The Truth About Gold

http://www.minyanville.com/businessmarkets/articles/markets-gold-dollar-GLD-CDS-treasuries/3/13/2009/id/21618?page=full

Op-Ed: Exterminating the Gold Bugs
By Minyanville Staff Mar 13, 2009 10:42 am
Super-bearish "dollar collapse" scenario is bogus.


Editor's Note: As an emerging-markets banking analyst, James Kostohryz has firsthand experience of banking collapses and their subsequent resolutions in Mexico, Argentina and Southeast Asia. Since leaving his position as Head of International Investments at Brazil's Banco Pactual in 2000, James has worked as an independent trader and investor.

Dear Professor Kostohryz,

I've been following your comments in Buzz & Banter, and I was interested in your opinion on gold. In particular, I wanted to ask about the correlation between gold and the dollar -- which haven't been correlated for some time -- and why they're now moving up at once. Some people have called this a fear rally driving gold, though now I see a number of people saying it's transitioning to an inflation rally. But can people change their rationale behind a rally that easily and justify increases? It's strange.

David


Dear David,

As you may know from the Buzz & Banter, a couple of weeks ago, I sold several gold stocks for a substantial profit. And I assure you, it had nothing to do with the US dollar/gold correlation.

Regarding the ever-shifting rationales cited by many gold “experts” (aka gold bugs) to buy gold, if you've been around long enough, you probably know this is a unique crowd. Among other things, they tend to be highly ideological. To them, everything and anything is a reason for gold to go up. And any decline in gold is dismissed as selling by ignorant people who, at best, don’t “get it,” or, at worst, by people who are part of some conspiracy.

Thus, we'll variously be informed by gold bugs, with great conviction, that if the dollar is down, that’s good for gold; if it's up, it’s good for gold. Gold is good as a hedge against inflation, and it's good as a hedge in times of deflation. If the S&P is going to crash, it’s good for gold; and if it rallies, it's good for gold. You get the picture.

Fundamentally speaking, at this juncture, I don’t think there's anything more to the gold/dollar inverse correlation than the fact that gold is an international commodity. If the value of gold remains constant on a trade-weighted currency basis, then its value in US dollars will decline when the dollar rises against a trade-weighted currency basket.

I say this correlation is of meager fundamental importance because, unlike many gold bugs, I believe that the super-bearish “dollar collapse” thesis is bogus. It's my fundamental view that the US dollar is actually more sound fundamentally than most of the world’s major currencies. If the US dollar ever collapses, other currencies will probably collapse faster and more profoundly than the US dollar.

Thus, gold might be a good investment in an environment in which there's a general crisis of confidence regarding fiat currencies, but it will have nothing to do with the correlation of gold versus the value of the US dollar relative to other currencies.

Certainly, it's possible that at times, there may arise an inverse correlation between gold and the value of the USD against other currencies, and that this movement may be related to the ascendance of doomsday “dollar collapse” theories. However, when such theories become popular, gold will tend to trade up, not only against the US dollar, but against everything else as well, on the basis of generalized fear - and speculation about fear.

To some extent, that was what was happening late last year. Gold was trading up against everything on the basis of general fear of a sharp deterioration of economic and financial conditions.

But, in truth, the specific fundamental basis for the gold/US dollar correlation is extremely weak. And to the extent that the correlation existed, it's because it was merely one indication amongst many others (equity, corporate bonds, CDSs, etc.) of a rise in generalized fear and a rise in systemic cross correlations amongst asset classes.

If one is bearish on the US economy, there are far superior vehicles to trade that hypothesis. For example, you could short equities, buy puts, etc. If you believe the US dollar is going down relative to other currencies, then play the currency markets and short the dollar against the yen or euro. And if you believe that all currencies are going down relative to gold, then buy gold. One has no necessary connection to the other.

Currently, the specific fear of a US dollar collapse has receded a bit, so one would expect the inverse correlation to gold might weaken, and it has. This brings us to another point. I think it's pretty clear that recently, gold has traded as a function of generalized fear (not just US-dollar fear) and speculation about a sharp deterioration in economic and financial conditions.

Look at the up and down days on the S&P and compare it to gold, day by day.

