A Framework for thinking about Gold and Silver

Gold and silver have become very popular investments in recent years. I’m sure you’ve all seen the ads pitching it. The reaction to this last Fed policy meeting and press conference makes it a good time to go over the main reasons people have had for owning it, and how those factors have been evolving.

Low real rates. Commodities in general tend to do well in environments of low real interest rates. None more so than precious metals. The two reasons are (1) the opportunity cost of holding precious metals is low and (2) periods of low real rates often precede periods of inflation, for which precious metals historically have been used as hedges.

Systemic risk. The US banking system was on the verge of collapse back in 2008, counterparty risk had already broken down, and those living in the bowels of global money markets believed—with good reason—we were hours away from seeing lines of people in pajamas in front of ATM machines hoping there would be cash still in them. And history has seared into our collective memory the role of gold as a time-tested refuge in systemic crises.

Fear of high inflation. Central banks around the world have been expanding their balance sheets. Aggressively. When this started in late 2008, the consensus view was that this would cause inflation, perhaps hyperinflation. This led to a surge in the interest in precious metals, and to many high-profile hedge fund managers buying gold to protect against it. The list is long: John Paulson, David Einhorn, George Soros (though he has reportedly since sold), and countless others.

Fear of fiat currencies/gold as an alternative currency. “All currencies are in a race to zero” seemed the mantra for much of 2010-2011. The belief seemed widespread that in a desperate quest for growth there would be a no-holds-barred currency war, with the US as the instigator. If everyone was going to debauch their currencies, the word was holding gold–which many have come to view as an alternative currency–would be the natural place to go.

Diversification and the Dollar Overhang. The global financial system has been massively dollar centric for the past 60 years. Two things, around 2002, catalyzed a major diversification wave away from the dollar. The first was the plugging-into-the-grid of emerging markets (Brazil came back from the brink; China joined the WTO, etc). The newly found growth and macro-economic stability in these countries  led to them trusting their home currency more, and needing the dollar—in which they were all heavily loaded—a lot less. Dollar-denominated funds joined the BRIC party, intensifying the decline in dollar demand. I’ve written in greater detail on this subject, one of the most misunderstood in global macro investing, here, here, and twice here.

The second was the emergence of the euro. The euro came into existence as an exchange rate regime in 1999, but only in 2002 did it become a deliverable currency. With central banks around the world holding reserves almost exclusively denominated in dollars, a liquid currency that could reduce their concentration in US dollars and better reflect their patterns of trade was a godsend to many. This too put downward pressure on the dollar.

Once the diversification away from the dollar gained momentum, its decline boosted demand for precious metals, first because of the traditional correlations, but second because it also led to fears that something was wrong with the dollar (nothing brings out sellers like lower prices). This further reinforced the diversification bid for precious metals.

Income effects: China and India. China and India have grown spectacularly over the past 10 years. The past decade really was their coming-out party. But these economies have woefully underdeveloped financial systems. Savers and earners have had very few investment vehicles from which to choose. Capital controls have limited choices even further. As a result, Chinese and Indians have resorted to the time-tested investments their grandparents told them about: real estate and precious metals. As their incomes grew, so did demand for both. The fact that precious metals were going up in price only fed the fever. (Nothing brings out buyers like higher prices.)

Where do we stand today?

You can go over each of the above factors, assign weights to them, and decide for yourself if in the aggregate they are waxing or waning. But let’s run through them quickly:

The low real rate environment persists. This, ceteris paribus, will be supportive of precious metal prices. However, the fear that these rates are going to lead to rapid inflation has faded considerably, as investors (and, embarrassingly, many economists) are slowly coming around to a better understanding of the transmission mechanism of modern monetary policy and negative money multipliers. We’ve also seen the serial predictions of those promising that Zimbabwe or Argentina-like inflation was ‘just around the corner’ fall repeatedly flat. Even Peter Schiff must be getting tired by now.

