Analyst Quiz is Gold Overvalued Based on CPI–Go SHORT?

gold vs cpi

You just got promoted to advise Ackman; he is keen to improve returns.  He slaps that chart on your desk and then asks if shorting gold would be a good idea? Why or why not based on this brilliant analysis?  In fact, with “Deflation” fears rampant, Ackman feels gold could drop to $650.

Also, you read: The Golden Dilemma where two PhDs project a $350 price target.  If experts such as these predict lower prices, then should you join the pack?

Also, you find a chart that supports what your boss thinks. Yahoo!


Unfortunately, some nut-job sends you this link: The Positive theory of gold and the The ultimate extinguisher of debt

You have until this afternoon to report back.  This tests common sense and critical thinking skills. Good luck!

A prize to be awarded.

10 responses to “Analyst Quiz is Gold Overvalued Based on CPI–Go SHORT?

  1. Gold is correlated to inflation but weak correlation to CPI.

    Gold is more of a bet against the monetary and financial system when it brings tail risk returns;

    You put up some links about thinking about gold not as a unit per dollar but dollar as per unit of ounce of gold. If perceived in this perspective, deflation or hyperinflation are both consequences of systematic breakdowns, which are likely to lead to a large demand for gold as an alternative to fiat currencies.

    • OK, you are halfway home. You are correct that CPI is useless as both a measure of inflation and as having any predictive power for gold future price. Manatee migration patterns correlate more with gold than CPI.

      Yes, gold tends to do better during monetary break-downs as shown by rising credit spreads, declining bank stocks, rising defaults, etc.

      But what should Ackman do?

      • Since a systematic sell-off is possibly going to put his fund at risk of large
        redemptions; I’d be advising Ackman to be holding Gold holding proportional
        to the probability of a market meltdown. Any large scale sell-offs in the
        market are likely to be offset by his increase in value of gold related holdings
        which would allow him to meet his redemptions without selling his equity holdings.

  2. From where I sit, Gold is the most misunderstood asset bar none. It has utility, but not in the commonly understood way. You have to adopt a specific way of thinking to understand gold. You have to think in terms pragmatic, integrative pluralism, drawing in economics, politics, policy, realpolitik and central banking.

    There are two primary camps vis a vis Gold. The ‘gold is a barbarous relic camp’ and the ‘gold is money/freedom/liberty camp’.

    Both are wrong.

    In the modern age, Gold is the implicit recapitaliser of last resort of the state. That’s it. It will never be acknowledged publicly, but that’s what it is. Fekete is wrong in so far as he focuses on debt and money. That is not its utility. The problems of gold as specie or explicit backing of note issue have all been well documented. Gold is not about paying debt, introducing debt free currency etc.

    If you accept the theory of Endogenous money, then you can work forward from there and reason that we can grow our way out of our current debt burden after a period of prolonged stagnation. As new bank credit for productive enterprise supplants bank credit for old, stagnant enterprise, we will slowly inflate ourselves back down to sensible debt:gdp ratios; provided of course that velocity doesn’t collapse, and there is no serious crisis. The role of the state in employing intertemporal smoothing is vital. Let me say that more explicitly: the role of the state in this process is *vital*.

    Zijlstra made the point best, Gold is the Sun of the Monetary Cosmos. Historically, it had a vital role in the equilibrating of trade imbalance, but that time has passed.

    Let me rephrase the question. Do you short the final recapitaliser of the state at a time when the state needs to recapitalised, and can be recapitalised by decree?

    I should note, when I say ‘recapitaliser of the state’ I don’t mean: ‘Put a bit more on the asset side of the balance sheet’, though that is also, I suppose, a possibility. I mean: ‘Make cross border payments using a fungible, internationally accepted medium / restore stability to a failing currency’ etc.

    I’m not suggesting that you go long gold either. I’m not a gold bug. I don’t own gold. It does however pay to understand the lay of the land.

  3. My rephrased question jars with my larger point. A better question would be: “Do you short the recapitaliser of the state at a time when the future need of the state to be recapitalised is an open question?”

  4. The more I think about it, the more I think my answer is unsatisfactory.

    Do you short Gold based on CPI now? Gold may go down. It could be a good trade. Equities are selling off. Animal spirits are taking over. The tides are going out. Everybody panics together, after all. What’s your timeframe? How much downside is left before it just grinds endlessly sideways or starts moving against you? I feel like you’re conflating two time frames in your question.

    A trade is a short to medium term bet on price. But by referencing Fekete, you’re introducing a long term consideration in to the equation. Gold certainly isn’t going to be revalued and used to extinguish debt tomorrow. My assertion is that it’s not going to be used to extinguish debt. Period.

    For Central Bankers, it is an option. Way out of the money and perpetual.

    In the short term you could get somewhere selling that option, in the long term it would seem like a potentially poor strategy.

