Jul 312015

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.