The idea -- propounded by many pundits, such as the ones you refer to -- that gold is currently trading as an inflation play, has little basis in fact. If that were the case, TIPS wouldn’t be projecting long-term below trend inflation. Long-term US Treasuries yields would not be at historic lows. And I could cite many other examples where action in financial markets directly contradicts the idea that inflationary pressures are building or that fears of inflation are building.

So I don’t think there's any real evidence that gold is trading as an inflation hedge. Besides, the fundamental case for inflation rearing its head anytime soon is extremely weak, to say the least. On this point, there are sophisticated ways to measure the “option value” of gold’s inflation hedge. When you perform such an analysis, it will indicate clearly that expectations of inflation have little or nothing to do with the recent dramatic rise in gold.

Gold is best viewed as a vehicle for a peculiar type of speculation. In particular, gold tends to trade as a function of speculations regarding general stress in the economy and the financial system. And one must analyze this within the context of a very particular community that trades gold. Because of this very specific milieu -- and the ideology that tends to drive people that trade in the yellow metal -- trying to find a fundamental rhyme or reason for the movements in gold is often an exercise in futility.

In a very real sense, and in many different ways, intense interest in gold can fundamentally be viewed as a symptom of irrationality. This is a market that's driven by greed, that traffics in fear; it's one where ideological dogmatism tends to reign, and where, as a result, rationality is at a discount. One must keep that firmly in mind when analyzing gold and gold-related markets.

Sincerely,
James Kostohryz





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http://www.minyanville.com/businessmarkets/articles/Kostohryz-gdp-gold-bugs-inflation-gld/3/30/2010/id/27537?page=full


Is Gold a Smart Indicator of Inflation?
By James Kostohryz Mar 30, 2010 9:20 am
What, if anything, the gold market is “telling” us about the prospects for a dramatic inflationary scenario on a global scale.


I suggest readers take a look at Howard Simon’s Article, entitled Gold Needs More Irresponsibility. It’s a really funny article that touches on some interesting points about the gold market. One of those points relates to how the gold market reacts to expectations about future inflation.

In a separate article yesterday entitled Gold Provides Invaluable Insight, Przemyslaw Radomski indirectly makes the useful observation that gold isn’t only rising against the USD, but against all currencies.

Why Invest in Gold? Getting the Reasons Straight

Many people think that investing in gold is a way to play a decline of the US dollar. As I've pointed out elsewhere (see Exterminating the Goldbugs), this is a nonsensical investment strategy. If you think that the USD is going to decline, then you should invest directly on that thesis by shorting the USD against some given currency or currencies (see UUP).

There are many perfectly legitimate reasons one might want to invest in gold, and most have nothing to due with the USD. For example, you might think that the demand for jewelry in India will rise significantly. Or you may expect that the supply of gold on the market at a given point in time may decline.

Another viable thesis is that the value of all fiat currencies around the world will soon decline en masse relative that of a given quantity of gold. The scenario is a bit macabre, but at least the investment thesis is coherent. Lest we think that this be completely unrealistic, as Radomski points out, gold has been recently gaining against just about every currency in the world -- just as it has, I’d add, for the better part of the past decade.

But this general “fiat trade” -- if you will -- is based on a very different sort of rationale than a prediction that the USD will decline. It’s important to understand this distinction.

The Difference Between Beliefs and Predictions

In this article I won’t address whether it’s sensible to buy gold as a financial markets investment based on the notion that all fiat currencies will soon fall victim to inflation. I will also won’t discuss whether there might be other investments that might outperform gold in such a global inflationary scenario.

What I would like to touch on in this article is the issue of what, if anything, the gold market is currently “telling” us regarding the prospects for a dramatic inflationary scenario on a global scale.

First of all, let’s distinguish between investors’ beliefs that markets transmit, and whether those beliefs are actually predictive of anything. Just for the record, virtually all of the serious empirical research that’s been done on the matter shows that gold isn’t a good predictor of inflation. In fact, my own research coincides with other academic research in suggesting that with the exception of a period during the 1970s, gold has, if anything, been a contrary predictor of inflation. (Don’t feel bad, gold fans. The research is also quite pessimistic regarding the ability of any variable or combination of variables to predict inflation in any sort of consistent manner.) So, let’s not confuse the beliefs of gold investors, or anyone else, with claims regarding their clairvoyance.

