Outside the Box

How Gold Lost Its Luster, How the All-Weather Fund Got Wet, and Other Just-So Stories

July 3, 2013

We have not revisited the topic of gold in Outside the Box recently, mostly due to the fact that nearly everything I read on the subject is derivative of what I have been reading for years. There hasn't been much that would cause me to think about gold in a different way, and that is the purpose of Outside the Box: to present new perspectives and make us think.

I have recently started to read the work of Ben Hunt at Epsilon Theory. His ideas are interesting in that he examines markets from a behavioral economics perspective, with ample doses of game theory and history, a combination that few people can bring to the table. (In a random but pleasant development, I will get to have lunch with him next week in Dallas when he visits my town. I look forward to it.)

I have read this piece twice and expect to look at it a few more times. He leads off with some interesting thoughts on the role and significance of sweeping social narratives, and in particular the "Narrative of Gold," but there is more than thinking on gold in today’s Outside the Box. Pure gold bugs will be annoyed, but since I am neither gold bug nor pure, I find this a very useful essay. A small taste –

The source of gold’s meaning, whether you are a market participant in 1895 or 2013, comes from the Common Knowledge regarding gold. J.P. Morgan said that gold is money, and he was right, but only because at the time he said it everyone believed that everyone believed that gold is money. Today that same statement is wrong, but only because no one believes that everyone believes that gold is money….

To market participants in 2013 gold means lack of confidence in money, and their behavior in buying and selling gold similarly reflects this meaning. Buying gold today is a statement that you believe that global economic events may spiral out of the control of Central Bankers. It is insurance against some sort of massive monetary policy mistake that cannot be fixed without re-conceptualizing the global economic regime – hyperinflation in a developed nation, the collapse of the Euro, something like that – not an expression of a commonly shared belief in some inherent value of gold.

Thus the Narrative of Gold is still significant, but mostly in contrast to the narrative that has assumed primacy today: the Narrative of Central Banker Omnipotence. Like all effective narratives, says Ben, this one is simple: central bank policy will determine market outcomes.

Then Ben makes a crucial point:

You may privately believe that J.P. Morgan is still right, that gold has meaning as a store of value. But if you participate in the market on the basis of that belief, then you will buy and sell gold in an incredibly inefficient manner. You would be a smart gold investor in 1895, but a poor gold investor today.

This is some of the best, most fundamental thinking about gold that I have seen. But Ben's thesis is larger than that. He wants to understand the manner in which historical correlations and correlation-based investment strategies come under tremendous stress in markets undergoing structural change. "I get VERY nervous," he says,

when I am told that … a socially constructed behavior such as the assignment of value to highly symbolic securities is "timeless and universal", particularly when the composition and preference functions of major market participants are clearly shifting, particularly when monetary policy is both massively sized and highly experimental, particularly when political fragmentation is rampant within and between every nation on earth.

I am back in Dallas after a long and very tiring trip. I think I overreached in terms of what I tried to do on the trip, and on my return I find myself as exhausted as I have ever been, on top of which I seem to have picked up a nasty virus somewhere along the way. Not that I did not enjoy every moment. Cyprus , Croatia, Switzerland, even France were all fascinating, with so many good times and meetings. I think I need to try and cram less into the schedule. That might mean a personality change is in order, as trying to do too much is one of my real weaknesses. So much opportunity, so little time. A little zen focus might be in order.

And now, I suggest you read Ben Hunt’s essay and appreciate his take on narrative. Have a great week, and for my US readers, enjoy the Fourth of July. I am off to the optometrist now to find out why I'm having such trouble focusing my eyes. I had laser surgery some 15 years ago, and they said it would last about 10 years, so my “sell-by” date is long past. The problem has slowly been getting worse and now demands to be dealt with.

Your thinking about multiple points of focus analyst,

John Mauldin, Editor
Outside the Box

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How Gold Lost Its Luster, How the All-Weather Fund Got Wet, and Other Just-So Stories

By Ben Hunt

"Gold is money. Everything else is credit."
John Pierpont Morgan

"The relationships of asset performance to growth and inflation are reliable – indeed, timeless and universal – and knowable, rooted in the durations and sources of variability of the assets' cash flows."
Bob Prince, Co-Chief Investment Officer,…

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July 28, 2013, 5:34 a.m.

I’m sorry. You lost me when you wrote:

“J.P. Morgan said that gold is money, and he was right, but only because at the time he said it everyone believed that everyone believed that gold is money. Today that same statement is wrong, but only because no one believes that everyone believes that gold is money.”