    So why do you go short Gold?

    Because of CPI? Because of technicals? Because of correlations? Because of reversion to the mean? Industry fundamentals? Expected Gold Repo dynamics?

    It’s been a while, but my recollection is that the bulk of gold is traded in opaque OTC markets. It’s a pretty illiquid market for big money. Whether you could get in and out is another consideration.

    No. You don’t short Gold. Because Ackman is a vain, arrogant boob and he’ll double down even after the price rockets and the CEO of Gold takes medical leave.

    You don’t short Gold because Ackman is your boss and he gets wedded to illiquid positions and blows himself up. And you have mouths to feed.

    That’s my final answer.

  5. “Well, Mr Ackman, you can’t know the true value of something that depends on mood, perception, and taste. Now, stop speculating and get back to work!”

    Seriously though, I can’t stand speculation in gold.

  6. I am not even going to look at the charts or analyses shown above.

    Gold generates zero cash flows. It is an asset that’s priced based on supply/demand drivers which are in turn largely based on sentiment. Sometimes it’s used as a fear hedge by the market and strongly correlates with volatility, sometimes the market uses it as a hedge against inflation, and other times the market prices gold based on other factors.

    Gold is a 5-year old kid in a candy store that goes in every day of the week and decides to buy different candies depending on what he’s feeling that day, what his friends are buying, what is running low (ooh, must be good), if he wants chocolate or sweet/sour, etc. Would you bet on knowing what this kid is going to buy the next day or the next week or the next year? Absolutely not.

    Even if the kid shows a long-term pattern on Wednesdays of buying chocolate Hershey’s kisses, like the up-til-now long-term appreciation of the yuan vs. the USD, and you extrapolated his long-term penchant for chocolate Hershey’s kisses on Wednesdays, his parents (i.e. Chinese gov’t) may intervene and say no chocolate anymore after years of buying chocolate Hershey’s kisses on Wednesdays.

    There has been an argument for investing in RMB-denominated bonds yielding 8-9% that has been pitched to a lot of high net-worth investors the last several years – the allure of getting a good risk-adjusted yield on BB-like credit quality of Chinese companies was great, AND investors also got the currency appreciation of the RMB vs. the USD which is likely to continue as a long-term trend – so the thesis went. So you got a nice yield and the extra carry from currency appreciation vs. the USD. Well, that thesis has been blown up in the last 15 months or so. In USD terms, their juicy spreads have been wiped out as investors are at current prices going to be receiving 10% less (10% devaluation) principal in USD terms, not even counting the compression of the bond coupon in USD terms.

    Would you make an investment or trade in large size based on so many variables, such as that which drives the price of gold? I would not. Kids grow up. Parents change. The drivers of gold prices change too often to make extrapolation of past trends (long-term or short-term) of any real value. There are macro traders like Druckenmiller or Soros that may be good at trading gold, but as Soros has said, he trades a lot on instinct, his view of the markets and macro picture and whether his back is hurting or whatever. That’s a trading skill that is not quantifiable before-hand and is likely honed from years of experience. Secondly, Soros will close his massive positions out the next day if he changes his mind, and not feel any loss of self-esteem. What we’re doing here is doing all this useless analysis to support entrance into the long-gold position – it would then be silly to say “but we may trade out like Soros the day after we enter our position” despite all the analysis we just did supporting the thesis of going long gold.” What? You gotta pick which one you are – staying consistent with your analytic/trading framework on both entry and exit. So I recommend that all this analysis on going short or long gold is hogwash, and move on to something else.

    Pick who you are first (a Soros vs. Ackman/Einhorn) and actually assess if you really are that type of investor/trader and then run with it. Paulson – I think he ran into this problem. His strategy since his subprime bet has been part big picture macro and gut-feeling style of trading like Soros and part fundamental analysis/data-driven exemplified by like his famous analysis individual mortgage default rates on pools of subprime MBS. Which one are you? Paulson, who’s lost billions on his investment in gold, in my opinion, was attempting to be Soros without realizing it, obscured by all the analysis his firm has done to justify that trade of going long gold.

  7. Some interesting comments above. Apologies in advance for the length of this response, but we are not talking about a simple stock here:

    I think the most important thing to recognise with Gold is that it is a unique asset. Clearly it’s not an equity or debt instrument, it is not an industrial commodity, nor is it obviously a paper currency. As Warren Buffet says, gold is this absurd metal that we spend billions of dollars a year digging up, only to have it melted down and stored back under the ground. Apart from its ornamental value it doesn’t serve any useful purpose he says. It’s typically never wise to argue with Warren Buffett. Also it has to be said that gold hasn’t necessarily outperformed equities over the long term… though when we say that we’re talking about the equity markets that have survived, which excludes more than a few markets (which have gone to zero at various times – Germany, Argentina, Austria, Hungary, Zimbabwe)

    More than anything Gold is a currency, and along with Silver the oldest currency in circulation today. But unlike what we have come to know as traditional currencies issued by central banks under the authority of the state it is not something that can be created by decree. It is obviously a naturally occurring metal that has several unique properties that have led to it becoming the old and most widely used unit of account that we have.