Systemic risk is still an issue, with Europe far from resolved, but with much of global financial system having successfully delevered, it is much less of one. US banks have issues, but the focus is on earnings run-rates in the new environment, not (for most of us) sovlvency. Heavily levered carry-driven investment strategies (remember Peloton and its ilk?) are the exception rather than the rule as risk aversion has pushed aside the pre-crisis go-go mentality. Plus, the EU has a better understanding of the kinds of problems they are likely to run into in crisis, given the Lehman dress-rehearsal, as well as which measures will be required to fix them—even if they are so far reluctant to fully engage them. Lastly, the better understanding of the deleveraging process has led many to conclude deflation may be the greater risk, and it is not clear precious metals will be good hedges for this.

The fever surrounding the currency race to the bottom seems to have broken when the US dollar stopped its decline. As is often the case, the bottom in the US dollar was found exactly when the predictions of its crash became loudest. Investors are coming around to the realization that expanding base money is not the same as expanding the money supply. And, while the link between the money supply and currency rates may tickle investors’ memories of Econ 101, this relationship can’t be found in the data of financially developed countries over the past 20 years. As a result, to the extent the fear of fiat currencies abates, investors who have been holding precious metals on this basis will likely become more nervous and look to reduce (especially when prices go down). Indeed, this explains a lot of the price action in gold and silver over the past year.

The secular diversification away from the dollar should be supportive for precious metals, in theory. In the near term, however, this is somewhat irrelevant: the currency flows related to EU deleveraging and global risk aversion should keep the dollar well supported (NB: irrespective of where funds are domiciled, they are still overwhelmingly denominated in dollars). Longer term, diversification away from the dollar will persist, but whether the main beneficiary of this will be precious metals or other fiat currencies will depend on whether fear of the latter continues to subside.

China and India for their part will continue to grow. And it is unlikely that the development of financial markets there will be fast enough to divert savers, structurally, away from precious metals and real estate for a number of years. But for now, growth rates in both countries are slowing sharply, ahead of expectations, and their real estate markets are under pressure. This, plus declining precious metals prices, is putting China and India off their traditional zeal for gold. (Again, prices and demand are positively correlated. It amazes me we still put so much equilibrating faith in the price mechanism, but that is a post for a future date.)

In short, the reasons for owning precious metals are waning rather than waxing. Some of this is cyclical, but the main reasons for owning precious metals are being revealed as conceptually flawed. And this, to me, is significant. The growing recognition of the impotence of central banks when faced with deleveraging is finally, it seems, driving this point home. More ominously, positioning in gold and silver is still heavy, as macro tourists and retail investors are slow in giving up on their investment theses.

Precious metals are notoriously difficult to trade. Even if I turn out to be right, knowing when to place and press your bets won’t be easy. But I do know this: gold and silver are small, fairly illiquid markets relative to the kinds of positions the biggest macro tourists have on. And when they decide to leave, the escape hatch is going to look very, very narrow.

What if the Fed doesn’t throw a party and everyone comes? (market view)

I don’t write very often about market views, especially short-term ones. There’s excess supply of that already in the system, and my comparative advantage should be melding policy, economics and behavior to try explain things that I think are misunderstood. At least this is what I try and stick to. 

But I am a trader, and I follow markets very closely, even when I am running low risk. And I have been getting a lot of inquiries about my views at this juncture.  So, here they are. 

Prospectively, I think guys are salivating to short risk in run up to/aftermath of the Fed tomorrow. I think a selloff is likely and will be short lived. The short-term indicators are quite overbought, but the intermediate-term indicators are very oversold, still. (Helene Meisler over at RealMoney.com lays these indicators out very well; in fact, she’s the only reason I’ve kept my subscription.)

A selloff that sucks the shorts back in followed by a return to rally is my base case. I don’t think the rally lasts too long, but breaks of 1410 in S&P, 1.31 in the euro, 1.03 in AUD, 13.40 in MXN, as indicative levels, seem doable—even if for the way I trade I care much more about the dynamics and sentiment than the levels themselves.

Part of the reason I have this view is because everyone is asking “What if the Fed throws a party and nobody comes?” Increasingly, people have recognized QE is largely psychological and the psychological response is diminishing. Even the Fed has. So a lot of bearish traders would like to see the Fed do something and then have the market selloff anyway. This would be ‘the dream sequence’. It would validate the bearish market view, vindicate the “it’s all artificial” theory of monetary policy, AND cast the Fed in an unfavorable light. Hat trick.

