What Is It About Gold?
In the past 10 years, the price of one ounce of pure gold has risen  from less than $300 to $1,500, far outpacing the return on stocks and bonds. And yet, to paraphrase the comedian Rodney Dangerfield, "It don't get no respect" in most gatherings of professional investors. Why is that? Why is the yellow metal treasured in some quarters and disdained in others? What drives the price of gold, anyway? And is gold really an appropriate investment in the 21st century?

In this issue of the Blue Sheets we set out to better understand this unique metal and the reasons that it has been considered "precious"in all cultures since the beginning of recorded history. We'll explore the reasons that some consider gold an important asset class with unique and valuable investment characteristics, while many or perhaps even most professionals regard it as a sort of investment sideshow.

It's Not Terribly Useful
Gold is a metal, but one with special characteristics that set it apart from industrial metals like iron, copper and aluminum. Au is its symbol on the Periodic Table of the Elements; the abbreviation derives from the Latin word for gold, aurum. Gold's atomic number is 79, which indicates the number of protons in one atom. Despite the fact that gold is the most malleable and ductile of metals, its industrial uses are relatively few, limited primarily by its high cost. Total industrial demand for gold accounts fornly 10% to 12% of annual goldroduction. Year after year, about 50% or more of the world's new gold production is fashioned into jewelry.

Pure gold is bright yellow, lustrous, and it does not oxidize in air or water. Because of these properties, and because gold deposits are rare and expensive to extract, gold's principle commercial uses have always been in the fabrication of jewelry and coins. Jewelry and artwork are believed to account for more than half of all the refined gold on the surface of the earth. And since nobody throws this stuff out, virtually all the gold that was ever mined is still here.

It's Expensive To Produce
Gold occurs as nuggets or grains in alluvial deposits and in rocks. Usually, the concentration in the surrounding material is so small that deposits are invisible to the eye. In a typical open pit mine, its concentration or "ore grade" is between 1 and 5 parts per million! Underground "hard rock" mines are typically 3 ppm. Said another way, on average a mine needs to process 17 tons of dirt and rock to produce 1 ounce of pure gold!

In recent years, all the world's active gold mines have been producing a combined total of around 2,400 tons of gold per year. Using an average ore grade of 3 ppm (I cannot verify if that is the actual average, but it is a decent ballpark figure) the industry would be digging up and processing about 1,440,000,000 tons of rock and dirt to produce 2,400 tons of gold. Their average cost of production has been in the neighborhood of $500 per ounce of gold, and ¼ of the cost is energy. To achieve that efficiency, they must dig up and process rock and dirt for an all-in cost of under $30 a ton!

It takes a lot of capital to build an efficient mining operation. Newmont, one of the largest gold mining companies in the world, recently announced a $7 billion 6-year expansion program indicating capital costs of about $125 million per ton ($4,000 per ounce) of productive capacity. But even this Herculean effort would add the equivalent of only 2% to world capacity, even as older mining operations are nearing the end of their useful lives. So, while the price of bullion is high, we don't see a sudden surge in the supply of new gold.

Capacity expansion doesn't happen overnight. Besides the exploration and testing process to locate and evaluate the ore grade of a potential mine, thereare extensive governmental and environmental procedural requirements, establishment of ownership and taxation rights, and the biggest of all... the infrastructure development. This includes not only the extraction equipment and ore processing facilities but access infrastructure, which can include miles and miles of heavy-duty roads and often landing strips and helicopter pads. As much as ¼ of all gold output is estimated to come from small, low-tech "artisanal" projects; but the big, efficient mines that comply with safety and environmental regulations can take 5-10 years to actually come on stream!

It Is Scarce
A high percentage of Americans seem to own gold jewelry. There are well-stocked jewelry stores in every mall. Is "Bling" really all that scarce?

Well, all the gold that's ever been mined throughout all of human history is estimated at 165,000 metric tons. That's about 5.3 billion ounces... which sounds like a lot until you realize it's less than one ounce for each human currently living on the planet.

At the $1,500 oz. world price for gold in May 2011, all the gold in the world has an implied value of about $7.9 trillion. That's more than half the GDP of the entire United States for a whole year. At first blush, that may sound like a lot of gold.

