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February 22, 2013

Too risky to dump gold now

Global economics and markets are still full of risks that are yet to materialise. This makes gold relevant as an insurance asset.

The spot price of gold has dropped to below 1600 dollars per ounce. It was once within touching distance of 2000 dollars per ounce. Since then, it has had its moments but has been unable to break above that number. Many say that the gold bull-run that began in 2002 is over. They are ready to conduct a requiem for gold. Gold bulls should be pleased. They have to hold their nerve and wait for this phase to end, for this too shall pass.

This column explains why. We did not see gold as an investment asset but as an insurance asset. The value of insurance rises or falls with the perception of risk that is being insured. If the risk materialised, the insurance contract compensates. If it did not, the insurance contract would expire. Gold plays that role. That role is relevant and still needed. In our mind, that is clear. Global economics and markets are still full of risks that are yet to materialise.

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Financial market investors, on the other hand, are confused as to how they wish to treat gold. They buy up gold when there is threat of inflation from quantitative easing measures. When they become risk-averse, they move to the US dollar. When they are positive on non-inflationary growth and on risky assets in general, they do not buy gold. They are happy to migrate into other risky assets and sell gold. That is what is happening now.

According to investors, quantitative easing is old news. It does not seem to have brought higher prices for goods and services (what is commonly known as inflation). The world is stable. Eurozone appears to have stabilised. Therefore, in a world of non-inflationary economic expansion, the best assets to own are stocks and other risky assets but not commodities.

Here is the simple cheat-sheet that they use:

Cheat_sheet

Investors think that the state of the world now is State 3 above. Hence, the yield on the 10-year US Treasury is now 1.97 percent (up from 1.4 percent in July 2012) and gold has dropped below 1600 dollars per ounce. The question is whether this assessment of the market is correct. Yours Truly disagrees with confidence.

We feel that financial markets reflect investors’ euphoria precisely at the time when asset prices appear closer to their peak and not at the bottom. Retail investors in the US have remained fearful of equities as it advanced from the lows of March 2009 but have piled into it in the last few months, after stocks have rallied more than 120 percent (S&P 500). Fund managers concede that junk bond yields are too low and yet feel compelled to hold on to them for the sake of higher yields. In doing so, they are showing the same tendencies as retail investors do: ignore risks in their quest for yield. On a risk-adjusted basis, yields on many risky assets have fallen to very low levels simply because their prices have gone up too much.

In general, financial assets become less risky as prices drop. They become riskier as their prices rise.  This is seemingly counter-intuitive but not hard to grasp. As stock prices drop, there is a clear floor. They cannot drop below zero. The closer they come to zero the risk of further price decline diminishes. It is as simple as that. That calls for counter-cyclical behaviour on the part of investors – trimming holdings of risky assets as they rise in value and accumulating them as they drop in price. However, investors do the opposite. They buy when prices rise and sell when prices drop. This is irrational but it is not about to change any time soon. Retail investors are buying stocks after they have more than doubled in the last four years.

This pro-cyclical behaviour makes financial markets inherently unstable. When the oil of loose money fuels this unstable fire of pro-cyclical investments, the result is exaggerated rise and fall in asset prices. We are about to experience one more any time soon. The trigger could be any of the following or something else completely unexpected. The key point is that assets are not priced for bad news.

Europe is far from stable. French economy is weakening. Smaller Northern European countries (The Netherlands and Finland) are already in recession. Italian elections may result in a fractured outcome. The US economy is muddling through. China has been unable to shake off its addiction to credit. Japan is about to launch a policy experiment whose outcomes and unintended consequences are hard to predict. Growth in India has dropped off the cliff and does not appear to have found a bottom yet. Economic growth in Korea has slowed to 1.5 percent at the end of 2012.  Indonesia is overheating.

As and when investors wake up from their reverie, financial assets will fall because investors will realize that the world is long way from being safe. All that has happened is that easy money has generated a false sense of well-being as it has done before. Both governments and investors duck the hard questions. Hence, the biggest disservice easy money has done is to turn investors into unquestioning lambs (being led to their slaughter), incapable of applying their mind critically and assessing their investment world for opportunities and risks.

In short, the insurance role of gold has not vanished. It is very much there. Investors perceive, wrongly, that risks have diminished. When they realise their folly, gold will resume its rise. Gold has gone through similar phases in 2004 and in 2005. The first three quarters of 2004 and 2005 saw gold drop and struggling to stay near previous peaks. The job of gold in protecting the ignorant, the uninformed and the naïve from their follies is far from over.

Photo: Mark McLaughlin


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