Gold: Has the ‘Narrative’ Failed?

Barry Ritholtz on the 'Gold Narrative'

Author Pater Tenebrarum: Presumably alerted by the failure of gold to break to new lows and the non-confirmation delivered by the gold stocks last week, Barry Ritholtz now believes gold could be due for a bounce that might be playable for short term traders. However, Mr. Ritholtz is also convinced that once said bounce is over with, the recent cyclical bear market will resume.

The reality is of course that neither Mr. Ritholtz, nor anyone else actually knows the future. Therefore, he cannot know whether the bear market is or isn't over. However, judging from the remainder of his post, he actually seems to think that the secular bull market in gold is over. In our opinion there is no evidence for that, and we will explain below why we think that he and others in the  long term bear camp are wrong.

Further below is the evidence marshaled by Mr. Ritholtz (actually, apart from the technical analysis he provides, it isn't really evidence at all – it reads like an unsupported opinion). To be sure, he does provide a link to a previous article of his that purports to discuss gold's fundamentals. We comment on this article (and its errors) further below. Contrary to Mr. Ritholtz's repeated assertions that he is an 'agnostic on gold', his tone reveals that he is indeed biased. Mr. Ritholtz is to our knowledge essentially an establishment figure with democratic leanings. Let us just note that socialists/democrats don't like gold much and generally believe that central banking and fiat money are just fine.

Here is what he writes about gold and the expected bounce:

“If you are a trader — and I no longer consider myself one — then you have to be wondering when Gold is going to bounce. It has plummeted on little inflation, a strong dollar and an improving economy. When the breathless narrative of hyper-inflation, collapsing fiat currency and end of the world failed to come about, Gold’s spectacular rise ended. Now, it has free-fallen so far that a counter-trend rally is over due.

How do the typical counter-trend rallies work? Well, the forced selling by margin clerks and futures traders becomes exhausted. A distraction may capture the investing community’s collective attention, allowing some stabilization to occur. As prices stop falling, the fear falling asset holders have been living with dissipates. A little bit of good news, a small reversal in price, and the prior (now discredited) narrative reasserts itself.

Note this scenario is non specific — we see it in stocks, bonds, commodities, real estate and yes, Gold. Apple will run this one day, AIG is already enjoying its turnaround, as all former high flyers do. And if the underlying business model improves, the turnaround could be for real, and the bounce morphs into a new sustainable uptrend.

Here comes the bad news: The bounce in a commodity like Gold — or its primary trading vehicle, GLD — is less likely to achieve that sort of happy ending. The bull market is broken, the prior narrative has utterly failed, and is no longer taken seriously, except by yellow metal jihadists and other assorted suckers.

(emphasis added)

So Mr. Ritholtz is completely unbiased about gold, but he considers any gold bulls that are still left 'yellow metal jihadists and other assorted suckers'. As a friend pointed out to us, this comes across as a racist and elitist in one fell swoop, almost a trifecta. In what way Mr. Ritholtz believes his analysis to be improved by making such insufferably arrogant comments we cannot say.

We have by the way no quibble at all with the short term trading call he makes (it seems well founded on technical grounds) and we also have no problem with someone having a bearish opinion on gold. It is true that a number of gold-bearish fundamentals have been in place in recent months, and we cannot be certain when the longer term outlook will finally trump these medium term bearish fundamentals.

However, what is the 'narrative' that Mr. Ritholtz believes to have failed? As he himself writes – we are not putting words into his mouth here – the 'narrative' as he understands it consisted of: “hyper-inflation, collapsing fiat currency and end of the world”. Since none of those things have come to pass (not yet, anyway), the secular gold bull market must be over.

That's his analysis? That gold requires a narrative about 'hyperinflation, collapsing fiat currencies and the end of the world' to remain in a bull market? If he actually believes that, then he knows very little about gold and would do better by not opining about it in public.

We must admit that there are a number of people in what is widely referred to as the 'gold community', who in spite of having their heart in the right place, are not necessarily very good gold analysts. Many stress facts that are really not all that relevant to the gold price (such as retail demand for gold coins, central bank buying/selling, primary supply/demand data, and so forth). There are also a few 'extremists' who indeed talk mainly about imminent hyperinflation and other end-of-the-world scenarios.