But melted down into traditional 14-inch gold bars weighing about 27 pounds each, all the gold on the surface of the earth... all the gold that's ever been mined and refined through thousands of years of human history... would fit easily into a simple 4-story office building in Columbia, Maryland! All the gold mined in the world during the past year would fit into the living room of my modest suburban ranch house!

Supply & Demand
Like any commodity, the price of gold is responsive to changes in supply and demand. Gold currently fetches 5 times the price it commanded as recently as 2002!

A dramatic move like that cries out for an explanation, and the simple fact that gold is "scarce" is not a very satisfying one. To help us judge whether it makes sense to own gold as an investment at today's elevated price, let's examine the forces of supply and demand that actually influence the price of gold.

We've identified three main sources of SUPP LY that affect the total quantity of gold available for investment:
The portion of current mine production that does not go into the non-investment categories. This has added about 1.5% a year to the supply of investment gold.
The migration of bullion from central bank reserves into investment gold.
Melting down jewelry to manufacture gold bars (not believed to be significant).

Here are five of the current influences on the DEMAND for gold as an investment that we think matter most:
1. Investment in gold as protection against the debasement of fiat currencies in the developed world (by both individual and institutional investors).
2. Speculative, price-sensitive demand; "momentum" traders.
3. Growing prosperity in the emerging markets which have traditionally regarded gold as a store of wealth and status symbol.
4. High valuation of stocks and bonds raises gold's relative attraction as an investment.
5. Rising international stress increases interest in gold as a "safe haven" during crises.

Mine Production
Pure gold wrestled from the earth at great cost is, of course, the only thing that supplements the existing quantity of gold in the world. Let's take a brief look at the history of gold mine production.

In the 110 years since 1900 the world's annual gold production has risen rather steadily from 386 tons to 2,500 tons, a compound annual growth rate of only 1.7% a year. That's about half the long-term real growth of the US economy. Rising output has been facilitated by new discoveries, but even more so by technological advances in machinery, mine design and especially in the late-1980s by rapid adoption of "heap leaching" as the preferred method of separating the precious metal from its ore. This has made economically feasible the working of lower quality ore deposits.

Mine output shrank during both world wars of the 20th century as these enormous conflicts drew manpower and resources away from precious metals mining. A third decline occurred in the 5 years following the cessation of gold convertibility with the US Dollar, when central banks dumped tons of gold on the market. And finally, mine production peaked in 2002 and has not regained that level since, despite the increase in the market price.

A long period of price weakness for gold was 1980-2000 (see gold price chart on page 7), during which the average annual price fell from about $650/oz. to $279.

During these 2 decades, global mine production soared from 39 million ounces to more than 82 million ounces a year! Double the production and the price falls 50%!

Just supply and demand at work.

The uptick in production in 2009-10 (see chart) was partly a response to the surging gold price (it became profitable to mine lower quality ores), and partly it reflected increased production of polymetalic gold (e.g. gold that is produced as a by-product of copper mining). But for most of the past decade, despite rising gold prices annual global gold mine output was actually shrinking. At the same time demand was rising because of both prosperity in the emerging economies and growing currency concerns in Europe, Japan and the US. We'll get to that in a moment.

On balance, we believe that physical gold production will grow grudgingly if at all over the coming decade, unless rich, new deposits are discovered. There haven't been any in recent decades, but hope springs eternal!

Central Bank Sales
That leaves two other supply sources: gold sales by central banks and the melting of jewelry. We have not found any convincing data about the conversion of jewelry to investment gold, but suspect it is a very minor issue in the overall picture. But Central Bank (CB) reserves policies have sometimes played a big role.

As you can see (with a magnifying glass, perhaps) in the charts below, gold bullion makes up only about 10% of CB reserves,way down from the 60% area in 1980. Even if CBs continue to be net sellers, their potential impact on supply has been marginalized. As a matter of fact, selling virtually dried up in 2010, down 96% from the prior year. It seems that these banks had been giving their balance sheets a boost by selling non-yielding gold holdings in favor of interest-bearing overnment bonds. But now, especially with their remaining gold rising in value, they tend to favor the security of gold over sovereign debt. A recent survey of many European central banks indicates they have no intention to sell. Finally, the Central Banks of China, India and Russia have become net buyers, of gold!

