Return to First Principles: Reaction to Extraordinary Developments

The past several weeks, we have been treated to some of the most extraordinary developments we have seen in financial markets in many years. Gold has not yet expressed its response but, in our opinion, the stage has now been set for reinstatement of gold as a preferred investment in the months ahead.

Let’s return to first principles. Gold is an alternative to the three main asset classes of equities, bonds and real estate. When confidence is high in these three, gold fares poorly by comparison. When confidence in these three declines, gold shines.

Equities, bonds and real estate have performed well over the past 25 years, a crash in tech stocks notwithstanding. It is our contention that bubbles have developed in all three driven by the biggest bubble of all, in credit. Never have so many owed so much. An excess has developed in credit markets world wide for a number of mutually reinforcing reasons: cheap credit in plentiful supply; lending standards which have declined to the point of absurdity in some markets; too many years without a recession, lulling lenders and borrowers into complacency; financial innovation packaging and securitizing credit, removing the last vestiges of prudence and control while also eliminating market pricing and substituting mark-to-model valuations; financial rating agencies applying to these structured credits (often comprised of subprime no-doc mortgages and car loans) the AAA rating previously reserved for seven of America’s largest corporations; credit default swaps and other forms of quasi-insurance issued by unknown counterparties or undercapitalized insurers. All of this has enabled a massive increase in leverage.

It is this infrastructure which has enabled the simultaneous levitation of equities, bonds and real estate in the early 21st century, with the further assistance of the yen and Swiss franc carry trade in which loans made in these weak, low interest rate currencies have been used to fund speculation in the securities of strong currencies.

Real estate has been the first to fall. All it took was a slowdown in price inflation to cause the late-to-the-party, marginal borrower to default in record numbers. No leverage, no problem. But the leverage is immense, in hedge funds, brokerages and banks. Structured credit products designed for a mark-to-model world have had to be sold into illiquid markets to meet margin calls. At Bear, Stearns, several billion dollars disappeared overnight.

The naïve among us might suppose that the problem is the subprime mortgage default rate. In our view, it is not. The problem is system wide leverage at historic levels. This is how exponential growth in the credit markets has been maintained. This is how equities, bonds and real estate have developed into bubbles.

All eyes are now on the credit markets. After reaching historic lows in recent months, credit spreads have begun to widen. Liquidity appears to be on the decline. We have little doubt that central banks will come to the rescue with the one weapon at their disposal, additional liquidity, and we are confident that order will ultimately be restored. The consequences, we believe, will weaken public confidence in fiat currencies as a store of value. Savers and savings will be sacrificed to bail out debtors. And gold will move to center stage, a currency without a central bank, a store of value which cannot be printed or duplicated electronically, and an increasingly attractive alternative to equities, bonds and real estate.

It is not with pleasure that we survey the current uncertainty. However, we at Seabridge take some satisfaction from accomplishing our task of providing exceptional and growing leverage to the gold price for our shareholders and, we hope, helping them preserve precious capital in volatile times.