William Smead
Chief Executive Officer
Chief Investment Officer

Dear Fellow Investors:

We spoke to two small groups in Spokane on September 21st, 2012. For better or worse, when I think of Spokane I think of my cousin Gary. It was 1981 and yours truly was a young stockbroker at Drexel Burnham Lambert. Gold had been in a wonderful bull market ride in the prior five to ten years. Gary was interested in participating in gold through a gold-mining stock traded on the Spokane Stock Exchange. Spokane’s proximity to the Northern Idaho mining towns and closeness to the Canadian border made it a natural place for commodity traders and mining enthusiasts to gather to transact business. The stock was around $2 per share and based on a bullish outlook for gold, seemed to be headed higher. Gary was a willing buyer.

An article dated September 28, 2012, at Marketwatch.com triggered me to expound on 1981. It explains which entities are the largest owners of gold in the world.

If exchange-traded products backed by gold were a central bank:
Gold reserves, in metric tons
United States: 8,133 metric tons
Germany: 3,396 metric tons
International Monetary Fund: 2,814 metric tons
Exchange-traded funds and notes: 2,579 metric tons (includes SPDR Gold Trust)
Italy: 2,451 metric tons
France: 2,435 metric tons
SPDR Gold Trust GLD-0.34%: 1,321 metric tons
China: 1,054 metric tons

Source: Barclays Plc., which tracks 47 gold-related exchange-traded funds and notes. Holdings as of Wednesday, September 26, 2012.
– Claudia Assis

In this same article, titled “SPDR Gold Trust tops China in Gold Reserves”, Claudia Assis wrote an incredibly revealing statement:

So, with gold firmly back on the limelight, it’s time to revisit that interesting comparison that illustrates so well how gold has captured the imagination – and pockets – of investors around the globe. That is, how massive individual and professional investors’ gold holdings have grown versus the reserves sitting in the vaults of central banks, which historically held gold as a standard for their currency.

The key line in the paragraph is “how gold has captured the imagination – and pockets – of investors around the globe”. Gold caught the imagination of my cousin, Gary, in 1981. We at Smead Capital Management (SCM) like to think of it as “extrapolation” rather than “imagination”. The rearview mirror is busy at work. Gary was looking backwards at the move in gold prices from the beginning of 1976 to the beginning of 1981. Those price increases caught his imagination. In our opinion, the circumstances which created the interest in gold were unsolvable economic problems with seemingly no end (historically high inflation).

We view Harvard’s John Kenneth Galbraith as the best economist and thinker about speculative episodes. In his book, “A Short History of Financial Euphoria”, Galbraith explains the features of a speculative episode:

The more obvious features of the speculative episode are manifestly clear to anyone open to understanding. Some artifact or some development, seemingly new and desirable— tulips in Holland, gold in Louisiana, real estate in Florida, the superb economic designs of Ronald Reagan—captures the financial mind or perhaps, more accurately, what so passes. The price of the object of speculation goes up. Securities, land, objects d’art, and other property, when bought today, are worth more tomorrow. This increase and the prospect attract new buyers; the new buyers assure further increase. Yet more are attracted; yet more buy; the increase continues. The speculation building on itself provides its own momentum.

We know that cousin Gary invested at the wrong time in the wrong asset class with the wrong mining security. The company he owned went out of business and the exchange it traded on has been gone for many years. Today, we believe the “well known fact” is that the US and a number of other major countries are debasing their currency by printing money. Therefore, every time the Federal Reserve Board announces a new version of QE, it stimulates a new group of investors to pile into gold and gold-related investments. Notice that ETFs and notes in Gold, combined with the SPDR Gold Trust, are approaching the size of the International Monetary Fund. Also, notice that the SPDR Gold Trust now dwarfs the Chinese Central Bank/Government holdings.

Galbraith described what the basic attitudes are of the investors who participate in speculative episodes:

This process, once it is recognized, is clearly evident, and especially so after the fact. So also, if more subjectively, are the basic attitudes of the participants. These take two forms. There are those who are persuaded that some new price-enhancing circumstance is in control, and they expect the market to stay up and go up, perhaps indefinitely. It is adjusting to a new situation, a new world of greatly, even infinitely increasing returns and resulting values. Then there are those, superficially more astute and generally fewer in number, who perceive or believe themselves to perceive the speculative mood of the moment. They are in to ride the upward wave; their particular genius, they are convinced, will allow them to get out before the speculation runs its course. They will get the maximum reward from the increase as it continues; they will be out before the eventual fall.

At SCM, we very much like to avoid speculative episodes. In the current fascination with Gold and commodities in general, it is interesting to consider who represents the two kinds of participants in today’s mania. First, you have those who watch the thousands of advertisements on TV and/or hear them on radio to buy gold and act on their imagination. Second, you have some of this era’s most highly thought of money managers running hedge funds, who have stated their belief in the success of major long gold positions. We would add a third category which didn’t exist before Galbraith wrote the last update of his book. They are wide asset allocators, who participate for diversification purposes in gold and would argue that their ownership of gold is price direction agnostic. As institutional and individual investors adopted wide asset allocation, we believe it automatically increased the demand for gold, gold-related securities and commodities in general.

We as a company have no idea how long this episode will last. Here is Galbraith’s take:

For built into this situation is the eventual and inevitable fall. Built in also is the circumstance that it cannot come gently or gradually. When it comes, it bears the grim face of disaster. That is because both of the groups of participants I the speculative situation are programmed for sudden efforts at escape. Something, it matters little what—although it will always be much debated—triggers the ultimate reversal. Those who had been riding the upward wave decide now is the time to get out. Those who thought the increase would be forever find their illustration destroyed abruptly, and they, also, respond to the newly revealed reality by selling or trying to sell. Thus the collapse. And thus the rule, supported by the experience of centuries; the speculative episode always end not with a whimper but with a bang. There will be occasion to see the operation of this rule frequently repeated.

We do, however, have a vision of what it will look like when the mania dies. If history is any guide, the hedge funds will be the first to flee, the individual investors will be in denial for awhile, but will ultimately give up in panic. Lastly, the price-agnostic asset allocators will sell when threatened with unemployment or as the clients liquidate to go elsewhere. We at SCM like the reaction which Galbraith describes to protect you and/or your clients from being damaged by a speculative episode:

Let the following be one of the unfailing rules by which the individual investor and, needless to say, the pension and other institutional-fund manager are guided: there is the possibility, even the likelihood, of self-approving and extravagant error-prone behavior on the part of those closely associated with money.

A further rule is that when a mood of excitement pervades a market or surrounds an investment prospect, when there is a claim of unique opportunity based on special foresight, all sensible people should circle the wagons; it is time for caution.

Cousin Gary and I had neither the experience nor a copy of Galbraith’s book in 1981 to draw from. We at SCM do.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

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