The cessation of Central Bank selling is effectively a 20% reduction in the annual supply of investment gold compared with the previous decade. It seems unlikely to us that even aggressive mine expansion could replace this lost source of supply. With the gold supply outlook flattish, the price behavior is going to depend on the demand factors. Let's take a look.

Monetary Influences On Demand
Let's start by charting gold's price behavior over a longer period of time. Nearby is a chart that begins in 1973 when gold was just under $90 oz. Before we discuss the subsequent price developments, we need to highlight some important things that took place in the US between 1970 & 1975.

Way back in 1933, by executive order of FDR, it became illegal for Americans to own more than $100 worth of gold without a special license! During the ban, gold's price for purposes of dollar convertibility (available only to foreign holders) was fixed by statute at $35 oz. On August 15, 1971 President Nixon announced that the US would no longer convert dollars to gold at a fixed rate, effectively taking the US currency off the gold standard! FDR's ban on ownership by private citizens was finally lifted by President Gerald Ford in December 1974.

While gold was still unavailable to US investors, but right after the US abandoned convertibility, gold's world price shot up from $35 to $150 oz. between 1971 and 1974. In the chart above you can see that gold then proceeded to wobble between $100 and $200 before exploding toward $800 between '78 and '80. As many readers will recall, that was a period in US history when general price inflation catapulted into double digits. Gold historians ascribe the late '70s gold price increase to the rampant inflation and concern that our currency, now untethered to any dependable metric, would be continually abused by government and the central bank. With the CPI vaulting ahead at 13% a year in 1980, hyperinflation seemed but a skip and a jump away.

Not to worry! Paul Volker came on board as Fed Chairman in the waning days of the Carter administration. Not a man to be trifled with, Volker took seriously his responsibility under the Federal Reserve Act to maintain price stability. Cranking up short-term interest rates as high as 20% by June 1981, he succeeded in driving inflation down from 13.5% to 3.2% in just 2 years!

Gold's price wasted no time getting with the program; it collapsed by about 60% and proceeded to bounce around between $250 and $500 for the next 24 years. During most of that time the Consumer Price Index was well behaved, increasing less than 3% a year.

So, to the extent that investor demand for gold is driven by inflation concerns, the Volker experience shows us that seriously conservative monetary policy seems to quiet those worries and dampen demand for gold.

You can see the gold price-CPI relationship in the chart above comparing the trailing 10-year change in gold's price with the trailing 10-year change in the CPI since the early 1950s. The overall connection between inflation (aka erosion of the dollar's value) and the price of gold seems undeniable. However, one thing is a little puzzling about the patterns. The trailing 10-year rate of inflation has trended lower ever since 1981; the gold price fell and then flatlined, which seems consistent. But around 2005 gold started accelerating upward without any apparent provocation from CPI inflation. Is there another price driver that a prospective gold investor needs to be aware of?

Money Supply As An Inflation Proxy
The Federal Reserve's original mandate from Congress was to preserve the national currency as a store of value by maintaining price stability in the domestic economy. The Fed mainly influences price inflation by expanding and contracting the "Money Supply" through various machinations. In overly-simplistic terms, if the amount of currency and credit outstanding just keeps pace with the volume of transactions in the economy, then Fed policy should have minimal influence on prices. The currency should more or less maintain its value.

The chart on page 9 compares the money supply with the gold price. We plotted a series called FTTM (Fed & Treasury Total Money) against the price of gold for the past 30 years. We made the beginning value of each equal 100 and tracked them year by year. As we saw in the earlier gold chart, the price of bullion remained in a steady range until 2004 even though the Money Supply kept increasing. But as Money Supply accelerated, especially in the 2008 crisis, we saw the gold price start to rise out of that $200-$400 range in which it had traded for so long.

The next chart focuses in on that latest 10 years to see what was happening. Lo and behold... their trends were right on top of each other. Since 2002 both the money supply and the price of gold have multiplied 5-fold!

