Hans Christian Andersen and gold: Are the new gold bulls modern day weavers?
In Hans Christian Andersen’s wonderful tale, “The Emperor’s New Clothes,” a couple of weavers promise the Emperor a new suit of clothes made from the most magnificent cloth imaginable. Beautiful and elaborate, the clothes would also have the special trait of being invisible to anyone who was stupid or not fit to view its splendor. The weavers continued to get paid more and more as they described to all of the Emperor’s officials who came by to check on the progress all of the intricate details and exquisite colors. While the officials saw nothing, none spoke up for fear of being stupid or unfit. Eventually, the Emperor himself sung the glorious praises of his new clothes that he could not even see lest he expose himself as unfit to be Emperor. Finally, during a great procession, the Emperor paraded himself naked through town with all the people extolling and cheering the virtues of his splendid new clothes until suddenly a little child shouted out, “But he hasn’t got anything on!” This led to whispers, and eventually all the people were saying, “He hasn’t got anything on!”
Lately, we’ve been reading a lot of bullish rhetoric about gold. Much smarter investors (and likely smarter people) than myself such as David Einhorn, Paul Tudor Jones, and John Paulson have each made outsized, well-publicized bets on the rise in the price of gold, and several hedge funds have even created share classes denominated in gold. The world’s largest gold producer, Barrick Gold Corp., recently announced it had eliminated all of its gold hedges in order to gain as much leverage as possible to the price of gold. Current broad sentiment on gold has been extremely bullish by almost any measure as can be seen here, and central banks have been big buyers as well. All of this has me thinking.
For nearly 15 years I worked for the brilliant market prognosticator Dr. Marty Zweig, where I was Co-Director of Research and did considerable work on our various models that determined asset allocations, etc. One of our core models was our Sentiment Model, which was contrarian in nature and would look for cases of extreme sentiment in one direction as a great opportunity to exploit a move in the opposite direction. A right of passage for any young analyst starting at Zweig was reading and grading on a very bearish to very bullish scale a multitude of newsletters to identify periods when the so-called “experts” were all aligned in one direction (they were nearly always wrong). The approach is remarkably intuitive (bearish sentiment means lots of cash on the outside that could move in on any positive news and vice-versa) – to learn more you can buy his terrific book, “Winning on Wall Street”. The model worked particular well at the poles. It is difficult to argue that we are not at or rapidly approaching a pole with respect to bullish gold sentiment. Witness the following chart showing daily volumes for SPDR Gold Shares (and the SPDR Gold Trust as a result has accumulated more metal than Switzerland’s central bank):
But sentiment (and 5000 years of history, for that matter) aside, I still can’t rationalize why in today’s world so many people, hedge fund managers (I know, I know – they’re people too), central banks, etc., would want to own large amounts of gold. I’ve talked to some colleagues whose investing acumen I respect, have read some articles and have done some research, but I still find myself wondering.
Many talk about gold as an inflation hedge, and while empirical evidence can be interpreted both for and against its effectiveness as a hedge – a challenging exercise since the price of gold here remained fixed at $20.67 for about 100 years and then $35 from 1934 up until the 70s – I would suspect that in this age of more and more sophisticated contingent claims wouldn’t there be much more precise and less speculative ways to hedge inflation such as these.
The argument of gold as a currency is a little more interesting. Central banks have been buying gold of late and may indeed become net buyers in the near future as the dollar by comparison appears more and more to be an inferior holding. So while gold no longer backs currencies, it is still regularly used to diversify fiat currency holdings. But as gold prices, already quite high, continue higher wouldn’t buying gold become incrementally less appealing? And how does a country with a reserve the size of, say, China’s attempt to diversify in any meaningful way into a supply-constrained asset without impacting the asset to such a degree that it loses the majority of its appeal?
The supply constraint argument may be the most compelling. There are only about 160,000 tonnes of gold that have ever been removed from the earth and this number is expanding at only 1.6% per annum. Money, by contrast, is expanding at a much greater rate right now as money will begin to lose its purchasing power. The supply-side argument makes enough sense in as much as I can see that current gold supply is limited and growing at a far slower rate than money supply, but it’s the whole demand thing that is a bit ambiguous to me since most of the demand appears to be driven by the constrained supply in what becomes something of a virtuous circle: a dynamic being driven in part by a lot of the rhetoric currently extolling gold’s virtues.