But the bigger pain trade right now seems to me the opposite. It’s the question in the market that no one is asking: “What if the Fed DOESN’T throw a party and everyone comes anyway?” This would imply the Fed announces no balance sheet expansion, the market sells off at first, then, once the bears feel like they’re back in control, a rally.

Reinforcing this whipsaw is my fundamental view that the Fed will disappoint. Expectations seem unrealistic. As traders we often act as if our anxiety level should be the principal criterion in the Fed’s reaction function. That, and, of course, the most recent move in the S&P. And our anxiety level has been high.

We have a strong tendency to project onto others our own thinking and preferences. But the Fed doesn’t think the way we do. I think we in the markets are projecting a bit too much here. So, I expect Son of Twist, with commitment to lower rates forever, or something along those lines.

There is very little short-term paper left on the Fed’s balance sheet to sell for a continuance of the current Twist, so I’m guessing they might buy further out and sell a little further out to continue the program. A twist on Twist. Just to be doing something. And because it can’t hurt. It doesn’t matter that I think it is pointless.

There are three main reasons I don’t think there will be any balance sheet expansion at this point—though the Fed will almost certainly discuss options for expansion should they need it further down the road: 

1)  The bar to expanding the balance sheet is high given domestic politics, international politics, and the Fed’s recollection of the sharp market reaction to QE2. I think they are still chastened, despite their intellectual recognition of its diminishing psychological effect; 

2)  Inflation and inflation expectations are running higher than in August 2010, when they were low and falling off a cliff. And they have a clear trend since last year; 


3)  They need the optionality now. “Taking out insurance” is pre-emptive. The US economy is healing, albeit slowly. So insurance is less necessary. The bigger risk is that of an exogenous shock from Europe or from a fiscal cliff (or hostage-taking in the run up to a fiscal cliff). The timing of these events is uncertain. Thus, the optionality of holding off with warheads that have been losing throw-weight anyway seems the superior risk-adjusted strategy. Again, I think these policies at this point are not very useful. But they can still short circuit negative sentiment in extremis when it gets to the point where that sentiment starts to feed on itself.

A little longer-term, I think the EZ did buy more time with Spain than the market is recognizing, and there is plenty of scope for further announcements in the coming days/weeks that could hurt those short risk.

To get a good entry point for my fundamentally bearish worldview, I would like to see the bearish tone subside and the bulls to get some chirping chips, to use another poker expression. I would like to see analysts on TV again saying “buy any dip” with the kind of confidence we saw in March/early April. We are not there yet. Until then, my strategic bias is to keep my bat on my shoulder. Often the most profitable trade is the one where you sit on your hands.

The takeaway: Germany is pot committed

The short-term market reaction to the Spanish bank deal should not blind us to the important longer-term implications: Germany is now pot committed.

Most of you know the poker term, I suspect. Pot committed is when you have bet such a large percentage of your chips that you cannot fold your hand. You are not all-in yet, but you eventually will be unless the others fold. (“Crossing the Rubicon” has roughly the same meaning, but seemed a little too evocative in the present context).

The Spailout, as it is being called, is the biggest one-shot resource commitment the EZ has made in this crisis. In fact, the commitment seems somewhat open-ended. And it is the first one explicitly made (SMP purchases are really indirect) to a large EZ member state. Moreover, reading between the lines of the official statements from inside and outside the EZ indicates a fairly high degree of commitment to going further and forging a banking union. There are increased murmurings of fiscal union as well. Greece may be already outside the circle of trust, but all this suggests that the EZ—and Germany—very much wants the rest of the EZ to be indivisible.

I have serious doubts about the feasibility of these ambitions, but this is not germane to the point here. What is germane is this: If Germany is indeed pot committed, and you believe as I do that the other players are not going to fold (i.e. the crisis will continue), then we now know on whom the peripheral countries will default.

It will be the official sector and local banks, where the risk has been increasingly concentrated with each round of official intervention. The supranational institutions take down a lot of the bad assets, plus Spanish banks buy the Spanish debt, Greek banks the Greek debt, Italian banks the Italian debt, etc. This is, has been and, we now know, will be the dynamic.