What we understand from this is that for the past ten years gold's price has been tracking the Money Supply even though the expansion of money has not shown up yet in the traditional CPI measure of inflation. Gold seems to be anticipating inflation!

The chart on page 10 is very busy, but it shows the moderating trend of inflation from 1990 to 2001, when gold's price bottomed around $270. It shows CPI's move back up to 5.6% in 2008, its recessionary plunge into deflation territory and a very quick surge to over 3% through May 2011.

We remain convinced that the erosion of currency values via inflation is the main driver of investor demand for gold bullion; an investment in gold is one way to protect the buying power of people's savings. While standard inflation measures have not seemed too worrisome recently, we do note that the price of gold has recently tracked the expanding Money Supply in apparent anticipation of the inevitable inflationary consequences. That seems reasonable to us.

Current Fed Chairman Ben Bernanke expects that the recent uptick in the CPI is "transitory". The gold market seems to be betting against his opinion. It seems to us that to own gold at $1,500 an ounce is to express a serious concern about price stability and about the likely future worth of paper currencies; not only in the US but throughout the developed world.

This seems a good time to transition our discussion to a consideration of a) the quandary in which the Fed finds itself, b) its likely behavior with respect to monetary policy, and c) the probable consequences for the price of gold.

Debt, Deficits and Denial!
Both the evidence and common sense indicate that investment demand for gold bullion is driven primarily by the waxing and waning of confidence in paper currencies as a store of value and reliable medium of exchange. Gold, which pays nothing and earns nothing, is mainly about jewelry demand when monetary inflation is low and stable, since there is little anxiety about the loss of purchasing power.

The US Dollar, accepted as the world's "reserve currency" after all major currencies abandoned the gold standard, enjoyed widespread trust in the '80s and '90s following Volker's monetary heroics. It is actually a little surprising that gold's price held up as well as it did in the face of a doubling of mine output during that period.

During the most recent decade, as shown above, the US money supply gained momentum under Chairman Greenspan during the bursting of the dot.com stock bubble, and really exploded when Mr. Bernanke addressed the 2008 mortgage-based credit crisis with a rapid doubling of the monetary base. The behavior of gold's price shows that currency-related investment became once again the dominant demand variable.

We all know that by legislative fiat the Federal Reserve Bank is independent of the central government. The Bank's officials are appointed, not elected. So, the theory goes, they are above pandering to the electorate and are free to make politically unencumbered monetary policy decisions. The Fed's independence may have been weakened a bit in 1977 when Congress gave the bank a dual mandate to fight not only inflation but unemployment as well.

How does this full-employment mandate influence policy? Well, the Fed's new goal of keeping economic activity brisk lets them justify insulating the government from the interest rate consequences of its deficit spending policies. To enable the expansion of the national debt, the Federal Reserve has been openly manipulating the interest rate down by setting the "fed funds" rate near zero (free money, for cryin' out loud!), setting liberal reserve requirements for member banks to stimulate lending, and, in the last two years, by actually conjuring dollars out of thin air and using them to buy government bonds at below-market interest rates. The fashionable name for this activity is "Quantitative Easing"; the traditional name is "money printing". It is the bane of sound money and raw meat for gold bugs.

The nearby chart shows a 21-fold explosion of US Government obligations from 1980 through (estimated) 2016! Debt grew roughly 9% a year from 1980 to 2011. In the same period, GDP that ultimately must support the public sector obligations grew less than 6% a year; even slower in the recent years.

The currently outstanding US debt is $14.3 trillion; by year end it'll be $15 trillion or almost 100% of US GDP. Just the current fiscal year deficit of roughly $1.5 trillion equals 10% of GDP. As of this writing, US debt is at the legally authorized debt limit and causing all sorts of political commotion. But our government goes on spending 60% more than it takes in! It's almost unbelievable. Studies have shown that economies with deficits equal to 40% of their budgets (as the US has today) tend to descend into hyperinflation! We have to ask ourselves if that could possibly happen here.

