I have written before on how gold is a pure epsilon asset and driven by narratives.
This article by Michael Pettis takes a similar approach to China’s recent
stock market problems but he makes a number of observations that apply
to markets in general. I think these observations have application to gold in
general as well as the current state of the gold market.
Michael notes that there are two types of players in markets – value
investors and speculators. He says that markets dominated by one or the other
type will generally behave differently.
A Market Dominated by Value Investors – Value investors
base their decision to buy or sell on their interpretation of a piece of
news. Because value investors generally vary widely in their investment
strategies and interpretation, “small changes in the way news is
interpreted or in market sentiment will have a limited impact on overall
supply or demand” and thus prices.
A Market Dominated by Speculators – Speculators base
their decision to buy or sell on their expectation of the collective
interpretation of a piece of news. Because of the dynamics of the Keynesian
beauty contest, in general speculator expectations “tends to converge
very quickly” with the result being that “a market dominated by
speculators is extremely sensitive to changes in the way news is interpreted
or in market sentiment.”
Michael’s point is that where you have convergence, you will have
higher volatility. Markets dominated by speculators will, as a
result, generally be more volatile. A market dominated
by value investors will generally have a wide range of views
and be less volatile.
However, it is also possible for a convergence in investment strategies to
occur (which he argues is happening in China today) making a value dominated
market liable to explosions in volatility. It is also possible for a
speculator dominated market to have uncertainty as such high levels that it
undermines “the ability of speculators to agree collectively on how to
interpret signals” resulting in a wide range of views and thus less
volatility (but the potential for a big move once consensus returns).
Michael’s next point is worth a bulk quote:
“volatility can never be eliminated. Volatility in one variable can be
suppressed, but only by increasing volatility in another variable or by
suppressing it temporarily in exchange for a more disruptive adjustment at
some point in the future. When it comes to monetary volatility, for example,
whether it is exchange rate volatility or interest rate and money supply
volatility, [or gold volatility?] central banks can famously
choose to control the former in exchange for greater volatility in the
latter, or to control the latter in exchange for greater volatility in the
former. Regulators can never choose how much volatility they will permit, in
other words. At best, they might choose the form of volatility they least
prefer, and try to control it, but this is almost always a political choice
and not an economic one. It is about deciding which economic group will bear
the cost of volatility.”
The reason I found Michael’s article of interest is because I believe that
gold is a market dominated by speculators. By that I don’t just mean evil
Comex shorts – all gold holders are speculators. This is what I mean when I
say that gold is a pure epsilon asset. That is not to say that we are
all gamblers, betting on whether gold’s price will go up or down. In
Michael’s conception “speculator” means one who is looking at consensus
of what the market thinks, what sentiment is.
Don’t think you are a speculator? Then that means you must be a value
investor. But to apply the concept of value investor to gold is to argue
that gold has an objective or fundamental value. I don’t see how that is
possible for an asset with such a large overhang of stock compared to annual
flow, where the withholding of supply by existing holders matters most (as I
argue here).
I don’t see how that is possible for an asset that is not productive, that
is, does not earn an income. Even for that rare group who can lend physical
gold, it is not the gold that is productive, it is the use to which it is put
that helps to determine its interest rate (you can’t value a dollar by
discounting the cash flows of its interest).
While value investors may disagree between themselves on what a company’s
future ongoing earnings will be, they all agree that the method of arriving
at “value” is to discount those earnings. But for gold no such discounting is
possible. All these “fair value” models of gold, when you look at them are
formulas based on correlations to other assets or macro economic
variables like interest rates, inflation, etc (eg here and here).
No value investor values Apple with a formula based purely on
relationships to macro economic variables, simplistically they estimate
current and future phone sales etc and the resulting profit.
Understanding whether gold is a value or speculative dominated market is
crucial for the rest of my argument, so I’ll leave it there for now as I’m
sure I’ll get some disagreement about gold being purely speculative/narrative
driven and it might be best to let that discussion play out. If you think
gold has a fundamental value, then please tell us what it is and the logic of
your calculation. I’m ready to be convinced. On Monday I’ll
continue with applying Michael’s ideas to gold and what it means for
where we are now.