    Nobody sat down 5,000 years ago and decided that Gold would “be” what today it has become. It is the ultimate example of survivorship bias. But clearly this survivorship bias did not happen without reason, and these include:

    1) Gold is rare…. All of the gold mined through history could be put into 2 Olympic sized swimming pools.
    2) Gold supply has over the very long term grown at roughly the rate of the global population.
    3) Gold doesn’t degrade, so can be kept generation after generation without impairment
    4) Gold is divisible and portable which sets it apart from land for example.
    5) Gold can’t be debased, although gold coins have frequently been debased by Monarchs in pursuit of expenditures.
    6) Gold is nobody’s obligation, it represents no promise to pay or redeem.

    Primarily for these reasons gold has simply stood the test of time that other units of exchange have not. Silver too has many of the same characteristics, but its high industrial usage and smaller base has made a much more volatile metal than gold.

    Another important and more subtle concept to consider when thinking about gold is that it is a constant. This is where the idea of gold being a store of value comes from. We are used to each day measuring the price of gold in US dollars, but in reality it is the value of a US dollar that is moving all about relative to an ounce of gold.

    The concept of constant can be drawn from the writings of Irving Fisher, perhaps the greatest economist you’ve never heard of. He would have carried the same cache as Keynes had he not sullied his reputation through the stock market crash of 1929. Writing in 1928 Fisher talked about our conception of the sun rising and setting each day. In the early morning one might stand looking at the horizon and watch the sun come up and at days end watch it gradually disappear over the western horizon. Although it has the appearance of moving up and down each day, the sun is a constant. It is the Earth’s rotation on its axis that gives the appearance of the sun’s movement. Although I’m sure it feels like it in Washington and Wall Street, we aren’t the centre of the Universe.

    Like the sun in Fishers analogy we can say that gold is a constant. I mean this in the sense that an ounce of gold today buys you roughly what it did a hundred years ago. Its real value is relatively (though not totally) constant. If your Great, Great Grandmother had left you two boxes that she sealed in 1911, one with an ounce of gold in it and the other with a $20 note, the box with $20 would have lost some 97% of its purchasing power by the time you opened it in 2011. The ounce of gold on the other hand would buy you today, approximately what it bought your great, great grandmother in 1911.

    Coming back to Australia in 2009 was a nice little real life experience to draw on. In the ten years I was away, I estimate that my daily cost of living has approximately doubled over that period. Whether it’s a 425ml glass of beer, a morning latte, loaf of bread, electricity to cool the house, the fuel that goes in my car or a basket of groceries. Granted some things are cheaper… LCD TV’s, cell phones, internet connectivity. But roughly I guess that my weekly cost of sustaining myself has doubled over that time. The key point here though is that the value I derive from these goods is the same as it was ten years ago, and I venture to say was roughly the same ten years prior to that when I was in university. By value, I mean utility. That ice-cold glass of beer at the end of a hot day gives me the same pleasure as it did ten yeas ago and probably the same pleasure that it gave my Father 40 years ago. My morning cereal gives me roughly the same units of energy necessary to sustain me through to lunch time. Electricity to power my air conditioning provides the same relief this summer is it did in the summer of 1998/9.

    So if the “value” of the goods hasn’t changed but they “cost” twice as much, something else has changed. That something is the value of my paper money. Sneakily, year by year without really noticing it (if you are living here), over a ten year period my paper money is worth only half what it used to be. Yes this is inflation, but is might also be known as paper money debasement. Inflation captures the phenomenon of higher prices for goods and services, and all kinds of things go into making this happen. Bread is obviously impacted by the cost of wheat today compared with a decade ago. But the cost of any item in an economy is also a function of the amount of money in circulation. Consider the following example of how this works.

    Imagine a simple one product subsistence economy producing only rice, governed by an overlord who controls money supply. They also have a stable population and fixed amount of land on which to cultivate their rice crop. Rainfall every year is the same, as are their crop yields. The market clearing price for rice in this economy is $100/tonne. As demand and supply of rice are stable, the price is the same in any given year as it was the last. One morning the overlord decides on a whim that he is going to double the amount of money in circulation. As people in this economy don’t save, they spend all of their earnings on rice to sustain themselves, beginning immediately the price of rice must rise as the increased circulation of money, against a fixed annual crop of rice has increased. We now have twice the amount of money buying the same fixed amount of rice. By definition the market clearing price will increase to $200/tonne and then stop. This short sharp burst in inflation happens very quickly as the velocity of money is 1 (no savings). Like my glass of beer example above, rice has the same “real value” at $200/tonne as it did at $100/tonne. The value of my money though has halved through a doubling of the money supply. In the real world we know that that the price of rice will also be affected by rainfall, available land, crop science and changing demand patterns. All of these factors obviously going into determining the market clearing price for the commodity.

