What to make of gold?

If we are to believe Shayne McGuire, a Texas pension fund manager quoted in this weekend’s Wall Street Journal, the price of gold is set to rise to $10,000 an ounce.   As the Journal points out, this puts him in the same dubious company as those stock market prognosticators who, in the 1990’s, predicted the Dow would inevitably rise to 36,000 and the NASDAQ would eventually top 10,000.  Well, we all know how that turned out.

But, Mr. McGuire isn’t alone in his predictions that gold has farther to run, and many who share that view are quite savvy.  George Soros, John Paulson, and Marc Faber have all predicted that gold will continue to rise (eventually)- even from these levels (see this article from August 2010 detailing some top fund managers’ gold holdings).  Moreover, many have pointed out that gold is far from in a bubble.  Brett Arends included a nice chart in a recent article that shows exactly how much farther gold would have to climb in order to achieve a status akin to the real estate and NASDAQ bubbles of the recent past.  There is also an excellent video on the FT.com site that compares the recent gold run up to a selection of past asset bubbles- including the gold bubble of the 1970’s.   Both these sources make it clear that gold is far from a bubble and could easily rise six-fold from here before it would match levels achieved in previous bubbles.

So, what are we to make of this?  Should individual investors load up on gold, as apparently many would like to?  Or, should they dump it if they have it and invest in stocks?  Well, I don’t have a crystal ball, but I do find it helpful to view this situation through a different lens: gold’s value relative to the S&P500.

The following chart shows the value of the S&P 500 relative to gold from 1970 to the present.

 As you can see, during the height of the gold bubble in the 1970’s, gold was worth almost six times more relative to the S&P500 than it is now.  This confirms what the comparisons to past bubbles have shown, which is that gold could still run a lot farther – even relative to stocks – if it is, in fact, headed for another bubble. 

What the chart also shows, however, is that gold has had a pretty good run over the last ten years or so relative to stocks.  The ratio of the S&P500-to-gold peaked in 1999 (at the height of the tech stock bubble) at 5.59 and is now trading only slightly above the low of 0.71 it hit at the bottom of the recent meltdown.  The S&P500 looks even cheaper relative to silver, where its relative value is below where it was at the low of the market meltdown in 2008, as the following chart shows.

 Given all this, what are we to do?  Should people buy precious metals in anticipation of a six-fold run up from here- in other words, a repeat performance of the 1970’s bubble?  Or is now the time to take profits in metals and buy stocks? 

I think the answer to that depends almost entirely on how irresponsible the Federal Reserve is in the coming months.  If you think that Ben Bernanke has lost his mind and is about to turn the USA into the United States of Zimbabwe, then gold is probably setting up for a nice run from here.  If, however, Bernanke acts as cautiously as he has hinted he will, and the US dollar doesn’t collapse, then now might actually be a great time to sell gold/silver and buy stocks.  A cautious Bernanke combined with a strengthening US economy would be even more bullish for stocks and bearish for metals.  The combination of the strengthening dollar and rising corporate earnings would drive down the price of gold while simultaneously supporting share prices.

So, which position you choose depends mostly on what you think will unfold in Act II of the Quantitative Easing drama.  My bet, if I may be so bold, is that Bernanke isn’t as big a fool as some think, and the market will ultimately be disappointed by the amount of easing he chooses to put into effect.  As a result, metals will weaken, stocks will ultimately rise, and a full-blown gold bubble will not materialize.  This is, undoubtedly, the optimists’ view and probably the minority view at the moment.

But, for anyone who agrees with me, my advice is to sell your gold and buy the S&P500.  And, if you’re feeling fancy, you could even short GLD and go long an equal (or greater) percentage of SPY’s, for example.  Such a position would act as a hedge if there's a sudden synchronized downturn in both stocks and metals, while it would be profitable if metals and stocks eventually decouple and stocks  outperform gold (for more on how stocks have usually outperformed gold in the past after a period of synchronized moves in gold, equities, and bonds like we've just experienced, see this video).  Of course, don’t sue me if it turns out badly- you’re money and your decisions are your own business- but it seems to me that the only way such a position could go sour is if Bernanke is a reckless fool.  And, I just don’t think that’s going to happen.  The man, as much as I disagree with some of his actions, is extremely shrewd and careful, and I don't think he's about to print money willy-nilly.

