Hathaway - Gold, Mining Shares & QE: 2 Persistent Questions

"The protracted correction in gold and precious metals stocks that began in September 2011 appears to have ended. Our conclusion is based on historically reliable gauges of sentiment, valuation and technical factors. (We will publish the specific readings on these gauges with our second quarter investment letter on June 30.) This basing, in our view, should establish a solid platform to launch both the metals and the related mining shares to new highs within the next year. The investment sentiment for gold and especially mining shares is demoralized and confused. This setting, in our opinion, equates to an outstanding, low risk entry point to both the metals and the shares in anticipation of future monetary debasement.

Question # 1: Gold Price Outlook and QE

The fundamentals that led gold to trade briefly above $1900/oz. nine months ago are, if anything, more compelling and supportive than ever. These include, but are not limited to, sputtering economic conditions, intractable fiscal issues in all Western democracies, the slow motion demise of the euro as a credible reserve currency, a loss of faith in traditional economic prescriptions, alarm at the readiness of policy makers to resort to radical, ad hoc measures to buy time, and general disaffection among disparate social factions with the status quo.

Traditional economic analysis seems to offer little to explain the contemporary social and economic drift. In our opinion, more enlightenment can be found in the study of complex systems and chaos theory. As explained by James Rickards in “Currency Wars”, systemic scale and risk correlate in a positive way. What works on a smaller scale does not translate to large systems. 

In large systems, “minutely small changes in initial conditions can lead to catastrophically different results.” The extrapolation of outcomes based on historical models and policy applications is a fruitless exercise. The evolution of Western democracy over many decades has resulted in a systemic structure that bears no resemblance to precedent. Rickards notes that “a phase transition from stability to collapse can begin in imperceptible ways based on tiny changes in individual preferences impossible to detect in real time.”

Citing the work of anthropologist Joseph Tainter (The Collapse of Complex Societies) who analyzed factors leading to the collapse of 27 civilizations, Rickards suggests that highly evolved societies generate the seeds of their own instability through complexity. The marginal benefit gained from contributing to the general well-being eventually vanishes as creative energy is diverted into propping up cumbersome and unproductive legacies. Rickards explains that the crossover occurs when the “elite echelons of society go from leading to leeching.”

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