Having got that point straight, let us turn our attention to Howard Simons’ observations regarding the beliefs being transmitted by gold markets about future inflation.This is interesting to contemplate because unless we think that gold investors are from Mars and that investors in other financial assets such as bonds are completely different creatures from somewhere such as Venus then it would be somewhat strange to expect that the beliefs of gold investors regarding inflation will be significantly different than the beliefs about inflation being reflected in other financial asset prices. After all, global financial markets are integrated, and arbitrage should ordinarily be expected to smooth out such divergences.

The gold market is far from unique as a gauge of investor expectations about inflation. Indeed, bond markets are, by far, the largest and most liquid markets that reflect expectations about future inflation. What are they saying? Well, Howard Simons pointed out yesterday, the prices of TIPS as well as other fixed-income instruments started signaling last year that bond investors were expecting an uptick in inflation. Interestingly, gold investors seemed to be thinking the same thing as the price of the yellow metal was rallying at around the same time.

Then, at the beginning of last year inflationary expectations reflected in the bond markets started to wane. And perhaps not coincidentally, at virtually the same time, gold prices started to pull back.

So, the bond and gold markets seem to be agreeing in regards to the general direction of inflationary expectations. But some investors might be curious: What magnitude of inflation are we talking about here?

Well, in the bond market, depending on what exact indicator you look at, investors seem to be pricing in expectations for average annual inflation rates in the order of about 2.4% for the next 10 to 30 years.

How about the gold market? Well, that’s a little harder to divine. But I have developed a methodology that allows one to “read” the inflationary expectations priced into the gold market. The methodology is far from perfect, but I haven’t seen anything better. It essentially consists of analyzing the premium/discount of the price of gold to an estimate of the all-in marginal cost of producing gold. The value of this premium/discount should relate to expectations regarding the rate of future inflation. The model is built on the expectation that the price of gold at a given point in the future will roughly equal its all-in marginal cost of production and that the cost of producing gold will rise in line with inflation. I also assume that the all-in cost of a marginal producer to produce an ounce of gold is $800. One can change any of these assumptions accordingly.

Based upon this methodology, the gold market appears to be factoring in an average inflation rate of about 2.1% per annum for the next 10 years.

An amazing coincidence, no?

So How Attractive Is Gold as an Investment?

Somehow, I don’t think that most of the investors and speculators that have been piling into gold-based investments such as GLD and GDX in the past few years have been doing so in the expectation that inflation is going to be 2.1% per annum. Indeed, I think that if you told them that this is what the gold market is actually saying, they’d be aghast.

So what do you think? Do you think that the gold market is “smart” about inflation?If you do, then you must concede that the bond market is currently just as “smart,” as it’s pricing in about the same amount of future inflation. And if you concede this point you may conclude that buying gold is a waste of your hard-earned resources. A 10-Year Treasury Bond currently yielding 3.86% would be a much better deal as it would provide you with a substantially better real return on investment.

Or maybe you think that the gold market and the bond market is “dumb” and that they’re grossly overestimating/underestimating future inflation. Indeed, my analysis shows that if you believe that the average annual inflation rate will be above 2.1% for the next 10 years, then gold might still be a great bargain at current prices.

Or perhaps you think that the price of gold and bonds in the market are “manipulated” by global conspirators, thereby making their current prices irrelevant. In this scenario, and assuming that these conspirators won’t be able to continue holding the price of gold down for the next 10 years, then gold might still be a bargain at current prices.

For example, let’s assume that you think the gold market is currently either dumb and/or grossly manipulated and that you therefore disregard as irrelevant the information about inflation contained in current gold prices. Let us also assume that you think the average inflation rate for the next 10 years will average 10%. According to the model described above gold today would be worth about $1,980 to you. Is such forecast reasonable? On such assumptions about inflation, such a prediction for the price of gold is entirely reasonable.

But if you believe that the price of gold is going to explode to $2,000, $5,000, or whatever, don’t come around tomorrow and tell me how the rising or falling prices of gold are “predicting” anything about inflation. You’d be engaging in a gross contradiction.Conclusion

What’s my point? My point is that potential investors in gold need to get their story straight. You can’t go around saying that the gold market is an accurate predictor of inflation when it’s currently forecasting 2.1% inflation and at the same time go around saying that there’s gong to be hyperinflation within the next 10 years and that therefore gold is a great investment.

You either think that the gold market is smart (i.e. efficient) and therefore acknowledge that gold is probably a mediocre investment at best. Or you drop the nonsense about gold being a great “predictor” of inflation and simply say what you really believe -- which is that the gold market is dumb and/or that it’s grossly manipulated. You can’t have it both ways.