No one should be surprised, then, that last month (April 2011) Standard & Poor's Rating Service downgraded its long-term outlook on US debt to "negative" from "stable". They said, "We believe there is a 1-in-3 likelihood that we could lower our long-term credit rating on US debt within 2 years." The report alluded to S&P's assessment that there is no evidence of any serious effort to arrest the government's financial deterioration. We very much concur.

When concerns about currency debasement or outright devaluation of a particular country's fiat money are ascendant, the first instinct of investors and businesses that denominate their affairs in that currency is to find shelter in other freely-traded currencies. Worried about the US Dollar? Then hedge with Euro futures; that sort of thing.

But what if there is widespread concern about all the world's major currencies? The Euro, Yen and perhaps the Pound Sterling are considered by most economists to be in even worse credit condition than the Dollar! A business or country or investor who needs to hedge against the risk of devaluation in all these currencies needs a liquid alternative. Gold heads a very short list of choices.

The fact is, the government sponsors of all four of these dominant currencies have created widespread misgivings about their stability by incurring unprecedented levels of debt to support huge and seemingly endless operating deficits. These deficits, in turn, result from an unwillingness to control the cost of social benefits, and a strong instinct for "bailing out" their equally undisciplined private banking systems.

A debt/deficit tornado is sweeping across the world's mature industrial economies; but credit markets continue in denial of the seriousness of matters, accepting interest rates that bear no relationship to the serious default risks.

It seems more and more likely that governments who have gotten away with "kicking the can down the road" will come to the end of the road sooner than later. It won't be pretty. It probably won't even be orderly. This is precisely what's driving investment demand for gold. Solve the Debt/Deficit problem and I think the dollar price of one ounce of gold will drop into three-digit range. But, fail to solve it within the next few years and the sky's the limit!

The Other Demand Factors
The prospect for monetary inflation is, we think, the main driver of gold's price. Here are a few others:

Speculative, price-sensitive demand... aka "momentum" traders. One place that government's newly-printed, nearly-free cash flows most readily is to hedge funds and other fast-money trading enterprises. They are certainly "onto" gold, and they are an influence to be reckoned with, especially in the short term.

Growing prosperity in the emerging markets which have traditionally regarded gold as a store of wealth and status symbol. India is the world's largest gold consumer, absorbing 20% of world gold production last year. China has become the leading producer (over 13% of world production) AND imports gold besides!

High valuations for stocks and bonds tends to increase gold's relative attraction as an investment. Readers know we are
believers in the ability of freemarket businesses to adapt to the economic and monetary climate, so our preferred investment class is common stocks. But in light of the slow debt-burdened outlook and very high current valuations, our commitment to stocks is risk-aware. We have room in our portfolios for a big defensive position in gold.

Rising international stress increases interest in gold as a "safe haven" during crises. North Africa, Middle East anyone?

Is Gold in A Bubble?
A five-fold increase in the price of anything in less than 9 years invites the bubble analogy; not a few commentators have been promoting this notion about gold.

The chart below compares the price of gold since it was $375 (its 20 year midpoint) until now, against the three largest bubbles of the last 40 years. On the basis of these the move in gold so far looks orderly and almost timid! Past bubbles have shown strong but steady growth for the first 7-8 years before moving into a hyper-growth phase for another 18-24 months. (Each series is adjusted for inflation and smoothed with a 3-month moving average.)

Clearly a 300% (inflation-adjusted) increase in less than 9 years is a heroic move. But if it should happen that the market price of gold gets as much emotional energy behind it as did NASDAQ in the twilight of the 20th century or oil in the opening decade of the new millennium, one could picture it soaring to $3,000 an ounce or more; and it would still just look like your run-of-the-mill bubble. If that should happen, it is probably worth keeping in mind what the downside of these bubbles have always looked like, especially in their first year of correction!

Oil and gold are both mature, established industries. They are both globally-traded, nonrenewable commodities, most often denominated in US Dollars. Their commercial buyers and sellers share the spot and futures markets with an active contingent
of speculators. They have also both seen their market price explode from 40 years ago, and it is widely accepted that currency valuation is a strong influence on their market price. I thought it might be interesting and perhaps even instructive to see how oil and gold have compared over the years.