Whether the bulk of default falls on the official sector and local banks, or the default falls on markets makes a big difference for contagion beyond the defaulting countries. If market participants are levered long troubled assets, or own troubled assets and are elsewhere leveraged—as was the case for markets pre-Lehman—contagion will be severe and collateral damage great. If, on the other hand, the official sector and the local banks (de facto official sector) own the bulk of the risk and market participants are not, in general, highly leveraged, the consequences—while still brutal for the defaulting countries—will not propagate through the rest of the financial system with anywhere near the same violence.

I am not arguing there will be decoupling. But for a number of months now I have been trying to gauge on whom EZ defaults will fall, the private sector or the official sector, because, ceteris paribus, the contagion implications are vastly different. And now I have my answer: Germany is pot committed, and the other players are not about to fold. This might not be fair or even efficient, but it matters a lot for eventual burden sharing, and on this count we just found out that markets are going to come out well ahead.

Quick market comment on the Spanish rescate

The Spanish loan and the statements around it are a big deal, IMO. That a deal for Spanish banks was in the works has been clear. What the statements and official comments have brought into sharper focus for me is how much commitment there already is to build a banking union and, in the more distant future, fiscal union.

The takeaway, however, is not that I now think they are going to make it, at least not to fiscal union. Nor do I think this will materially change Europe’s fatal flaw: its growth prospects. But there are two significant positive implications from a market perspective:

  1. It is now more clear to me than ever that the bad risks in the system will migrate fairly fully to the balance sheets of the public sector (either explicitly of by contingent liability) by the time this is over.
  2. They’ve bought themselves another chunk of time.

Together, this suggests that when—X years from now—the peripheral countries realize their growth trajectories are insufficiently robust to get them out from under their debt burdens, and some enterprising politician tells them they should not subject themselves to the Nth round of belt-tightening, the reverberations through markets when countries leave the single currency will be much less than they would have been if markets hadn’t already largely passed the hot potato to the public sector.

Bernanke, breakevens, and volatility

I was surprised when I saw Tim Duy’s post, via Mark Thoma (Tim Duy is a blogger and economics professor at the University of Oregon) that took Bernanke to task for his poor management of market-based inflation expectations since the 2008 crisis.

This is what he says:

“Bernanke doesn’t appear to see that the inability to hold market-based inflation expectations at a consistent level as a problem:


What’s wrong with this picture?  Notice the volatility of expectations after the recession (Ryan Avent has made this point as well).  The Fed claims to have some mythical “credibility,” but it certainly isn’t evident in this graph.  If anything, it is clear that the Fed has failed miserably in establishing credible expectations for either 2 percent or stable inflation.  Instead, what they have created is very unstable expectations because of start-stop policy.  It is almost ludicrous to place so much blame on Congress for the unstable fiscal picture when they themselves are creating an unstable financial and economic environment.”

Psychological testing has shown than in building a story what matters most is not the completeness or quality of the information set, but rather its coherence relative to one’s priors. In other words, simple wins. And I’ll take this a step further: often the less we know, the easier it is for us to build a coherent story. (This is yet another well-kept secret of the money management business). The bottom line is that if a story is simple and intuitively compelling, it is fiendishly hard to disabuse people of it, no matter how false it might be. (Why do you think it was so hard for NBA talent scouts to give Jeremy Lin a shot?)

One would have thought that academia would be one of the spheres in economics best insulated from this confirmation bias. Evidently not.

I have three problems with his assertion.

The first is the premise.  The volatility patterns exhibited in his graph of 5-year and 10-year breakevens (the Fed’s preferred market-based inflation expectation input is the 5-year breakeven, 5-years forward, commonly denoted as 5y5y breakeven) is no different from the volatility pattern is ALL markets since the crisis. A good proxy for this is the VIX.


You will note that the pre-crisis average level of the VIX was 14.3 percent (green line), while after the crisis (using the same date used in the first chart) jumped to almost 23 percent. Moreover, as one might expect after a crisis, the volatility of the volatility also increased significantly.