Look. Gold has a history of 6000 years to our present knowledge. Gold has been fought over, died for, and even worshipped since then. Why would anyone think this has suddenly changed? Because of JP Morgan, Ben Bernanke, or the advent of the Internet? Don’t think so. These might be important in our minds if we think that the world started 100 years ago. It didn’t.

Nothing on the earth (or elsewhere) has value unless someone thinks it does. Gold would not be mined unless enough people want it. There would be a run on banks if enough people think that their paper is going to be worthless. Food would not be produced unless people needed to eat. Oil would be more or less worthless if we did not have the combustion engine. Things are as they are. Gold has ALWAYS been believed to have a value. Why? Because it has properties which are unique, or better than other elements, and a very special one - it does not tarnish (think about that one). It has even found its way into state of the art medicine because of these properties. The Aztecs certainly didn’t know that about gold back then, but they knew a good thing when they saw it. Strangely enough, the Conquistadors did too.

Now, one might argue about the price of the product, but a starting point must be how much paper currency one needs to get it into your possession. For this, about US$1400 is the current norm. There are mines producing for much less, I know, but these are volatile places, with miners being paid a pittance, and just getting it to the surface is not the finish line. One has to look at R+D, i.e. finding more resources.

The problem with gold currently is quite simple. There is not the amount available to match the amount bought. How much that shortfall is, I have no idea, but common sense would tell me that it is a cavernous gap. There have been enormous puts on the ETFs, which are only 6% of the gold market, to force the price down so that physical gold can be bought at under a reasonable market price. One only needs to look at the charts of Monday mornings from Chavezs’ demand for gold to be repatriated to Venezuela, until the price capitulation a month ago, to see that. At the same time, physical gold has been bought, not sold (from market makers, that is). It doesn’t take JP Morgan to work out that something stinks in the State of Denmark. I am not being a conspiracy merchant here, just simple arithmetic. The 300 tonnes that Germany wants back will take 7 years to buy in. That means that when the world gets its calculator out, the price for the actual physical element will exceed US$1400. By how much, I do not know, but like the Aztecs, Pharaohs, Moguls, emperors, kings and pirates, I know a good thing when I see it! And I hope I am ready for the Conquistadors!

Paul Harris-Lowe

July 10, 2013, 10:07 a.m.

Dear Mr. Mauldin:  Ben Hunt’s article was very interesting.  The concept “everyone believes that everyone believes….” is extremely thought-provoking.  One concept that I’m surprised hasn’t been explored in more detail is valuing the S&P500; against gold instead of dollars.  When you divide the S&P500; value by the value of gold you’ll see a graphic that coincides nicely with secular bear and bull markets. 

Using Mr. Hunts concept I believe “Everyone believes that everyone believes the US economy is central to global economics and there is a time when ‘big money’ views gold as cheap or expensive relative to the US economy.”  We saw a similar ‘dead cat’ bounce in 1975 and 1976 but there is no getting away from the idea gold has become expenseive relative to the S&P and long-term money is looking to sell gold and buy US stocks.

Bob VanTassell

July 8, 2013, 4:15 p.m.

Grant Williams nailed it a few months ago when he explained that gold fell double digits percent in two days because someone (Big Banks, Central Banks) sold mega-tons of gold on Friday, WHILE THE LONDON exchange was DOWN, so that London players came in Monday morning to margin calls. 

To make this trade profitable, one would either have to have massive short positions (Big Banks, part of the Fed?) or an asset (dollars or yen), which Look Better when gold is beaten down. 

Since I believe the Fed and other Central Banks manipulate markets, I am a fool to own the gold and silver I own.  A couple of green MBA’s with some good algorithms and deep pockets at Goldman Sachs can keep PM’s and the PM miners down forever.  I only wonder why they didn’t do it years before. 

Ronald Nimmo

July 8, 2013, 5:16 a.m.

This article is a very interesting and potentially useful psychological analysis, but the following statement about gold contains some sheer nonsense:

Gold is the most pronounced example of an asset with a mutable behavioral foundation because for all practical purposes there is no practical use for gold. It’s pretty and shiny and relatively rare, but so are a lot of things.

Gold has incredibly numerous and important practical uses, which is what made it valuable in the first place. It is one of the most chemically non-reactive of the metallic elements; it never rusts or tarnishes. It is extremely malleable and ductile because of it’s incredible tensile strength. It is the most desirable substance of all for dental work and jewelry because of these qualities. It is an excellent electrical conductor, surpassed (as metallic elements) only by copper and silver, and it’s uses for electrical and electronic connections is enhanced exponentially by the fact that it does not corrode, making it an extremely reliable connector. For applications with a high cost of failure, such as jet aircraft electronic and electrical connections, it’s use is mandatory.
  It is really somewhat astounding that Mr. Hunt would write an article about the inherent value (or lack thereof) of gold without acquiring a tiny modicum of knowledge about the properties and uses of the metal.

