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TheTrueBeliever

GlobalInvestmentResearchStrategyandEconomics
byBartonM.Biggs,MorganStanley&Co.

Withequitymarketshavingfallensosharplyandtherallyinhighgradebonds,ourtenyear
returnstudyneedstinkeringwith.Nevertheless,nothinghashappenedthatchangesourlong
termassumptionthatweareinforanextendedperiodofmidsingledigitreturnsinbothstocks
andbonds.Largeportfoliosaregoingtohavetobeimaginativeandunorthodoxtobeat6%
nominalinmyopinion,andtherewillbebiggerallocationstohedgefunds,arbitragestrategies,
realestate,emergingmarkets,andprivateequity.Whetheralltheseassetclassesworkas
advertisedorthecapitalmarketsarbitrageouttheexcessreturnsisahorseofanothercolor.
Inthatregard,ahorseIhaveneverbelievedinisgold,foralltheconventionalreasons,butnowI
amchangingwhat'sleftofmymind.Ithinkthereisaplausiblecasethataprofessionally
managedportfolioconsistingofthemetalitselfandgoldsharescouldrealizereturnsof15%real
perannuminthedifficultenvironmentahead.Hereisthestory.
Iknowanumberofinvestorswhoaredeeply,almostfanaticallycommittedtoaninvestment
philosophy.Theyarethe"truebelievers."Thepurest,moststeadfastdiscipleofanassetclassI
knowofisanoldfriend,PeterPalmedo,whoisagolddisciple.
Bydefinition,atruebelieverhastoendurelongstretchesoutthereinthecoldandbleakwindsof
thewildernessasanexilefromtheherd,whenhisorherstyledoesn'tworkandtheworldthinks
heisbothterminallywrongandcrazy.Certainlyinthelate1990svalueinvestorshadavery
toughcoupleofyears,andifyoudidn'tbelieveintechinthesummerof1999youwerenutsand
obsolete.ButotherthanPeter,nooneIknowhassufferedadecadeofanguishandstillpersisted.
Peterisareallyinterestingguy.Now46yearsold,hehasboyishgoodlooks,isveryfit,issoft
spoken,buthasalwayshadarebelliousstreak.Ifhisprepschoolcoachtoldhimtopracticefoul
shots,Peterwouldworkonthreepointers.Toldbyauthority"it'seithermywayorthehighway,"
Peterinstinctivelyheadsforthehighway.Aftermajoringineconomicsandoptiontheory,he
joinedMorganStanley'sequityderivativesgroupin1980anddidalotofeverything.Inthe
summerof1987usingaseriesofquantitativemodelshedeveloped,hebecameconvincedthat
dynamicdisequilibriumwasimminent.Hepersuadedthefirmandcertainaccountstobuydeep
outofthemoneyS&P500puts,whichhedemonstratedwereveryunderpriced,andinaddition
boughtaloadforhimself.ThencametheCrash!
Withanestegg,PeterbegantothinkthehighstressandtravelMorganStanleyrequiredwerenot
histhing,whenhehadawifeandthreeyoungchildren.Askier,climber,andbiker,hemoved
hisfamilytoSunValley,Idaho,andbegantosearchforanassetclasstoimmersehimselfin.

Immerseistheoperativeword.Peter'sstylehasalwaysbeentofocusintenselyononething,
studyit,buildmodelsonit,anddevelopananalyticaledge.Hecameupwithgoldbecauseitwas
complex,misunderstood,underresearched,andsusceptibletohisoptionpricingtheories.In
1990hefoundedSunValleyGold.

Source:SunValleyGold,MSIMAssetAllocationResearch

Overthenextdecade,Peterbecamearguablythemostknowledgeablegoldanalystintheworld.
Hetotallyimmersedhimselfinthestudyofgold,alwaysapplyinghisoptionpricingtheories.In
timehebuiltafourmanresearchteamofgeologistsandminingengineersthatprobedminesites
andgenerateddetailedinputsforcashflowandresourcevaluemodels.Inaddition,heuses
dynamicvaluationmodelingandwarranttheorycashflowtodetermineaccurateandconsistent
corporatevaluations.
Forthemetalitselfhebuiltmodelsthatattempttopredicttheeffectofsmallchangesinthe
variablesofthesupplyanddemandcurves.Goldisanintriguingcommoditytomodelbecause
thereisahugeabovegroundstockandlimitedproductionincreases.QuantstellmethatPeter's
modelsandequationsarehighlysophisticatedandthatSunValleyGoldhasthebestmining
research.Ashestudiedtheliterature,Peterfocusedonalongscholarlypiecewrittenin1988by
LawrenceSummers(laterSecretaryoftheTreasuryandnowpresidentofHarvard)andRobert
BarskyentitledGibson'sParadoxandtheGoldStandard.Theconventionalwisdomisthatgold
isabarbaricmetal,ithasanegativeyield,anditsonlyroleisasahedgeagainstinflationandthe
apocalypse.Bycontrast,SummersandBarskyarguedthattherelativepriceofgoldisdrivenby
(andisthereciprocalof)therealrateofreturnfromcapitalmarketsandthatthisrelationshiphas
strengthenedsincethepriceofgoldwasfloated.
Goldisahighlydurableasset,andthus,asstressedbyLevhariandPindyck(1981),itisthe
demandfortheexistingstock,asopposedtothenewflow,thatmustbemodeled.Thewillingness
toholdthestockofgolddependsontherateofreturnavailableonalternativeassets.We
assumethealternativeassetsarephysicalcapitalandbonds"