This gives me a great idea. If the supply constraint is really the driving force, why don’t we create a vehicle that removes this whole sticky demand and utility thing altogether? We’ll call the units Supply Constrained Assets Minus Any Real Utility or SCAMARUs.
Initially, we’ll only create 160,000 units and the only characteristics these units need to have is that the float can only grow by 1.5% a year maximum and that they oughtn’t be hard since hard assets tend to have some real utility, and we want to keep these babies pure and devoid of any worthwhile use vs. the current hard assets that people currently use to hedge inflation. For instance, steel is quite hard and that comes in handy with respect to building cars, infrastructure, skyscrapers, bridges, appliances, etc. Gold is also hard and gold can be used for fine jewelry, and (pausing…), and, hmmm… well there’s NFL superstar Chris Johnson’s teeth and this gorgeous Vertu cell phone, and… come to think of it, maybe my SCAMARU idea is not so differentiated after all. Wait – I did think of one other thing… The Emperor’s New Clothes were weaved from gold!!! Where’s that little boy when you need him?
December 16, 2009 at 3:13 am
If you believe the dollar will continue to fall in value and trading patterns don’t support moving into euros, Gold is a short-term hedge I suppose. But in terms of creating global wealth, expanding commerce and providing the liquidity that expanding global trade requires, it makes as much sense as going back to Mercantalism as an economic philosophy.
December 17, 2009 at 6:37 pm
When I read about your take on gold, I thought about the value of equity research itself and its supply considerations. While “equity research” as a unit has unlimited supply, would the value of that research be greatly diminished if it found its way into the hands of a lot of people? In that way, it seems to act like money supply. While access to research can be cut off through higher subscription fees, perhaps the market is doing right by cutting off the access to money supply by dropping its value. I think America needs to invest in venture capital and idea generation as a real hedge against mediocrity and perhaps not in gold, as you rightly pointed out.
December 22, 2009 at 2:11 am
If you believe the dollar will continue to fall in value and trading patterns don’t support moving into euros, Gold is a short-term hedge I suppose. But in terms of creating global wealth, expanding commerce and providing the liquidity that expanding global trade requires, it makes as much sense as going back to Mercantalism as an economic philosophy.
December 22, 2009 at 2:12 am
But sentiment (and 5000 years of history, for that matter) aside, I still can’t rationalize why in today’s world so many people, hedge fund managers (I know, I know – they’re people too), central banks, etc., would want to own large amounts of gold. I’ve talked to some colleagues whose investing acumen I respect, have read some articles and have done some research, but I still find myself wondering.
Many talk about gold as an inflation hedge, and while empirical evidence can be interpreted both for and against its effectiveness as a hedge – a challenging exercise since the price of gold here remained fixed at $20.67 for about 100 years and then $35 from 1934 up until the 70s – I would suspect that in this age of more and more sophisticated contingent claims wouldn’t there be much more precise and less speculative ways to hedge inflation such as these.
The argument of gold as a currency is a little more interesting. Central banks have been buying gold of late and may indeed become net buyers in the near future as the dollar by comparison appears more and more to be an inferior holding. So while gold no longer backs currencies, it is still regularly used to diversify fiat currency holdings. But as gold prices, already quite high, continue higher wouldn’t buying gold become incrementally less appealing? And how does a country with a reserve the size of, say, China’s attempt to diversify in any meaningful way into a supply-constrained asset without impacting the asset to such a degree that it loses the majority of its appeal?
The supply constraint argument may be the most compelling. There are only about 160,000 tonnes of gold that have ever been removed from the earth and this number is expanding at only 1.6% per annum. Money, by contrast, is expanding at a much greater rate right now as money will begin to lose its purchasing power. The supply-side argument makes enough sense in as much as I can see that current gold supply is limited and growing at a far slower rate than money supply, but it’s the whole demand thing that is a bit ambiguous to me since most of the demand appears to be driven by the constrained supply in what becomes something of a virtuous circle: a dynamic being driven in part by a lot of the rhetoric currently extolling gold’s virtues.
This gives me a great idea. If the supply constraint is really the driving force, why don’t we create a vehicle that removes this whole sticky demand and utility thing altogether? We’ll call the units Supply Constrained Assets Minus Any Real Utility or SCAMARUs.
