hedge against an accelerating inflation rate: Canada’s second-biggest pension fund, the $72 billion Ontario Teachers’ Pension Plan Board. The board currently allocates 23 percent of its total assets to various inflation hedges, up from 6 percent in 1996. This includes positions in commodities indexes, inflation-linked bonds, the equities of commodity producers and real estate.
To satisfy growing institutional demand for commodities, Pacific Investment Management Co. in 2002 launched its Commodity Real Return Strategy fund, a portfolio that combines TIPS (Treasury inflation-protected securities), whose values rise with consumer prices, and commodities indexes. Pimco buys swaps on commodities indexes -- but instead of collateralizing the swaps with T-bills, it uses TIPS, making a bigger bet that prices will rise.
In the past ten months, the fund has pulled in $200 million in assets; Pimco runs an additional $100 million in segregated funds using the strategy. “We think this will continue to be a strong seller because the threat of inflation is real,” says fund manager Robert Greer.
Ron Mitchell, CEO of $2 billion-in-assets Liberty Ermitage Group and a strong proponent of gold investing, echoes that assessment. “For centuries gold had been regarded as a monetary asset,” Mitchell observes. “That role has been supplanted by the dollar in the past 20 years. But the dollar is now in trouble, and there is no other currency to take its place. The euro is an unknown quantity.” Mitchell’s alternative-investment firm is currently raising capital for a gold fund.
Acknowledging the impact of a weak dollar, gold bull Tice argues that the Fed could unwittingly cause a spike in inflation. “When you have Fed governors talking about turning on the printing presses and doing everything to avoid deflation, it tells me that the dollar will continue to fall and inflation is set to rise.”
MLIM’s Hambro focuses on the microeconomic fundamentals of the gold market. He believes that the balance of supply and demand supports a rising price for the precious metal.
Hambro points out that there have been no significant discoveries of gold for many years, simply incremental finds at existing goldfields. When the price was languishing at $250 an ounce, Hambro reckons, “over half of the world’s mining companies were losing money on a cash flow basis and digging up existing reserves. There was no new capital chasing exploration, and there is very little even now.” About 2,500 tonnes of gold are mined each year, and the industry estimates that gold production will fall by about 2 percent in 2003.
At the same time, demand is on the rise. Gold prices were depressed through the 1980s and 1990s by the sales of reserves by the world’s central banks; the 1999 Central Bank Agreement on Gold limits their combined sales of gold to 400 tonnes a year. Since then sales have slowed, and some central banks, including China’s, are net buyers.
Although the jewelry industry’s demand for gold has been slightly depressed amid the global economic malaise -- tonnage demand for gold jewelry was 4 percent lower in the fourth quarter of 2002 compared with a year earlier, according to the World Gold Council -- there are signs of recovery. The biggest gold consumers are in Asia, which has been buoyed by the health of the Chinese economy and the strengthening of local currencies against the dollar.
The June decision by China’s government to allow its citizens to buy gold from regulated exchanges could further kick-start sales. Says MLIM’s Hambro: “A quarter of the world’s population, people with a historical affinity with gold, are now able to buy it for the first time in a generation. It could be very significant.”
Because gold has been in a bear market for the better part of 20 years, gold mining companies have tended to sell their production forward and lock in prices. Now that gold prices are rising, many are unwinding these hedging strategies, which should further boost prices.
“Investors are demanding that producers not hedge, and companies that do not heed this message are being punished by the market,” notes Hambro. Canada’s Barrick Gold Corp., the world’s third-biggest gold producer and a major hedger, saw its shares slump 5.5 percent in 2002. During that period gold prices rose 30 percent, and the FTSE gold mines index gained 54 percent. The world’s leading producer, Newmont Mining Corp. of Denver, and the No.5, Canada’s Placer Dome, are avowed nonhedgers. Placer Dome stock fell for reasons unrelated to gold; Newmont was up 45 percent in 2002 and a further 20 percent as of mid-July.
J.P. Morgan’s Henderson has a heavy overweight position in gold mining shares, partly because he believes this hedge unwinding has only just begun.
“With interest rates so low and the gold price firm, there is little incentive to sell forward,” explains Henderson, who estimates that “industrywide there are still 21 months’ worth of production hedged forward. That is certainly grounds for optimism.”
Another sign of optimism about gold mining, at least within the industry: hyperactive M&A activity. In 2002, Placer Dome bought Australia’s Aurion Gold for $869 million; Barrick Gold bought Homestake Mining Co., in California, for $2.2 billion; and, in the biggest acquisition, Newmont paid $4.4 billion for Australia’s Normandy Mining. South Africa’s AngloGold, part of AngloAmerican, has an outstanding $1.27 billion bid for Ashanti Goldfields Co. of Ghana.
Expecting the industry to consolidate further, Tice is buying the stock of second-tier mines, which he thinks will sell to larger producers. A number of investors cite Freeport-McMoRan Copper & Gold as one likely target.
As equity markets show new signs of life, with the Standard & Poor’s 500 index up nearly 15 percent through mid-July, 30 percent above the lows of last year, might gold lose some of its luster? Certainly not, says überbear Tice. “It is not atypical to have a 50 percent rally in the midst of bear market. That is all that is happening now,” he says. “Investors should take their profits from equities and buy gold.”