In fact, as a market participant, I recall thinking in early 2009 how remarkably stable market-based inflation expectations were, given the prevalence of the fear of hyperinflation and overall levels of market volatility. You can get a sense of just how prevalent the talk of hyperinflation was if you look at the timeline of Google search for that word:


Second, at these levels of inflation, it is pretty clear that any volatility in market-based inflation expectations is the tail and not the dog. And the dog is doing all the wagging. What I mean is that variations in inflation at low levels have little negative effect on economic growth. At these levels the causation, empirically, runs from growth to inflation expectations, not the other way around.

We frequently hear in market commentary that every tick up in inflation is a tax on the consumer and every tick down is a windfall. But that’s not so much the case here at these levels of inflation. In reality, the level matters. A lot.

From low levels, upticks in inflation levels tend to indicate an increase, or an expected increase, in economic activity. And downticks, especially when growth is punk, are bad. The structural break in this relationship comes, again empirically, when inflation gets north of, say 5-8 percent. At this point the function that relates inflation to economic growth goes non-linear and the effects of inflation get very bad very quickly. So even if inflation expectations were more volatile, as long as they are well south of 5 percent it is not likely that they do much damage.

The third issue is conceptual. I could imagine someone looking at the chart of the VIX and the chart of breakevens and saying, okay, there was volatility in all markets, but that too was all Bernanke induced. And there may be some truth to that. But after a shock or crisis, normalization in markets typically follows the pattern of what is called disaster myopia: the acute memory of a disaster leads us to overstate the probability of its recurrence. In markets, that means volatility stays in the system. Volatility of the volatility stays too. Then, over time, as the memory fades, we progressively ratchet down our fears. (And, if a long enough time has passed, normalization eventually crosses over into complacency, FWIW.)

This is the pattern that you would expect to see across markets after a financial crisis like the one we had in 2008, and indeed, that is what is happening. Fear of the next Lehman, or the ‘next shoe to drop’ are waning, spasmodically, but waning. Hopes of a V-shaped recovery have exhibiting a progressively less amplitude as well.

Though there is much debate over whether the Fed has done too much or too little, it is hard to imagine that a radically different policy approach from the Fed would have led to a markedly different behavioral pattern, or to a rapid return to pre-crisis levels of volatility.

How you can go broke taking profits. Really. Reflection effects.

How many times have we all heard the line “You can’t go broke taking a profit”? Unfortunately, it’s dead wrong. Perhaps the dirtiest of secrets amongst professional money managers is that ideas—the primary basis on which they sell themselves to clients—come in third behind risk management and portfolio construction in generating replicable returns.

It doesn’t matter how much you explain to clients the centrality of risk management, they obligingly nod, wait for their turn to speak, and say, “Oh, that’s great, Mark. Very nice. And you were great on TV last week. Now, what do you think about the euro here?” Clients, like traders, crave stories. They want to believe the people to whom they entrust their money are genetically superior, multi-lingual polymaths. We managers want to believe this about ourselves, too.

But the truth is that in addition to loving stories we are all hard wired to be poor risk managers. Behavioral studies show that we are risk adverse when it comes to losing money, but we take on much more risk when we are trying to ‘get back to even’. This is referred to as the reflection effect (Tversky and Kahneman, The framing of decisions and the psychology of choice, 1981). Translated in trading, this means we tend to harvest profits too early, and tend to let our losers run. This is where the famous “I’ll sell it when it gets back to where I bought it” comes from. The reflection effect generates negative payoff asymmetries

One of the most important risk management tools I know, therefore, is doing the opposite: generating positive payoff asymmetries. Risking one to make three. Risking two to make five. This is what good traders do, even if they claim their P&L comes from superior intellect. And, of course, if a trade breaks your way you can use trailing stops and/or other techniques to improve your payoff asymmetries even further.

So, what one really needs to do is set up trades so that winners run and losers are dumped quickly. Think about the math. If you are risking one to make a minimum of three, and your ideas are right 50 percent of the time, you will be doing very well. In fact, your batting average could be far less than 50 percent and you’d still make money. If you regularly take profits quickly, as nature (and the aphorism) would have us do, your batting average would need to be far higher. Anything that appeals to our instincts to take profits quickly is likely to make us worse traders, not better. And trading is hard enough as it is.