Initially, we’ll only create 160,000 units and the only characteristics these units need to have is that the float can only grow by 1.5% a year maximum and that they oughtn’t be hard since hard assets tend to have some real utility, and we want to keep these babies pure and devoid of any worthwhile use vs. the current hard assets that people currently use to hedge inflation. For instance, steel is quite hard and that comes in handy with respect to building cars, infrastructure, skyscrapers, bridges, appliances, etc. Gold is also hard and gold can be used for fine jewelry, and (pausing…), and, hmmm… well there’s NFL superstar Chris Johnson’s teeth and this gorgeous Vertu cell phone, and… come to think of it, maybe my SCAMARU idea is not so differentiated after all. Wait – I did think of one other thing… The Emperor’s New Clothes were weaved from gold!!! Where’s that little boy when you need him?
December 22, 2009 at 6:42 pm
When I read about your take on gold, I thought about the value of equity research itself and its supply considerations. While “equity research” as a unit has unlimited supply, would the value of that research be greatly diminished if it found its way into the hands of a lot of people? In that way, it seems to act like money supply. While access to research can be cut off through higher subscription fees, perhaps the market is doing right by cutting off the access to money supply by dropping its value. I think America needs to invest in venture capital and idea generation as a real hedge against mediocrity and perhaps not in gold, as you rightly pointed out.If you believe the dollar will continue to fall in value and trading patterns don’t support moving into euros, Gold is a short-term hedge I suppose. But in terms of creating global wealth, expanding commerce and providing the liquidity that expanding global trade requires, it makes as much sense as going back to Mercantalism as an economic philosophy.But sentiment (and 5000 years of history, for that matter) aside, I still can’t rationalize why in today’s world so many people, hedge fund managers (I know, I know – they’re people too), central banks, etc., would want to own large amounts of gold. I’ve talked to some colleagues whose investing acumen I respect, have read some articles and have done some research, but I still find myself wondering.
Many talk about gold as an inflation hedge, and while empirical evidence can be interpreted both for and against its effectiveness as a hedge – a challenging exercise since the price of gold here remained fixed at $20.67 for about 100 years and then $35 from 1934 up until the 70s – I would suspect that in this age of more and more sophisticated contingent claims wouldn’t there be much more precise and less speculative ways to hedge inflation such as these.
The argument of gold as a currency is a little more interesting. Central banks have been buying gold of late and may indeed become net buyers in the near future as the dollar by comparison appears more and more to be an inferior holding. So while gold no longer backs currencies, it is still regularly used to diversify fiat currency holdings. But as gold prices, already quite high, continue higher wouldn’t buying gold become incrementally less appealing? And how does a country with a reserve the size of, say, China’s attempt to diversify in any meaningful way into a supply-constrained asset without impacting the asset to such a degree that it loses the majority of its appeal?
The supply constraint argument may be the most compelling. There are only about 160,000 tonnes of gold that have ever been removed from the earth and this number is expanding at only 1.6% per annum. Money, by contrast, is expanding at a much greater rate right now as money will begin to lose its purchasing power. The supply-side argument makes enough sense in as much as I can see that current gold supply is limited and growing at a far slower rate than money supply, but it’s the whole demand thing that is a bit ambiguous to me since most of the demand appears to be driven by the constrained supply in what becomes something of a virtuous circle: a dynamic being driven in part by a lot of the rhetoric currently extolling gold’s virtues.
This gives me a great idea. If the supply constraint is really the driving force, why don’t we create a vehicle that removes this whole sticky demand and utility thing altogether? We’ll call the units Supply Constrained Assets Minus Any Real Utility or SCAMARUs.
Initially, we’ll only create 160,000 units and the only characteristics these units need to have is that the float can only grow by 1.5% a year maximum and that they oughtn’t be hard since hard assets tend to have some real utility, and we want to keep these babies pure and devoid of any worthwhile use vs. the current hard assets that people currently use to hedge inflation. For instance, steel is quite hard and that comes in handy with respect to building cars, infrastructure, skyscrapers, bridges, appliances, etc. Gold is also hard and gold can be used for fine jewelry, and (pausing…), and, hmmm… well there’s NFL superstar Chris Johnson’s teeth and this gorgeous Vertu cell phone, and… come to think of it, maybe my SCAMARU idea is not so differentiated after all. Wait – I did think of one other thing… The Emperor’s New Clothes were weaved from gold!!! Where’s that little boy when you need him?