PetergavemeacopyoftheSummersBarskythesis,andit'stoodenseathicketforme.Hehas
writtenasuccinctpaperthatiscomprehensible.*Inithepointsoutthatthisrelationshiptothe
capitalmarket'srealreturnandparticularlytothestockmarkethasprovedstunninglyconsistent
sincethatpaperwaswritten(Exhibit1).Since1988thepriceofgoldhashadanegative0.85
coefficientofcorrelationwiththeS&P500andanRsquaredof72%.Asthingsgotcraziersince
1994,thenegativecorrelationroseto0.94,withanRsquaredof88%.Inotherwords,thestock
marketexplains88%oftheweeklypricefluctuationsofgoldoverthelasteightyears.Thelong
termcorrelationwithTreasurybondsisnotashighbutstillverysignificant.
Asheexplainsit,thesocalled"problem"withgold,whichcausesitserraticpricebehavior,is
thattheelasticityofapositivelyslopedinvestmentdemandfunctionoverwhelmstheinelasticity
ofsupply.Only18%ofthegoldminedthroughouthistoryisheldininvestmentform,orslightly
morethan$200billion.Theinvestablecapitalmarketsoftheworldareestimatedtobeabout$60
trillion.Inalowreturncycleforstocksandbonds,monetaryandinvestmentdemandforgold
turnspositive,andthereisadramaticshortageofavailablemetal.Thislargedifferentialcanonly
besolvedbymuchhigherprices.
Petermaintainsthatthelongtermequilibriumorinflationadjustedpriceofgoldintoday's
dollarsisabout$500/oz,ascomparedtothecurrentpriceinthelow$300s.SummersandBarsky
alsosaythatthereisaseculartrendtowardahigherrealandnominalprice.

Populationandincomegrowthexceedtheconstrainedgrowthofthephysicalstockof
metal,whichhasbeenamere1.75%overthecenturies.Inaddition,inthemodern
world,monetarygrowthfarexceedseconomicgrowth.
However,goldwasnotahappyplacetobeinthe1990s.Goldwasstillcorrectingtheexcessesof
itshugebubbleofthelate1970s,sothemarketpricewasintheprocessofnotonlyrevertingto
themeanbutdramaticallyundershooting.Thebestcompanyspecificresearchandthemost
sophisticatedmodelswerefornaughtinasecularbearmarket.Peterwasviewedas"thatguy
whousedtobesmartthatwentcrazyandbecameagoldbug."However,hedidn'tcarebecause
hewasconvinceddoubledigitrealreturnsonfinancialassetswereunsustainable.Hewasatrue
believer,andmeanwhilehisfamilygrewupinSunValley,heclimbedeverymountaininsight,
andwaitedforhistimetocome.
ThispieceisasummaryofmuchlongerdiscussionsPeterandIhad.Youneedtoreadhispaper.
Butmypointisthatifweareinanextendedlowrealreturnperiodforfinancialassets,thereisa
placeforagoldinvestmentprograminbothlargeandsmallportfolios.
Peterrunsportfolioswherethebenchmarkisgoldbullionandgoldshares,eachat50%,ina
rangefrom70%to30%.Allocationcanaddacoupleofhundredbasispointsayeartogold's
return.Goldsharestendtohavetwicethevolatilityofthebasemetalbecauseoftheirinherent
operatingleverage.SunValleyGold'srecordisthatactivemanagementofagoldsharesportfolio
canadd800to1000bpayeartothereturnofthegoldsharesindex.Thisstrikesmeas
optimistic,butthegoldsharesmarketisveryinefficient,andanalyticalresourcescanmakea

hugedifference.Theoptimumsizeofamanagedgoldstockportfolioisprobablyaround$200
million.
Soifyoubelievethisstoryandthinktherealreturnfromcapitalmarketsoverthenextdecadeis
goingtobe4%perannum,therealreturnfromamanagedgoldportfolioisgoingtobearound
15%real(+7%metal,+1%allocation,+14%goldshares,plus8percentagepointsofalpha).I
don'tneedtotellyouthatreturnsofthismagnitudewouldbespectacular,butIstronglysuspect
thatthereturnswouldbehighlyvolatilegiventhehistoryofgold.Howmuchshouldalargefund
haveinprofessionallymanagedgold?Isay5%.
Itcertainlyispossiblethatgoldcanreturntoitslongtermequilibriuminflationpriceof$500an
ounce,oreventakearunatitsalltimehighofcloseto$1,000.Whatwouldcausesuchan
explosion?Asteepdeclineintheequitiesmarket,higherinflation,orcompetitivedevaluationof
themajorcurrencies.Inableakworld,goldcouldbeatalmosteverythingelse.