What’s my own take on gold? My views of gold as an investment have nothing to do with a prospective collapse of the USD, expectations of out-of-control inflation, or gold market conspiracies led by the Council on Foreign Relations. My view is that gold is in sweet spot right now and will probably remain so as long as global growth is strong. Strong global growth should drive vigorous jewelry demand in Asia and the Middle East as well as industrial demand around the world. Furthermore, the fears of rising inflation that always accompany economic recoveries should help maintain the level of investment demand for gold in positive territory.

For a different, more “hopeful” sort of rationale to be advanced in favor of gold, we need a lot more disastrous “irresponsibility,” in Howard Simon’s parlance.

But don’t despair if you believe in such a scenario: For belief in imminent financial Armageddon doesn’t necessarily imply that you will always be a grumpy old fuddy-duddy. As Howard Simons suggests, gold bugs are quite upbeat folks when speaking of economic meltdown -- in much the same way that Anne Stiller becomes the happiest woman on earth when she imagines her husband to be miserable.

Seriously, let’s be careful not to confuse our deep-seeded longings regarding what we’d like the world to be like with predictions of what it will actually become. And let’s be conscious of the logical implications of our beliefs.

In the case of the gold market, belief in its wisdom necessarily should imply recognition of the virtual impossibility of making any money in it. Furthermore, logical coherence requires that faith in the efficiency of the gold market be accompanied by a belief that the long-term rate of inflation should be quite low.

On the other hand, if you believe that the annual rate of inflation over the long term will be substantially over 7% then paraphrasing the urging of one Christopher by a certain Ferdinand: “Get gold, cheaply as possible, but by all hazards -- get gold."

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http://www.minyanville.com/businessmarkets/articles/gold-euro-eurozone-dollar-index-USD/3/29/2010/id/27469

Gold Needs More Irresponsibility
By Howard Simons Mar 29, 2010 7:55 am
After years of low interest rates and debt crises, the yellow metal needs more frivolity to push it further.

The comedienne Anne Stiller, wife of Jerry and mother of Ben, had a signature line loosely remembered as, “If I knew you were miserable, I’d be the happiest woman on earth!” I have no idea what her position on gold is, if any, and I thought better of contacting her publicist for fear of winding up on one of those stalker lists, but her attitude toward others’ miseries always has struck me as redolent of gold bugs’ attitude toward the rest of humanity.

When we strip gold of all the mysticism, gold as a financial asset is really a very simple market: When expected inflation rises faster than the short-term interest rate costs of holding it, its price will apparently rise. A more accurate way of saying this is gold remains constant while the purchasing power of the currency measuring it declines.

Gold is an actual physical market replete with supply/demand balances as well. One of the great propellers of gold’s move higher between 2004 and 2008 was the income effect in India, Dubai, and other markets where gold was purchased, as it always had been, with newly acquired paper money.

This last factor allowed gold to rise during the period between 2004 and 2006 when short-term interest rates were rising. We can map the excess of expected inflation as derived from the TIPS market over the three-month repo rate against the price of gold both in US dollar terms and in dollars adjusted for changes in the dollar index. Once the Federal Reserve began its loose-goose response to the financial crisis in August 2007, marked with a magenta line, gold began to track the net expected inflation measure closely.



The net expected inflation measure peaked on January 11, 2010 at 2.415%, and has lost almost 30 basis points since then. Gold peaked on December 2, 2009 in USD terms; in dollar index-adjusted terms, it peaked much later, March 2, 2010.

The implications are astonishing: Years of ultra-low interest rates, global competitive devaluation of currencies, sovereign debt crises, and fiscal policy out of a Fellini movie have pushed gold so far but have been unable to push it further. The yellow metal needs an exponentially greater level of irresponsibility. Will you do your part?

Euro Gold

The picture changes if we look at gold priced in euros and construct a similar net expected inflation measure for the eurozone. Here gold rose along with the aforementioned increase in physical demand even as net expected inflation declined into the financial crisis of 2008, once again marked with a magenta line. Interestingly, the pace of gold’s ascent didn’t change materially before and after September 29, 2008: The two periods are identical at 80.6% confidence.