For those of you who don’t want to take just my word for it and prefer the comfort of being aligned with professional investors, a recent survey of money managers in Barron’s revealed that 62% of professional managers polled think that stocks will be the best performing asset class over the next 12 months, while only 15% believe that gold/metals will be.   Usually, going with the crowd isn’t a good idea in the investment world, but this crowd is one whose opinion must be taken seriously, since they are the ones with the most capital to deploy and, as a result, their prophecies are often self-fulfilling.  If I have to choose a bandwagon to join, I’d rather it be theirs than the “goldbugs” currently populating chat rooms and tea party rallies- even if it means ignoring our Texan friend Mr. McGuire's prediction about gold's inevitable date with $10,000.  

In any case, here's hoping Bernanke is "careful" on Wednesday when he announces his intentions for the next round of quantitative easing.  It might disappoint the markets in the short-term, but in the longer run it will be better for all of us- especially those of us who are bullish on stocks and skeptical of precious metals.

Quantitative Easing is a Ponzi Scheme in which the Government is the Greatest Fool

US Government debt now exceeds 90% of GDP

Bill Gross, one of the world's largest bond fund managers, in his November Investment Outlook finally called quantitative easing what it is: a Ponzi scheme.  According to Gross, both the government's financial stability and the value of its current bonds depend largely on the existence of new buyers willing to buy future bond issuance.  In other words, the government can issue IOU's and expect them to retain value only as long as there continues to be a supply of customers willing to buy new bonds in exchange for the promise of a "certain" return.  As long as this situation persists, the government can pay its earlier bond buyers interest with the money it gets from its newer buyers, and so on ad infinitum.

Of course, one might wonder if the interest on existing bonds can't simply be paid with tax receipts.  Unfortunately, tax receipts do not cover all the government's funding needs.  So, even though the interest on existing bonds could be paid entirely with tax receipts, this could only happen if the government cut other spending.  The current gap between government expenditures and government receipts is such that without a constant influx of new money raised from bond sales, the government would be forced to cut expenditures drastically just to have enough cash to make interest payments on existing bonds.  The chart below illustrates the difference between government expenditures (the orange line) and receipts (the black line).

Government expenditures exceed receipts by a wide margin

This chart illustrates a situation in which new bonds must be sold in order to raise money to pay the interest on existing bonds and to fund ever-expanding government spending, since tax receipts alone will not cover all the government's costs.

Unfortunately, this sounds an awful lot like a Ponzi scheme.  And it all starts to unravel when the government can no longer find enough willing buyers for its debt (e.g. the Chinese, banks, and money managers like Gross), because buyers have lost confidence in the government's ability to keep the scheme going.  So, the government is forced to buy its own debt by printing more money and then using it to buy its own bonds.  This money can then be used to pay the government's earlier customers (e.g. the Chinese, the banks, and money managers like Gross) their interest, keeping the game going for a little while longer.  But then the money itself starts to seem questionable.  After all, any new money that's printed simply dilutes the value of money already in circulation, does it not?  The Fed isn't creating any new value when it prints another trillion dollars, is it?  In fact, what Gross points out is that the Fed is actually creating inflation (their stated goal, by the way), which is bearish for bonds and ultimately means they will fall in price and rise in yield as the market adjusts to higher inflation.

In the end, this means that the government is probably buying at the top of the market, and savvy investors will likely be lining up in droves after Wednesdays QE announcement to sell their bonds back to the government. Gross' article reads to me like a pretty clear indication that he plans to do exactly that.  And he owns enough bonds to really move the market.  It can't be long until other large players follow his lead, and (in Gross' words) "the Fed’s announcement will likely signify the end of a great 30-year bull market in bonds..."  If this scenario pans out, then the government- by buying trillions worth of bonds at their peak- will essentially be playing the role of the greatest fool in a game of selling-to-the-greater-fool that has run out of fools.

An ancillary- but possibly even more outrageous-  byproduct of this action, as Gross points out, is that it changes the government's role from being the referee who guarantees that the invisible hand of capitalism is allowed to work (i.e. by providing a rule of law, enforceable property and contract rights,  and maintaining a competitive marketplace by inhibiting monopolies, etc.) to being an active participant in the market.  The government is now a player in the game, not just the referee.  And, at the moment, it is the biggest player.  As such, the government threatens to squeeze out all the other players and, in fact, has already created a distorted macro market environment in which all assets move primarily based on what people believe Bernanke will do next.  Other considerations- like earnings, employment, supply and demand, etc.- are trumped by one all-important factor: how much money Uncle Sam is planning to print (here's a good video on the recent synchronized movement of assets and a good piece by Michael Santoli of Barron's in which he mentions this dynamic). 