As readers of this blog probably know, we believe that we happen to have a pretty solid grasp of gold's fundamentals and what one's analysis should focus on (for a list of gold's fundamental drivers, see here, for an excellent summary of how the price of gold is determined see Robert Blumen's article here, and for a comprehensive analysis see Ronald Stoeferle's 'In Gold we Trust' reports here [2012] and here [2013]).

In short, neither imminent hyper-inflation, nor an imminent collapse of the fiat currency regime or any other end-of-the-world scenarios are actually required to be bullish on gold. In other words, this particular 'narrative' does not require 'reassertion' in order for gold prices to rise. It never was what drove gold's bull market in the first place.

Gold has no Fundamentals? Really?

So as to be fair to Mr. Ritholtz, we will also quote what he wrote in the article he pointed to as containing his fundamental analysis:

“We looked at Gold as a trading vehicle in the past, and identified the many ways it is different than assets like equities or bonds. Back in 2011, we noted that Gold is a trade, not a religion. During that presentation at the Agora conference in Vancouver, we discussed how commodities spike and collapse versus how equities roll over and break trend lines.

History shows Gold trades differently than equities. Why? It comes back to those fundamentals.

It has none.

This is not to say gold is not affected by Macro issues. But that is very different than saying Gld has a fundamental value, an intrinsic worth. It does not. That led to this heretical advice: Gold is not, and can never be, an investment. It has no true intrinsic value, no cash flow, no earnings, no coupon. no yield. What people call fundamentals are nothing more than broad macro analysis (and how have your macro funds done lately?). Gold is the ultimate greater fool trade, with many of its owners part of a collective belief theory rife with cognitive errors and bias.

I do not want to engage in Goldenfreude — the delight in gold bugs’ collective pain — but I am compelled to point out how basic flaws in their belief system has led them to this place where they are today. Gold does trade technically, and is especially driven by the collective belief system of the crowd. When that falter, well, you know what happens…”

(emphasis added)

Sure enough, gold has no yield, no conference calls, and no income statements (paraphrasing Jim Grant). That is actually the beauty of it. But that does not mean it 'has no fundamentals', nor does it means that it 'cannot be an investment'. In fact, since gold is currently not employed as a medium of exchange, it is nothing but an investment asset – one with monetary characteristics to be sure. The remark about gold not possessing 'intrinsic value' is entirely superfluous, as nothing in the world has 'intrinsic value'. This is not a feature that is an exclusive characteristic of gold, as all value judgments are subjective. Hence the notion that anything could possess intrinsic value is mistaken. The way Mr. Ritholtz formulates it above suggests that he believes that while gold has no intrinsic value, other things actually might have it. That is not the case.

The 'macro' issues that are driving gold are indeed gold's 'fundamentals'. To deny this is tantamount to denying that any currency has fundamentals, but obviously, every currency can be analyzed fundamentally. The fact that gold has no yield can be traced back to the fact that it is the only currency that cannot be inflated by central banks and bears no counterparty risk (see also Ronald's 2013 gold report on this topic). It is the high quality of gold as a currency that is the reason why it has no yield (it is by the way possible to lend gold out, so it actually does have a yield – but that yield is so small as to be negligible).

With regards to 'greater fool trades' and the 'cognitive errors and biases' exhibited by investors, these are also not features that can be said to be specific characteristic of gold. They can be found to assert themselves in every type of investment asset. Was buying the Nasdaq at 5,000 points in March of 2000 an example of a 'greater fool' trade exhibiting the 'cognitive errors and biases' of the buyers? We would argue that it was.

In other words, all the things Ritholtz lists as characteristic of gold's allegedly 'non-existent' fundamentals are things that are not specific to gold in any way.

Just about the only thing we agree with is that gold traditionally tops and bottoms in a manner that is different to how equities tend top and bottom out. That is however not exactly big news either. Earlier in his article Mr. Ritholtz makes a few additional points that are also worth commenting on:

1) Gold had a huge rally came as the dollar collapsed 41% from 2001 to 2007. The Dollar is now at a three year high. Why would that be a fundamental positive for Gold?

2) Quantitative easing has been going on int he US for 4 years, and worldwide for a while. What is the basis of Hathaway’s assumption that this is a net positive for Gold? We have so few examples of this phenomena that I do not understand his analysis here.

3) Cyprus is a terrible example of “governments’ new confiscatory inclinations.” Readers need to recall that Cyprus banks were paying 6% in a zero interest rate environment. These were not “risk free checking accounts” but rather high yield, high risk trades. This “confiscation” as described by the usual paranoics was nothing more than a capital loss in a high risk trade. (about 16 months of interest payments).”

