Michael Pettis argues that a market dominated by speculators tends to be more volatile as it is sensitive to changes (in consensus) in the way news is interpreted. If gold is entirely a speculative market, as I argued in Friday’s post, then we should see high volatility. While gold is more volatile than many other assets and currencies, it is not as excessive as we would expect based on Pettis’ theory. Why is this? I think it is because it is difficult for gold speculators to converge on a consensus view.
Divergence of Convergences
While I agree that the game theory-ish Keynesian beauty contest means speculators will converge on a view of a market, gold is composed of a number of groups with fundamentally divergent frameworks through which they view gold. A US Hedge Fund has a completely different view of gold compared to an Indian farmer, for example. Furthermore, many of these groups do not have a game theory approach – if you mentioned to an Indian farmer whether he is considering what all gold investors think about how all gold investors view gold, he would say “what the?” If participants are not aware of beauty contest dynamics then convergence doesn’t occur.
Note that within each group there is a convergence or agreement about how to view gold and when to buy it, there are just divergences between each group. Hence we have lower volatility as each group’s differing view counterbalance. The above implies that a savvy investor needs to implement a modified beauty contest: identify groups unaware of such game centric thinking and estimate their view of gold then identify game aware groups and then work out their view of the unaware groups plus their view of what game aware groups think other game aware groups think. Confused? No wonder no one can agree on gold.
In the latest World Gold Council (WGC) Gold Investor report they say break down the “drivers of gold into key factors: currencies, inflation/deflation, interest rates, consumer spending and income growth, systemic and tail risks, and supply-side factors.” Plenty of areas for divergent views. In addition, the WGC then point out that gold is a global market, so each of those factors differ between countries. I would argue that even if every gold market participant was playing a Keynesian beauty contest there is no way that with such a wide variety of factors to consider, and difficulty for the participants to communicate/signal their view, could any convergence occur.
Divergence Over Time
Adding to the complexity of the gold market is the fact that its structure is changing. As an example, it used to be that Western retail investors would run away when gold dropped significantly, but on the big drops in 2013 and 2015 we saw big surges in buying. Another example – consider the following two charts from the WGC Gold Investor report.
As the make up of participants in the gold market changes, then their influence on gold changes as well. WGC also makes good points on how conventional (ie Western professional investor) views about the influence of the US dollar and real interest rates on gold may be wrong.
I think the result of the above may explain why gold has no correlation to many asset classes. In the chart below from the WGC the correlations in red are not (statistically) significantly different from zero.
Those assets with zero correlation to gold are basically equities and debt; the positive ones being commodities, and the big negative the dollar. It shows that there is no consensus about how gold should relate to equities and debt.
Current Market Situation
While I have been arguing that gold is basically a highly divergent market, at the moment I think there is a dangerous convergence on the idea that gold will continue to fall, certainly in the Western markets (as discussed here) but this would also affect sentiment in other markets. It seems to be primarily driven by narratives around US interest rate rises as signalled by the Fed. On that I’ll leave you with this from Pettis’ article, modified to suit the current gold market:
“In this market, you [sell] because you believe that everyone has agreed on the collective interpretation of government signaling. Anything that undermines the confidence you have in the collective interpretation must undermine your decision to [sell], and in fact because everyone is watching everyone else, at some point, this can become a collective decision to [buy].”