Tuesday, April 7, 2009

Advisor Perspectives: Au revoir Jean-Marie Eveillard: A Final Interview

Which worries you more – a decline in the dollar, rapid inflation, or deflation? How are you positioning your portfolio to defend against these scenarios?

We have many worries, but we are not positioned against any particular outcome. Our top-down analysis is focused on those trends that will affect the intrinsic values of the companies we own. We believe the most effective defense against these scenarios is to spread risks through diversification.

You have called your billion-dollar purchase of gold “calamity insurance.” What potential events do you perceive possible that makes such a large position advisable? How do you go about determining your allocation to gold?

Our gold position is based on our belief that gold is a universal store of value. We believe a gold position of less than 5% of our assets is irrelevant and a position of more than 15% would be too painful if we are wrong. For most of 2008, our position was between 7-8%, but it eventually grew to almost 15%. This was not because we bought more gold, but because the value of gold rose relative to the value of the rest of our holdings.

After World War I, during the great inflation of the Weimar Republic, the German government acted very shrewdly. They forbade German citizens from buying gold and from holding foreign currencies, and they taxed real estate very heavily. As a result, some rich farmers bought grand pianos. They did not want the paper currency being issued, because they knew it would be worthless the next day. Instead, they chose pianos as a hard asset that would hold its value. Today, we see gold as having these same characteristics.

The current actions of the US and UK governments, through “quantitative easing” – which is really just a code word for printing more money – will be rather good for common stocks. Initially, at least, these actions will be bad for cash and Treasury bonds. At some point, they will be good for real estate and fine art. However, these actions are very good for gold.

The path of increased money supply leads to real assets, and gold is our asset of choice. Common stocks will also benefit, as they are representative of real assets.

Remember, the opportunity cost of holding gold is near zero, because interest rates are so low. Gold investors should keep in mind the two extremes. The government has a strong incentive to keep long-term Treasury rates low, because it allows them buy Treasury bonds to increase the money supply. At the other extreme, the government dislikes high gold prices, because it reflects poorly on their policies. This is partly why FDR, during the Great Depression, made it illegal to own gold. So, to some degree, gold investors are betting against the government.

Is the worst behind us? Will we continue to see more surprises on the downside, or will there be unexpectedly good news?

A bit of a reprieve may be in the making, thanks to the stimulus package. One year from now, however, a wave of option ARMs begins to reset. [Ed. Note: See our article on this topic.] These loans were made at the peak of the credit cycle and the magnitude of this problem will rival that of the sub-prime problem. The housing market will need to absorb another round of foreclosures.

We are one year into the recovery process, but a full recovery will likely take longer.

We worry about the actions of the authorities, who are attempting to subvert the laws of nature. By printing more money, they are doing a rain dance in Washington, but the result could be a hurricane of inflation.

What sources of information world-wide should people in the United States seek out to become more informed and better investors?

Read the Financial Times. It is more international and, overall, better than the Wall Street Journal. We also recommend Jim Grant’s Interest Rate Observer. Grant was one of the rare few people who correctly forecast the financial crisis. Nor is he a “perma-bear” – just recently he was bullish and correctly advised readers to buy long-dated call options on a basket of bank stocks.