The nearby chart tracks the price of an ounce of gold divided by the price of a barrel of oil. Said another way, it shows how many barrels of oil you could buy with one ounce of gold at the going market price. The ratio is smoothed using a 12 month moving average.

You can see that on May 4, 2011 an ounce of gold was worth about 15 barrels of oil. That's about where it was 30 years ago when gold was hitting its previous peak. It's also about where it was at the end of WWII. But the ratio is closer to the bottom than the top of its long-term range. In short, gold doesn't look extreme compared with oil.

Here's our final thought on the question of whether gold is in a bubble: it is not gold that is in a bubble; rather it is what's causing gold to go up that is in a bubble. In his Frontline memo of May 14, 2011, John Mauldin opined convincingly, "The biggest bubble in the history of the world is the sovereign debt bubble."

It looks to us like the economy is struggling (1Q growth rate 1.8% real) to provide any meaningful growth even with the tailwind of a huge federal deficit on the order of 10% of GDP. At an annual nominal growth rate of 4%, our GDP is plodding ahead by $600 billion a year. Our government is buying this growth at the cost of $1,500 billion added permanently to our national obligation. Money down the drain... pushing on a string... helium in the balloon. Pick your favorite analogy... it's not working and it is wrecking the national balance sheet and diminishing confidence in the underlying currency.

Will the Federal Reserve keep supporting our patently irresponsible fiscal policy? Our fear and expectation is that the central bank is a one-trick pony. Ben Bernanke is no Paul Volker. Today's central bankers appear smug with satisfaction that QE1
seems to have quieted the credit and liquidity crisis of 2008, and equally thrilled that QE2 succeeded in raising stock prices by 25% from last September and bringing the 10-year treasury rate down to 3%. When the applause dies down and economic sluggishness threatens, QE3 will follow. Runaway debt, runaway money supply; and gold is the investor's most liquid hedge against the inflation surge that lurks around the corner.

What Makes Gold A Currency?
For people to enjoy the benefits of commerce, the economic system absolutely requires a widely accepted standard unit of value that makes it possible for anyone to compare the value of a day's work with the price of a box of Cheerios, a Ralph Lauren dress or a BMW Z4. Gold and silver played that standardization role in countless cultures for at least 4,000 years. In advanced systems, like the Roman Empire, tradable precious metal usually took the form of coins; these were marked with official imprints attesting to their weight and purity.

Eventually, technology ushered in the far more convenient paper currencies with which we are familiar; these of course could be
printed as needed by the regulating authority, creating the potential for some serious conflicts of interest. To minimize such abuse and assure the acceptability of currencies, until the early 1970s all major modern paper currencies accepted and exchanged within the global banking system were undergird by an enforceable gold exchange ratio.

As recounted above, President Nixon, to prevent a run on the Treasury, put an end to the Dollar's gold convertibility in 1971. The other world currencies quickly followed suit. How has that worked out? Well, the proud British Pound Sterling that was once worth a pound of silver changes hands today at US $1.63.

History is littered with the ashes of currencies that have crashed and burned. Without exception, their failures stemmed from abuse by their sponsors. A list of the 20th century's standout currency disasters is headed by the German Mark. Backed by gold until the beginning of WWI, it was replaced by a paper Mark so that war costs and, later, war debts could be managed. After just 5 short years it took 1 billion paper marks to equal 1 original Gold Mark! That's not just inflation, of course, it's hyperinflation.

In our digital age, government currency sponsors don't need clumsy printing presses; a central bank can conjure unlimited
quantities of non-convertible currency with a committee meeting and a few taps on a keyboard. Recently, America has been
tapping un-backed currency into existence at a $1 trillion annual rate. The temptation to increase the supply here and in Europe
seems to have become irresistible, so overwhelming are the credit problems that have built up.

That's where gold comes in. News flash... you can't print gold! It is the only reliable unit of exchange that cannot be increased by government fiat. That's what makes it attractive. It is the standard against which competing paper currencies can be measured and either kept honest or discounted by the marketplace as necessary. One commentator said it very well:
Gold is real money... paper currencies are derivatives of it.