This is not a healthy situation and one that is likely to end in another crisis for the financial (and political) system.  If it doesn't happen right away, and we enjoy some illusory prosperity thanks to money printing, then we will be experiencing nothing different from what Weimar Germany or Zimbabwe first experienced when they tried printing their way to prosperity.  Inflation feels good- at first.  But, after people realize that the currency raining down upon them in the form of higher wages and/or asset prices isn't holding its purchasing power in the face of even more rapidly rising prices for essential goods and services, then bad things can happen.  Did I already mention Weimar Germany as an example?  I think we all know what happened after that.

For more reading on the subject of sovereign debt, I highly recommend Reinhart and Rogoff's "This Time is Different."  One of R&R's essential points is that once a country reaches a debt-to-GDP ratio that exceeds 90%, it is extraordinarily difficult to avoid falling into a debt trap in which the compounding costs of servicing debt eventually exceed the government's ability to pay, and a default becomes inevitable.  It's worth noting that the U.S. government's debt-to-GDP ratio currently exceeds 90%.

Benoit Mandelbrot, mathematician and inventor of fractal geometry, dies at 85...

This Guardian article is a nice survey of Mandelbrot's career and the development of his best-known contribution: fractal geometry. 

What The Guardian doesn't mention, however, is Mandelbrot's equally interesting work on price behavior, which he presented in a relatively recent book, The (Mis)Behavior of Markets.  Mandelbrot's basic thesis is that prices have "infinite variance" and are not normally distributed.  In other words, a set of price data ultimately won't fit into a bell-curve-like distribution, but instead looks more like a bell curve that gets wider at both extremes.  It's essentially the "fat-tail" idea that has recently become popular in other fields applied specifically to price data.  Mandelbrot began developing this theory while researching the price of cotton-  analyzing price data going all the way back to the 19th century.  Ironically, the price of cotton just hit a 140-year high- an extreme that surely lies far out on the right hand extreme of a distribution of historical cotton prices.

Here is an interesting video from FT.com about Mandelbrot's impact on financial theory.

Here's another video in which Mr. Mandelbrot himself talks about how his thinking differs from the theory of efficient markets.

A simple but important illustration of the power of diversification...

A diversification study from Ed Seykota's site.

The effects of correlation need to be taken into consideration when performing an exercise like this, but the essential point is still valid and important (i.e. that using a broad basket of investment strategies -provided they have a statistical edge to begin with- will smooth out drawdown and increase overall return).

The trouble with multitasking...

 The Myth of Multitasking.

Although multitasking is often presented as a virtue, evidence suggests that productivity suffers and stress increases when people multitask.  Learning to focus and pay close attention may, in the end, be far more useful than learning to multitask in an environment full of distractions.

(Even) more unintended consequences of quantitative easing...

   It's a fairly well established fact that cheap money printed by the US Fed is chasing higher yields in overseas markets, where raging asset prices and higher yielding currencies make for more attractive investments than US-based assets.  This pursuit of hot markets and stronger currencies is possibly becoming self-reinforcing and starting to exhibit bubble-like dynamics.  For more on the bubble-making tendencies of easy monetary policy as well as its current effect on emerging/overseas markets see Billige Dollars bereiten nächste Finanzkrise vor and Fed's Danger of Leaks with QE2.
   One particularly egregious example of this is Hong Kong.  Here is a chart of EWH, an ETF composed of a basket of Hong Kong stocks that trades on the NYSE:

Notice that the run-up began just as the markets started to believe that QE2 was on its way.   What's wrong with this?  Well, nothing if you are a sophisticated American investor or a rich person living in Hong Kong.  For everybody else, however, this is a disaster.
   The problem is that this sort of asset-only boom only enriches the people at the very top of the economy (i.e. people who already own lots of assets like stocks and real estate).  It does nothing to help the middle and lower classes, since these gains seldom translate into wage and employment gains.  If anything, these asset-only gains hurt middle and lower income earners by making the cost of real estate and food prohibitively high.  For a particularly depresssing example of this, see this video about people living in cages in Hong Kong.
   A less stark version of this dynamic is playing itself out in the U.S. today, where Wall Street executives are set to receive record pay while the official unemployment rate still stands at 10%.  A Barron's reader left a comment recently that aptly summarizes the American dynamic:

"The fed is destroying the American middle class. My grocery bill is up, my heating bill is up, and it costs more to fill my gas tank. Meanwhile, I earn no interest in savings, have a flat paycheck, and have a 401K that is too small to benefit from asset inflation."