    We can use lots of different ways to measure changes in relative value through time. For example the average house in Sydney ten years ago used to buy you about 10 new cars. In 2010 the average house would have bought you 23.3 new cars. The value of houses relative to cars has increased. Our most common denominator though in measuring value is money, paper money. If the amount of money in circulation rises (or falls), the price of all goods and services in this economy will also naturally rise (or fall). Houses have risen more than cars because land is fixed and global auto-manufacturing is not.

    Gold is important because it is a time honoured way of measuring value. Time-honoured for the reasons I mention in the first paragraph. So if we think about the value of all goods and services denominated in gold rather than paper money, this is just another way of expressing value. If the amount of paper money in circulation increases relative to the amount of gold, then the price of gold must rise (as in the case of rice above). Under a standard where paper money is directly linked to the amount gold held, the value of paper money relative to gold is by definition stable. A paper money system that is not linked to hard assets is subject to wanton debasement for reasons most often driven by politics and popularity. America (and anyone linked to the USD) went off the gold standard in August 1971, and today we live in a totally paper money world. I needs to be said however, that no paper (non hard-asset backed) money system has every survived though history. Some paper currencies in fact have gone to zero (Zimbabwe, Weimer Germany, Hungary, Austria, Argentina), with most have ultimately gone back to some form of backing or linkage to a perceived stable unit of account. It remains to be seen how long this current (now 40 year) cycle of paper money experimentation will last. Several American States are moving to accept cold coin as legal tender of merchandise transactions.

    It also has to be said that Gold in the context that we have been talking is not alone in exhibiting many of the characteristics relative to paper money. Oil for example is also rare, has limited annual growth, is global and cannot be debased. Similarly with copper, palladium and nickel. One can rightly make the argument that any analysis of gold versus paper money can be made for any real commodity, and I agree with this. Gold simply has history on its side and is not subject to the same supply/demand vagaries as industrial metals and commodities, which tend to drive wide cycles around the equilibrium clearing price.

    So-called “Gold Bugs”, as far as I can tell hold the view that gold is good at any price. I don’t think this is true either. In 1980 when gold exceeded $800/ounce, the value of gold at that time exceeded the value of all the paper money in circulation, clearly a point of overvaluation. Measured against other commodities in 1980, Gold also looked very expensive in an historical context. Clearly as in any market, gold prices can get overdone to the upside as to make them poor investments.

    Valuing gold is I agree very difficult. But directionally we can I think make a pretty good guess at where it is heading. As we survey the global landscape today for answers as to where the price of gold is headed I think it is helpful to look at the fiscal and debt situation that exists amongst G20 countries.

    Very simply today the G20 is drowning in debt. Over the past decade global credit has grown at a compound annual rate of 12% against real GDP growth of 3.5%. Broadly defined, global credit today is running at levels never before seen in history relative to GDP. An increasingly it looks as though pay-day has arrived. It has certainly arrived in Europe. It is very likely to arrive in Japan quite soon, and the US and UK will not be spared if such a contagion takes hold.

    Reported inflation today is apparently well contained, but the dramatic expansion in the balance sheets of the Fed, BoE, ECB and very likely the BoJ, the seeds of widespread and accelerating inflation are being sown. The broken transmission mechanism within the banking sector, appears to be the only thing keeping these excess reserves from spreading into the real economy, thus mitigating the efficacy of central bank balance sheet expansion.

    Reagan made the notion that debt doesn’t matter popular, and convenient. Very simply though, there comes a point where debt does matter. Critically government debt as a percentage of GDP crosses 100%, an economy needs to grow by at least its rate of interest in order to keep their nominal debt balance in check. It’s not apparent this is happening anywhere in the world. At some point creditors must ultimately demand additional returns to bear the risk to extending credit in such a situation. When the creditor back away, or the cost of procuring credit becomes unpalatable, it will fall to the central bank to monetise the debt. This is precisely what is happening in debtor nations at present. The currency by definition is being debased and our old friend Gold, but just standing still by is worth more.

    The real world is a more complex picture, with all types of investors driven my fear, greed, institutional factors and like, determining prices on a given day, but the big picture remains as clear as ever as it pertains to the global monetary system, and that is surely supportive of the trends we have seen in the past 8 years.

  8. Quite an interesting group of comments. I will post again and send out the prizes. My bias is that negative interest rates illustrate the unsustainability and absurdity of a debt-based monetary system controlled by bureaucrats who have never created a profit in their life.

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