John B. Robb

July 6, 2013, 8:43 a.m.

Dear Mr. Mauldin: I just read the piece by Ben Hunt and while I found it provocative, there are a number of reasons why I don’t take it seriously.  Since you are still accumulating gold yourself, you presumably don’t either.  But it is interestingly indicative of every thing that is best, and also worst, about financial commentary.  Because that is what it is - not prognostication, not deep analysis.

One of the things I like about the piece is that it spares us the math, and the scholarly cloaking, but it amounts to an especially simplistic kind of mathematical modeling all the same.  In fact all of both it’s virtues and its shortcomings are the same as those of technical analysis: it focuses on the most essential factor of market behavior, psychology, and it appears to strive for objectivity in picking out patterns - in this case one grand pattern, a major “secular” paradigm shift from the “gold is money” paradigm to the “omnipotence of central bankers” paradigm.  Although his model is overtly focused on market behavior, he attempts to justify the “secular” label by bringing in a deus ex machina by the name of “common knowledge”.  And therein lies the rub.  Whose “common knowledge”? The common knowledge of Wall Street traders, or the international financial community, or the typical American man in the street?  The typical Chinese of the rising middle class with new money to spend or invest?  The typical Russian apparatchik or gangster who is trying to deploy money to advantage?  The typical Indian merchant who prefers to keep much of his store of capital in the form of gold?

The only common knowledge that Hunt seems to take seriously is that of the first category: the Wall Street whales who make their living essentially by manipulating markets, not by investing, or by engaging with the economy.  And he acknowledges in passing, that most of the trading these days is done by computer algorithms, or mathematical models that are indeed focused on what everybody thinks everybody thinks but in view of the fact that virtually every attempt to model human behavior of any complexity has failed, and will probably always fail, that is to admit implicitly that his take on current market psychology is built on a rapidly accreting pile of sand waiting for its Minsky moment.

This piece has all the features of the daily financial commentary that everybody reads to see what everybody else is thinking, but which no one of any intelligence or experience takes seriously in its own right.  It is stamped all over with “this time it’s different” presumptions, and while throwing in a couple of “on the other hand” disclaimers as an escape route, it amounts, even in its pseudo-sophistication in ludicrous oversimplification, and hyper-truncated perspective.  The essence of such pieces, after all, is in what they leave out, and if they didn’t leave out at least half of the most important market factors, they would have no coherence: after all, for every seller there is a buyer, and vice versa.

As for the merits of Hunt’s thesis: yes, it has certainly become evident from the market action, not only of the last few months, but of the last five years or so, that gold has become a trading apple of many a whale eye, and it is probably a component of most of those computer algorithms, and that for those who live in the tiny, claustrophobic, self-constructed world of the trading elite, there has been a paradigm shift regarding attitudes toward gold, or perhaps “change of fashion” would be the better phrase.  Unfortunately, though, changes of market fashion occur as unpredictably in both timing and magnitude, as those sand pile landslides, so paying overmuch attention to the current one can be perilous to your capital.  Ever notice how, for all the sophistication of the modeling and commentary, hardly anyone actually makes a prediction that isn’t pretty much a single straight, or at most a single curved, line extension of the particular graph they have chosen to embrace at the exclusion of all other variables?  Which accounts for why financial prognosticators systematically underperform the monkeys throwing darts at the Wall Street journal.

For example, left out of this analysis is the fact that in the 1970s, when both common knowledge and academic and mainline market consensus was that gold was a barbarous relic, and that money was whatever the central banks of the world said it was, yet once price inflation began to accelerate, the ordinary man in the street started allocating part of his income to Krugerands, and the gold price shot through the roof in just a few years.  The single curved line extrapolation at that point predicted that fiat currency was going to zero, but in this case a black swan even occurred, and it indeed took the form of central bank intervention: Paul Volcker came on the scene and pulled the plug on the entire financial community, and the world economy by raising interest rates to disastrous levels.  The realistic and prudent person takes account of historical cycles while recognizing that they seldom provide guides as to timing, which is all that matters to the trader.