Gold’s recent rate of ascent in euro terms exceeds the change in net expected inflation. The idea that Europeans eager to hedge their continent’s woes are fleeing to gold and not to those once-scorned dollars isn’t supported in the data. Both measures have declined in recent weeks; net expected inflation peaked on February 19, 2010 and gold on March 5, 2010. The dollar has gained more than 2.05% against the euro on a full-carry basis since February 19, 2010.

Yes, we need more irresponsibility here in our global village. Some real Bugs Bunny, Zimbabwe numbers on inflation will do the trick. But then why would you ever sell your gold to get the paper money to buy food; were you planning on carrying your stash around with you?

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http://www.minyanville.com/investing/articles/gold-precious-metals-USD-index-correlation/3/29/2010/id/27508?page=full

Gold Provides Invaluable Insight
By Przemyslaw Radomski Mar 29, 2010 8:05 am
Its relationship with the USD Index suggests that precious metals are ready to move higher.


In China News and Recent Moves in the Dollar Index, I analyzed the situation on the USD Index, and because it has just moved sharply higher, I believe you'd appreciate an update. After covering the situation on the US Dollar market, I'll move to the implications it may have on the precious metals sector.

Moving on to the technical part of this week's update, let's begin with the long-term chart:


Source: StockCharts.com

Previously I mentioned that I saw the USD Index break below the up-trending channel line. This move was confirmed with three consecutive closes below the lower channel trend line, so the next significant move in the index is likely to be down.

Well, by definition, from time to time unlikely has to occur, and this is what we've seen this week as the USD Index rallied dramatically higher. This week the USD Index pierced the lower border of the previous trading
channel and once again moved inside of it. However, there is still a lot of evidence that this rally isn't going to last because the latest upswing is knocking up against resistance at the Fibonacci 50% retracement level of the previous decline (March to December 2009). Key Fibonacci levels have historically been reliable in identifying key support and resistance, especially on the US Dollar market.

In addition, the Relative Strength Index (RSI) is right at the 70 level and, looking at when this was the case, in the past four out of five times at least a small rally took place in the precious metals market. Therefore, the long-term USD Index chart suggests higher precious metal prices. Let's take a look at the short-term chart for more detailed view.


Source: StockCharts.com

What is even more visible on the short-term chart than it was with the long-term one is the way precious metals reacted to the recent strength in the US Dollar. Please note that even though the USD Index had a significant rally, Gold and Silver were basically unharmed as they moved down just slightly. I realize that the very recent downswing in precious metals might have appeared dramatic on a day-to-day basis; it's much less so when one compares it to the analogous move in the US Dollar. This certainly bodes well for the possibility of higher prices in the precious metals going forward.Therefore, despite this week’s price appreciation in the USD Index, I'm still not bullish on this market. Given the historical significance of the RSI being at 70 and the fact that the USD Index has just touched the 50% retracement of the previous rally leads us to anticipate that the recent USD Index rally will stall out and retrace. In addition, a rally for precious metals and precious metal stocks is looking more and more probable.

Additional details regarding the correlation between the USD Index and the precious metals can be found in our correlation matrix:



The main thing to notice on the correlation matrix this week is how we're starting to return to the highly negative correlation between the US Dollar and the precious metals. Look over the last 10 trading days how that the Gold/USD, Silver/USD, and HUI/USD are all starting to increasingly get more negative.

Additionally, please take a look at the 30-day column and the values of correlation coefficients between Gold and USD Index/S&P 500. What is particularly interesting is the fact that for the first time in many weeks the correlation between gold and USD Index is stronger than with the general stock market. Moreover, that is also the case with the HUI Index.

When I commented on the correlation matrix last week, I wrote:


These values are nothing to call home about per se, but once you compare them with the values from the previous week we see that they have all declined, suggesting that perhaps we won't have to wait too long for the return of the strong negative correlation between precious metals and the USD Index.


This week, I see stronger evidence of the return of the negative correlation between gold and USD Index, which (as mentioned two weeks ago) is one of the things that would indicate that the precious metal market is ready to move higher.

Summing up, the USD Index moved to its resistance level after having rallied strongly. This rally caused gold to move lower, but its decline was relatively small. This is bullish for precious metals in two ways. Firstly, it means that gold is once again becoming negatively correlated with the USD Index, which in the past meant that precious metals are ready to move higher. Secondly, it suggests that the gold market is strong, as it has held up relatively well.

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