Investment Conclusions
Economic context An often unnoticed part of our responsibility as managers of retirement savings for real people is to keep their asset mix appropriate to the global economic context in which the investments are held. The two most compelling forces affecting that context, and shaping the outlook for this young century are:
a) The sovereign debt crisis in Europe, Japan and the US, and how the governing authorities choose to manage it

b) The extraordinary GDP growth of the less developed economies, whether it is sustainable and how the forces of global trade
eventually play out.

From our study of these forces, we think it is a fair generalization that in the Developed World:
a) Growth is stagnating under the mounting sovereign debt burden; so far, the only political response with any traction seems to be extraordinarily loose monetary policy.

b) The national balance sheets are rapidly deteriorating as governments continue to choose currency debasement as their policy default option.

Given this economic context, we think the odds favor continued abuse of the paper currencies; so, our portfolios are tilted in favor of a future characterized by rising interest rates, rising inflation, and domestic economic growth that is labored at best. Our bond portfolios are dominated by high credit quality issues (mainly corporate obligations) and short maturities to limit our interest rate risk. Our fixedincome positions are supplemented with meaningful investments in gold to protect their buying power.

In our CORE Profile, gold is a 7% position, which equals about 1/5 of our bond exposure. Our more risk-averse IN COME Profile has a larger bond portfolio, so a greater gold allocation seems appropriate.

Gold As An Investment
With respect to the price prospects for gold itself, it needs to be said up front that nobody knows where it will sell next month, next year or ever. Gold is a commodity; a very special one, but a commodity nonetheless. As such, its price tends to be volatile. If stocks and bonds generally were trading at more attractive prices relative to estimated future cash flows, we might have little or no interest in owning gold as an investment. But those two traditional asset classes are, in our opinion, somewhere between expensive and very expensive. We invest in stocks very selectively when we find well-run businesses at attractive valuations.

Our core belief as capitalists is that the two most effective ways for citizens of free countries to cope with the risks of currency
manipulation by the monetary establishment are:

To support the election of candidates most likely to pursue sober and transparent fiscal and monetary policies.

To invest their savings in global, prudently managed, legal businesses. Business, we think, is in the best position to contend with
weak currencies and other threats to prosperity.

We have a saying: "Businesses can adapt, bonds cannot". So, our philosophical bias is toward equities. We regard gold
as a defensive holding that is sometimes necessary... now is one of those times.

As to the specific challenge of valuing gold bullion, James Grant, one of the truly elite money mavens, (www.grantspub.com)
puts it well, we think: "You can't value a non-earning asset, even though you can pretend to. Gold's valuation takes the form
of a fraction: 1/n, where 'n' is the world's confidence in paper currencies and the mandarins who manipulate them." He goes on to say that, "Regrettably, 'n' is not quantifiable."

In a way, that is the essential mystery of gold, isn't it. There is no dependable metric for gold's valuation comparable to a P/E
ratio for a company's stock or the "real" yield on a sovereign bond. The total value of investment gold is, as we have seen above, tiny compared with traditional asset classes, and gold's physical supply tends not to respond very much to price changes the way other commodities do. So, what we have is an asset whose price can change rather dramatically in response to shifts in "currency confidence" which is impossible to quantify.

Inflationary monetary policy is the current fashion in areas accounting for about 2/3 of global  GDP. If that remains the state of
affairs, I think the price risk in gold is less than the risk in stocks as an asset class. If however, a convincing attitudinal conversion should take place among the central bank Pooh-Bahs, confidence in the major currencies could conceivably be resuscitated. I think we ought to assume that such a development would shake out the momentum traders and knock gold's price back to the pre-credit crisis era... a potential setback of about -40% to the $900 oz. area.

But, the potential for an upside price explosion seems to me more than offsetting, especially given the real need to hedge
against runaway inflation because the Executive Branch, the Fed Chairman and the ECB seem dedicated to "stimulus" at almost
any cost. The key to gold's upside is that it is virtually absent from institutional portfolios. John Hathaway of Tocqueville Funds
has often said that if all investors suddenly wanted to own a 1% position in gold bullion, "It's a trade than cannot happen!"