   Let's hope that Ben Bernanke, who is a very smart man, is thinking this through.  I don't envy his position, but it might be time to stop the presses and let the economy adjust the old-fashioned way...

QE2 as a game theory optimization problem...

Myron Scholes on QE2.  Points #4 and #5 are particularly interesting.  QE2 really does feel like a game theory optimization problem working itself out in the real world.  If Bernanke makes the optimal move (and the world recognizes that his move is optimal), then QE2 may be harmless/net positive.  If, however, Bernanke doesn't make the optimal move (and/or the world doubts or doesn't think that he has done so), then the negative effects of QE2 will likely outweigh the positives (i.e. other countries may respond in a way that causes everyone to lose).  Which outcome seems more likely?

Even The Party faithful are censored by their own watchdogs...

Chinese ex-officials seeking end to censorship are censored themselves.

It seems to be a characteristic trait of totalitarian governments that they set up "departments" whose original purpose is to suppress opposition but which eventually evolve into self-sufficient power centers that are hellbent on their own preservation and that nobody can control- not even the bureaucrats who set them up in the first place. Looks like the Chinese Central Propaganda Department is the latest example of this...

Doubts from within the hallowed halls of the Federal Reserve...

Would QE2 Have a Significant Effect on Economic Growth, Employment, or Inflation?

Apparently, not everyone with a job within the Federal Reserve system thinks that quantitative easing will have the desired effect.

More cutting edge ways to invade your privacy...

'Scrapers' Dig Deep for Data on Web

This is both scary in general and an excellent example of how our laws often don't keep up with technological change.

If architecture is "frozen music," then what is music?

 Michael Levy's "Giant Steps" Animation

 Music Animation Machine

A few excellent examples of music made visual.

Sing it Alan Murray...

The End of Management

Corporate bureaucracy is becoming obsolete. Why managers should act like venture capitalists 

If this is actually true, then life within corporations should improve for the average worker.

The Checklist...

The checklist may be the best management tool ever invented.

The internet at its best...

http://www.khanacademy.org.

To me, this represents the promise of the internet fully (or almost fully) realized.  These high quality educational resources can be accessed for free by anyone with a computer (or smartphone) and a fast internet connection.  The democratization of education this represents is a true cause for celebration and should be modeled/imitated by others.  Sal Khan deserves all the good things that come his way.  Let's hope thousands of kids (and adults) find their way to his site and maybe even a little enlightenment there.

A thought provoking essay on the internet and the self...

Kampf ums Ich

one of the funnier lines...

"Die Renaissance hat einst dem Ich das Bewusstsein geschenkt. Ein halbes Jahrtausend später ordnet Google auch das neu. Wer die Suchmaschine nach "Renaissance + Ich" suchen lässt, erhält als ersten Treffer ein Urlaubsresort in der Karibik."

Gimme back my housing bubble!

Compared to this, the housing bubble will be seen as a productive and efficient allocation of resources.  At least the housing bubble left a huge stock of poorly/hastily built houses that may someday be used as actual homes (except, unfortunately, for the ones built with toxic Chinese drywall).  But this gold thing isn't doing anybody any good...

Uh, Oh! The Rich Are Buying Gold Again

The Money Illusion...

This is the ultimate example of what economists call the "money illusion."  If you think your 401k/stock portfolio has been increasing in value over the last 18 months, think again...

Finally, somebody in the West admits that it takes two to tango...

Currency impasse

More scary european nationalism...

Sarkozy's War Against the Roma

This is a good thing...

The US gov't could use some credible competition in this arena- especially when it comes to inflation stats.

Google to map inflation using web data

Unreal!