Hunt’s particular single-factor analysis rests on an equivocation (though he disarmingly acknowledges this in passing) - an equivocation between “gold as money”, and “gold as money in its capacity as a store of value”.  To nearly all of us, whether Wall Street traders or middle class Americans trying to support a family on middling five-figure incomes, “money” nearly always means currency, but to a prudent few stepping back from the current market insanity, money in its capacity a store of value becomes increasing desirable.  And there has only been one such money that has had universal acceptance amongst civilized peoples for at least the last 2500 years: gold.  To recognize that, and to have regard for the rapid deterioration of all modern fiat moneys as currencies is neither to be a “gold bug”, or to be an “inefficient marker trader”.  It is to be a realist, and a prudent man.  A prudent realist never gets carried away by market fashions, nor does he put much stock in plausible rationalizations of market behavior.  He recognizes that all such rationalizations are self-serving, and that belief in same is a function of the almost infinite human capacity for denial.  He has learned from experience that Minsky moments happen in human affairs, but that neither human psychology, nor the deep-seated patterns of human social behavior have changed much in 2500 years, or ar ever likely to change this side of genetic engineering.

It seems inevitable to me and to many other prudent realists who know some history, that the scenario of that earlier period, fresh in my memory, is inevitable, and is only being kept at bay at present by the depressionary psychology that has taken hold over the last ten years or so in the First World economy, which Wall Street remains largely in denial about.  Both the velocity of money, and employment as a percentage of the population continue to fall, and only Wall Street partying fed by the Fed has managed to maintain the illusion, for now, that all is well.  At some point in the future, it could be five years from now, or five weeks from now, depending on the unpredictable unfolding of political events in America and elsewhere, the central banks of the world are going to have to flood the world, and not just Wall Steet, with fiat currency to keep the mobs at bay, and at that point gold as the only reliable money as store of value will almost overnight become the desiderata of everyone, as they dump paper assets of all kinds.  The only alternative I see to this, in view of the massive and unpayable pyramid of debt and governmental obligation, is massive worldwide fiat currency revaluation vis a vis gold, and that could literally happen overnight.  The central bankers have no power to manage markets, let alone control them, but they can sure shut them down and disrupt them, pretty much at will.  Either way, gold remains the only universally acceptable store of value for significant accumulations of capital, although certainly food, tobacco, and bullets will serve as the day to day currency after the social breakdown which also seems inevitable at some point, unless these become the underground currencies of a 1984 world.

So, I found Hunt’s rationalization of the latest ETF gold market behavior entertaining and thought provoking, but as with all other such material, I pass on now to the more serious business of safeguarding my wealth and my future.


July 4, 2013, 9:09 p.m.

I am not sure I understand all I know about Gold. First, during 1600 and 1700’s Spain was bringing Gold from the new world by the boatloads but steadily lost wars with England because they were not able to finance their wars as well as Britain. Today the U.S. has the most Gold and the most Bankers, but are losing wars around the world for lack of financing. Methinks the relationship between Gold and currency seems to be divorced lately as is the FED and rational thinking.
If you want to really sober up take a look at ETF’s. How much of their value is in underlying stocks? ETF’s are grossly overvalued and underfunded, in actuality they are not unlike bitcoin. Personally I think ETF’s are a giant BUBBLE, even bigger than the mortgage market circa 2008.


July 4, 2013, 8:30 p.m.

I was not comfortable with gold and sold my shares last year.

After I had considerable trouble focusing my eyes last year, cataracts were discovered, the old lenses in my eyes were removed, and new lenses were slipped in my eyes.  Afterward, I believed my vision was like high definition TV.  Amazingly improved.

Linda Weekes

July 4, 2013, 7:45 p.m.

All I can say is ...wow, what a valuable reassessment of a strategy in investment in gold and gold’s place in the world’s current understanding of value. This is incredibly useful as a step back, or up to the 500 foot level to reexamine the assumptions we are making in hoping and expecting gold to be viewed as a safe haven and inflation or deflation hedge. The recent decline can be explained as a correction and condsolidation, but what we need is fresh points of view, to allow us to recalibrate our thinking and reassess whether our choices continue to be relevant. I have invested 1/3 of our pension funds in gold and gold mining shares, because the fundamentals of the current economic situation did not seem sound, but Ben is quite right that the response or consequences of a failure of the current financial system may not play out according to past practice. This begs the question, according to his thesis, what would further the purposes of the central banks or the Fed Reserve if the fiat currency is challenged? What would they like to support next? If they continue to fight gold and support a different option, then gold may not perform as anticipated. What would be a useful second choice?

Chad Cundiff

July 4, 2013, 2:18 p.m.

Great article.  One of the best in a while.  Gold is money, except when its not.

Carl Swenlin

July 4, 2013, 12:59 p.m.

I thought the article was entertaining and gave a plausible explanation for the recent decline in gold prices, though not the only one we might choose.

But I would beg financial writers to GET TO THE POINT, STAY ON POINT, and SAY IT WITH AS FEW WORDS AS POSSIBLE! The academic setting where most learn to write requires a ‘50 page paper on XYZ’ when five or ten pages will do.

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