We would answer these as follows: a declining dollar is better for gold than a rising one, there is no question about that. However, the dollar's exchange rate is but one of many drivers of the gold price. If that were not the case, gold could never rally in non-dollar terms, but it certainly does. In fact, the biggest gold rallies in history happen to have coincided with a stable dollar.

'Quantitative easing' or better, money printing, is indeed fundamentally relevant for gold. As Steve Saville recently pointed out, it is not 'QE' as such that drives gold, but rather its negative effects, which usually only assert themselves with a lag. Even if one doesn't know what exactly those are, one actually doesn't really need to be au fait with monetary/economic theory in order to realize the following: It should be obvious on a very simplistic level that if the supply of one currency rises relative to that of another, the currency with the faster growing supply will in the long run decline in value against the one with the slower supply growth. What's so difficult to understand about that?

Regarding Cyprus, we agree that the Cyprus affair as such is correctly characterized by Mr. Ritholtz. However, the fact that depositor 'haircuts' have been made the new 'template' of how future bank insolvencies will be dealt with does strike us as relevant for gold. Big depositors have very good reasons to worry about the safety of fractionally reserved banks and hence the safety of their deposits. A number of them may well consider holding gold a good alternative – after all, it is essentially a form of cash and it is certain that no central banker can print more of it. Gold in allocated accounts is moreover an insurance against the failure of banks.

The Long Term Bullish Case

So why is there still a long term bullish case for gold? The main point to be considered is that the central bank backstopped fiat money system and the fractionally reserved banks operating in it have created a huge debt overhang. To see how extreme this has become since the dollar's last tie to gold was cut in 1971, one must ponder this chart of total credit market debt compared to GDP:

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All credit market liabilities compared to GDP since 1971 – via St. Louis Fed – click to enlarge.

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Although what is compared here is a stock (debt) to a flow (GDP), this chart does tell us something about the economy's ability to use debt productively, as well as its ability to service it.

It is well-known that the true liabilities of the regulatory democracies, resp. welfare/warfare states, vastly exceed even this enormous debt mountain. In fact, these so-called 'unfunded liabilities' are so enormous that everybody knows that there will either be a default or they will be 'inflated away'. Moreover, any honest assessment of the fractionally reserved banking system and its uncovered deposit liabilities must come to the conclusion that the 'end of the line' has essentially been reached.

As Ronald Stoeferle notes in his recent gold report, it is therefore a near certainty that governments will engage in various forms of 'financial repression' in order to 'fix' the situation in a manner that is regarded as politically painless. This almost guarantees that things will get even worse, as capital formation will stop dead in its tracks.

The current monetary system essentially faces two possibilities: either there will be massive deleveraging on a scale never before seen (commensurate to the build-up of the debt overhang), or it will continue to inflate. Guess what: massive deleveraging is simply politically intolerable. It can perhaps be forced on a few hapless smaller victims like Greece and Portugal, but no-one can force it on, say, France or the US. On the contrary, the current orthodoxy of central banking has one, and only one, solution for the dilemma: print more money.

As long as this is the case, we can expect the fundamental drivers of the long term gold bull market to remain intact. This time, no Volcker will ride to the rescue either. What he did simply can no longer be done. If you want to know why, compare the stock of debt of 1979 (approx. 150% of GDP) to that of today (approx. 360% of GDP).

One day we may even get to see those parts of the 'narrative' play out that Mr. Ritholtz deems to be an impossibility, namely the collapse of the current monetary system. Contrary to what one may think, it would not be a big deal historically speaking. Currency systems have imploded throughout history, and the current one is a prime candidate for that fate, given that it is entirely based on a mixture of faith and coercion. We certainly don't believe that eventuality to be imminent, but we think it is almost inevitable in the long run.  However, let us once again stress: this has no relevance to the secular gold bull market's likely progression over the next few years. We happen to believe that gold's price will eventually rise to levels that would be considered absurd today. When gold was 'cut loose' from the dollar in 1971 at $35 per ounce, a price of $850 looked like an absurdity as well, and yet it eventually happened.

Of course, right now, a cyclical bear market is underway, so let us not get carried away here. As noted above, we cannot be sure to what extent the tree will need to be shaken before the bull market resumes, but we do feel quite confident that the long term bullish case remains perfectly intact.

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