16 December 2014
How I Learned to Stop Worrying and Love the Gold
Bullion Baron had an excellent post out last Monday on how cash is not some bedrock asset without risk, based on a Barry Ritholtz statement that it is a huge investment mistake to hold an asset which you can never envisage selling. On the assumption you've read the post including comments by Cullen Roche and Kid Dynamite, here are some thoughts.
Cullen's comments that you hedge your equity exposure with non-correlated assets (excluding gold), options and insurance misses the point. He says these "provide you with a certain future value in the case of catastrophe" but I think his definition of catastrophe differs markedly from that of gold investors. His hedges are just promises, which to gold investors are likely to fail in a real catastrophe. Cullen, who represents the views of Mainstream Investor Adults (MIAs), only envisages a catastrophe sufficient to cause significant damage to his portfolio, but not that much that the insurance contracts wont be honoured. Convenient. MIAs are doing a Barry: saying that there is nothing that would change their view that their proposed insurance promises will not work. They are effectively dismissing Kid Dynamite's scenario of "when people are *desperate* to allocated out of cash", that is, hyperinflation.
OK, so MIAs sees zero chance of SHTF, so they holds zero gold - that is logically consistent. But the only way this makes any sense to me is if MIAs believe that financial panics will not get out of hand because government or central bankers will do something to prevent it. I guess the lack of a complete breakdown after the financial crisis gives MIAs a reason for this view, and gold investors would have to concede that. However, readers of this blog, as diverse and disagreeing as we are, would all argue I bet that the underlying problems are not fixed. Maybe some new Committee to Save the World will come along and get us out of the next blow up, but gold investors don't see a zero chance of no blow up, so they don't hold zero gold. How much depends on how confident they are in these masters of the universe.
Side Note: I think it is interesting that MIAs who put their faith/trust in governments and central bankers to manage the economy, and not gold, don't see the contradiction in the fact that those very governments and central bankers hold gold themselves. If gold is such a stupid investment, doesn't that make governments and central bankers stupid? In which case you shouldn't trust them. In which case you need some gold.
Cullen/MIAs then argue that gold is a poor form of insurance because its value is extremely volatile and uncertain. Volatile and uncertain - I couldn't agree more. This is what you should expect from an asset that reflects the sum total views of the market about the likelihood of governments and central bankers losing control. That is a very difficult thing to analyse and come to a view on so we should expect diverse views on the matter, and the whipsawing in the gold price reflects the changing balance of sentiment between MIAs and, dare I say, the less naïve. As an aside, I would note that WGC research shows that gold can reduce the volatility of a portfolio without sacrificing returns and also help to reduce potential losses for tail risks, but lets stick to the facts here.
Anyway, even if gold has no benefits for portfolios during normal times and the occasional (recoverable from) tail risks, and as such is a poor investment, what MIAs miss is that gold will perform in a real catastrophe. Putting up with gold's volatility is something the buy-gold-for-insurance investors do for that hedge. Whilst MIAs may see gold's value as too volatile and uncertain, I'd suggest that we can be certain gold will be valued during catastrophes. This because the narrative (there I go again with Ben Hunt) or common knowledge around gold is that it is a safe haven in such extreme circumstances: everybody knows that everybody knows gold is where you run to when the SHTF. MIAs think this is a "faith put", that it is a myth that gold "warrants a price premium well above its cost of production". That is very logical, but we aren't talking logic here, we are talking human behaviour, perception and belief.
I can understand why MIAs who analyse stocks and bonds using hard numbers find this too fuzzy. Indeed some goldbugs who read this blog find Ben Hunt's work too wishy-washy. I am a hard numbers person myself, but surely the MIAs will concede that markets can be irrational (Dot Com, QED)? In which case, I know that when people get fearful they will run to gold. Irrational? Maybe, but rational me accepted that gold will "work", when I need it to. So just get over it and Learn to Stop Worrying (about its irrational volatility) and Love the Gold*.