Tamagotchi

Gameplay

Upon removing the tag of a Tamagotchi unit, an egg will appear on the screen. After setting the Tamagotchi unit's clock, the Tamagotchi will hatch after several seconds, after which the player will be told of its gender and will be given the opportunity to give it a name, which can be as long as 5 to 8 characters in length. From then on, the player is given the task of raising the Tamagotchi to good health throughout its life and attending to its needs, such as feeding it, playing games to make the Tamagotchi happy and keep it at a healthy weight, cleaning up its excrement, punishing or praising the Tamagotchi based on its actions, returning it to proper health with medicine if it gets sick, and shutting off the lights when it goes to bed. If the Tamagotchi is left uncared for, it will soon result in the death of the Tamagotchi.
As time passes, the Tamagotchi will evolve through various stages (Baby, Toddler/Child, Teenager, Adult, and Senior), the results varying based on the gender of the Tamagotchi, its current generation, and on the player's actions. A Tamagotchi that has been cared for well enough will result in a better and a well-mannered Tamagotchi, while excessive poor care will instead result in a Tamagotchi that requires much more attention and often does not behave well. Upon reaching a specific age and friendship level with another Tamagotchi, the player's Tamagotchi will be able to mate with another Tamagotchi of the opposite gender, usually arranged by an elderly Tamagotchi known as "the Matchmaker" or "Mrs. Busybody". Once the two Tamagotchis mate successfully, the female produces two infant Tamagotchis, one which is kept by the father, and the other by the mother. After 24 hours pass, the parent leaves the baby, starting a brand new generation.

 

The US is #1 in attempts to censor the internet. China is "?"

http://www.google.com/transparencyreport/governmentrequests/

 

A new specter haunting Europe?

Continent of Fear: The Rise of Europe's Right-Wing Populists - SPIEGEL ONLINE - News - International

 

Economic protectionism, currency manipulation, and good old-fashioned right wing populism are all variations on the same theme - keep the foreigners and the unknown out of my society.  Unfortunately, while Europe has a relatively enlightened understanding of how to manage their economy, there's a disturbing trend towards the anti-enlightenment in their immigration and integration policies. 

George Soros on China's currency policy...

China must fix the global currency crisis

This is pretty depressing. One of the things Soros is saying is that the Chinese practice of offsetting their trade surplus by selling yuan/buying dollars essentially transfers the fruits of the Chinese people's labor into the pockets of the Chinese gov't ("it has the same effect as taxation but it works much better"), which then allows the government (not the people) to decide what to do with the surplus (which has been converted into us dollar reserves). This would be bad enough if it weren't for the fact that other countries must now follow suit (mostly because of the Fed's quantitative easing and China's insistence on maintaining their weak currency). It's happening as we speak at the IMF. Several countries have already announced capital controls. The fruits of people's hard work all over the world are being sucked up into gov't coffers and converted into US dollar reserves as part of a lose-lose game that nobody is willing to give way on. Geithner blames China, China blames Bernanke, and everyone else scrambles to weaken their currencies at the expense of their own workers, who could be spending their surplus on goods and services (like education) that would improve their own lives. The upshot here is that Chinese currency policy isn't really about enhancing the Chinese economy. It's about maximizing the Chinese gov't's control over its people. And now that same policy is being exported to other emerging economies who have no choice but to artificially weaken their own currencies at the expense of their population's autonomy.

A Catalog of Human Error...

Wikipedia's List of Cognitive Biases.

This is a good list to peruse before you make any life-changing decisions or, perhaps, before you go into the office on a Monday morning...

Why a blog?

Well... I spend an awful lot of time reading things on the internet, linking from page to page as I get into a specific topic.  I often stumble onto interesting (at least to me) and occasionally arcane articles, videos, blogs, etc. that I would like to keep track of somehow and share with others in the process.  I could use Facebook for that I suppose, but I'd like to experiment with posting the links (and sometimes my commentary on them) here and then seeing what happens.  If nobody is really that interested, then this will at least become an archive for my own personal use.  If, on the other hand, like-minded people find their way here and extract some value from this, then so much the better.  I'm not looking to convince anyone of anything or even to express a cohesive viewpoint on a particular topic.  I'm just collecting links to ideas I find exciting and/or important in these times and hoping that like-minded people may someday stumble onto this resource and jump in with their own references and ideas.  Will it work?  Who knows, but I intend to have fun either way.