Shayne McGuire is head of research for the giant Teachers Retirement System of Texas. In his wide-ranging new book, "Hard
Money", he makes the point that a typical pension fund has an almost negligible 0.15% position in gold. Gold is not regarded as a major investable asset class on Wall Street today.

The global investment assets of pension funds ($24 trillion), insurance companies ($19 trillion) and mutual funds ($19 trillion) total $62 trillion. To invest 1% of that in gold would mean new demand equal to half the current value of investable gold in the world! If $620 billion of new demand tried to squeeze into a $1,300 billion asset, even without considering the inevitable emotional enthusiasm of traders, it's easy to picture at the very least a 50% price increase to the $2,250 oz. area. Probably more. Possibly a lot more.

A 50% gain would be pleasant, of course, but compared with a downside risk of 40% it's little more than a 50-50 proposition. We value investors are not so easily persuaded. We own gold because the upside potential seems much greater in the (likely) situation where central banks stubbornly cling to their illusion that imaginary money will kick-start the kind of real economic growth we were used to in less-leveraged times.

Rather, we think, the developed world is nearing a very dangerous inflexion point, and this is the environment in which we must invest. Lined up behind the central bank banners of Euroland, the United States, Japan and the UK, we 1.2 billion citizens are a parade of Wiley Coyotes marching mindlessly toward the monetary precipice. If the march is somehow turned back from the edge, we'll be as happy as the next guy. But as unwilling yet rational subjects of the realm, at least we can pack our golden parachute.

As more investors actually do choose gold as their "insurance policy", how high could the price go? It really depends on how
fast the consensus evolves from, "Problem? What problem?" to "Oh, NO!" A chapter in McGuire's book is titled, "How $10k gold is possible". Essentially, the answer is that much of the small total value of all investment gold in the world is made even smaller by the large percentage that is privately owned as a core holding and is not for sale. It seems that this is becoming a larger part of gold's reality. For example, the Teachers Retirement System of Texas recently took physical delivery of $1 billion of gold bullion; you don't lease vault space and take delivery of something you bought for a trade! That bullion is off the market.

For small investors, mutual funds and pension funds, investing in gold used to mean buying gold mining stocks, which have operating risks and often do not respond to rising bullion prices. The creation of gold ETFs in 2003 opened up direct gold investment to the public. Roughly $70 billion of bullion is currently owned in ETF form, but this is a 0.05% drop in the ocean of financial assets. It is less than the market cap of Walt Disney!

Literally thousands of investment funds now have access via ETFs to a new, differentiated asset class from which they were heretofore literally excluded. If and when any kind of consensus begins to develop around the idea that gold is a legitimate asset class, there is the potential for the price to, as they say, "go parabolic".

Think about it. In 1980, central banks held about 60% of their reserves in gold bullion; now, after a couple decades of selling,
gold is down to only 10% of CB reserves. That's not an awful lot of baseline assurance at a time when the authorities are printing money with the express intent of creating price inflation! Even if gold's price doubles, gold as a percent of central bank reserves would still be only 1/3 of what it was when Paul Volker was at the helm!

Could gold reach $3,000 oz.? $5,000? $10,000? Again, we cannot know, but if even 1% of the publicly-traded investment
assets in the world should become earmarked for gold bullion, that would represent new demand in excess of $1.4 trillion. That's an awfully large number compared with the $70 billion currently parked in gold ETFs, the easiest way for investment companies to own gold. And it's twice the current value of all the investment gold in the world that might be for sale (assuming about half is long-term, private core holdings.)

With paper money coming under increasing scrutiny, we like the appreciation potential of the real thing!

The FAI Strategy
Our gold strategy is simple (and subject to revision at any time!) We have a core gold allocation for each of our three Risk Profiles, largely based on each Profile's exposure to fixed income securities. A gold price correction to about $1,200 would make us a buyer unless we have reason to believe that fiscal and monetary policy is improving. If gold rises 50%, we will consider initiating a profit-taking program of rebalancing back to the core allocation, and we'd keep doing that until either the price is
ridiculous or stocks and bonds are more attractive.