This may seem obvious, but if it were that obvious, no one would ever again say “You can never go broke taking a profit”. Ever.

Euro. It’s a Design flaw. And it’s fatal

Eduardo Porter captured the sentiment of many in the run up to the launch of the single currency when he said this the other day in The New York Times: 

“Virtually every economist on this side of the Atlantic – and most of those on the other – figured out that the euro would be fatally flawed.  What took economists some time to understand was that Europe’s leaders didn’t much care what they thought.”

The Book List

I’ve been getting a lot of requests for a book list on behavioral economics, finance, etc. I promised a few of you I would post one.

Here are what I find to be some of the best books on these subjects. I picked books that are aimed at the intelligent reader who does not necessarily have specialized training in economics, sociology, or evolutionary psychology.

But I would also suggest you start with the 30 minute video of Daniel Kahneman’s Nobel price lecture. Videos are always easier than books, and it’ll open your eyes to our cognitive limitations as a species. Yes, that means you, too. Especially you.

Daniel Kahneman’s Nobel lecture

James Montier, The Little Book of Behavioral Investing

 Dan Ariely, Predictably Irrational: The Hidden Forces That Shape Our Decisions

George Akerlof and Robert Shiller, Animal Spirits: How Human Psychology Drives the Economy

Richard Thaler, The Winner’s Curse: Paradoxes and Anomalies of Economic Life

Eduardo Porter, The Price of Everything: Solving the Mystery of Why We Pay What We Do

David Brooks, The Social Animal: The Hidden Sources of Love, Character, and Achievement

And, my favorite all time book—though I don’t recommend this if you are interested exclusively in how behavior affects finance, and only should be read if you have a hard-core interest in evolutionary psychology—is:

Robert Wright, The Moral Animal

Since I first put this book list together, Daniel Kahneman came out with an accessible version of his life’s work, Thinking Fast and Slow. I highly recommend it. I have read many of his papers over the years, but this book is by far the most jargon-free of anything I’d seen from him.

Lastly, if any of you are interested in Africa, or economic development, I would recommend you the best, least politicized book I have read on the subject: Paul Collier’s The Bottom Billion: Why the Poorest Countries are Failing and What Can Be Done About It.

Happy reading.

IMF and Spain – putting on the face paint

A quick note on how the IMF works with its member countries (in this case, Spain).

The IMF is always monitoring its members. There are teams with desk officers assigned to each country. They track all the data, news, policy measures and political backdrop. As times get tougher in a particular country, or set of countries, the resources allocated to tracking increase. Communication with the member is also stepped up.

If things get bad enough and/or the country is systemically important enough, the IMF will “war game” contagion effects. They will also get as prepared as they can for “the call”, the moment when the authorities of the member country formally ask for assistance in putting together a program. A country asking for a program has a stigma attached to it—especially for a wealthy, developed one. So the IMF is painstakingly scrupulous about “not getting out in front of” a member request. This is what is going on here.

So, up until “the call” the IMF will publically say “we are not in talks with country X about a program”. This may lead to some confusion because many wrongly infer preparations are not being made. But they are. They always are.

The IMF is an extremely professional organization. The most impressive bureaucracy I’ve ever seen (and I’ve seen a lot of them). Trust me; they are putting on the face paint.

More Greek Cognitive Illusion: What they really think about Germany

A quick update on the post about Greece and cognitive illusion when under stress from Tuesday. I mentioned one of the most powerful attributes of human nature is our insidious, and often subconscious, ability to shift blame to others when things aren’t going well. Another thing we do is take shots at others’ success.

For example, here’s a slide from the results of a recent Greek survey of “Greek Public Opinion about Germany and its policy”, from VPRC, an Athens-based public opinion survey consultancy.

Basically, Greeks surveyed attributed 51% of Germany’s economic performance to corrupt foreign practices, and only 18% to its competitiveness. If this is truly the mindset, this should be a warning to those suggesting Greece could reduce its financial burden by pledging, privatizing, or somehow monetizing its assets. Not gonna happen. And any political support for doing so is going to decline, not increase, as the pressure to leave the single currency continues to mount.