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Tuesday, October 5, 2010

"I buy gold; you should too!"

I think by now we have learned that low interest rates create asset price bubbles, while high interest rates create bargains.

What’s a bubble? An asset class that is overvalued relative to its discounted future cashflow. Right now, the leading candidates for price bubbles are gold, treasuries and JGBs.

It is paradoxical  that the price of gold, treasuries and JGBs have been so closely correlated since the crisis. Gold is a hedge against inflation, treasuries are a hedge against deflation, and JGBs are a hedge against common sense. 
What’s good for gold should be bad for treasuries. Remember 1980, when gold was at an all-time high and bond prices were at an all-time low?

So what’s going on? I think the reason is that “safety” is highly overpriced, while risk is highly underpriced. This is due to the volatility of risk asset prices since 2006.

Also, as in the case of all bubbles, the assets in question have “momentum”: bonds and gold have been the best (and steadiest) investments during this period, while stocks and real estate have been volatile and ugly. Momentum, of course, is meaningless as an investment criterion unless you believe in astrology or technical analysis.

The real return on treasuries is extremely low (unless you expect deflation). If treasury yields returned to ~5%, you would be looking at massive MTM losses.

The real return on gold is nothing because it pays neither interest nor dividends. But isn’t gold a hedge against inflation or the dollar or bad news or something?

Why? How can an overvalued asset that has no intrinsic value be a hedge against anything besides evil spirits? Gold at $35/oz in 1971 was, in retrospect, a good hedge against inflation and a weak dollar. But is gold at $1,300 a good hedge against inflation? It wasn’t in 1981, when its value collapsed in spite of unprecedented inflation.

There is simply no logic to the price of gold. It is a talisman, a fetish, a religious article, not an investment.

Will gold and treasuries remain correlated when things turn around? I don't know, because there is no logic behind the price of gold. If the Fed can revive inflationary expectations, treasury prices will fall; that is axiomatic. Inflationary expectations will revive nominal activity and the stock market. Flows into bonds should reverse, resulting in a bond crash. That I know.

And gold? Well, it could go down due to flows into equities, or up due to inflationary expectations. But, because it has no intrinsic value, it has no economic “support level” to prevent a repeat of the 1980 crash.

My view would be that, as confidence in equity valuation returns, and the ERP goes down, gold will stall, then dip, and then crater (to below $1000).

That would be the rational prediction. But I reiterate: there is no logic to movement in the price of gold. It is a random walk.

1 comment:

Ian Elbanbuena said...

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Well, gold has been a stable investment for years. However, as far as the inflation rate is concern, real estae industry comes as the best moneymaker of all time. In the early years only UK and US has the edge but now even asian countries are competing with them too. here are some of the investment samples they have. http://www.onlinepropertydeals.com/sell-a-property/