Dylan Grice Discusses When To Take Profits On Gold: Hint - Not For A Long While
In the most recent stellar analysis by Dylan Grice, the SocGen analyst discusses the reasons for not only owning gold (and there really isn't a more profound one than taking a trip to the Marriner Eccles building and checking out what goes on in the first subbasement) but, more importantly to many, selling it. His summary view on owning Au79: "The reason I own gold is because I'm worried about the long-term solvency of developed market governments." We all know developed markets are now insolvent and merely exist due to the continued debasement of fiat paper. Period. As to when to sell: "Eventually, there will be a crisis of such magnitude that the political winds change direction, and become blustering gales forcing us onto the course of fiscal sustainability. Until it does, the temptation to inflate will remain, as will economists with spurious mathematical rationalisations as to why such inflation will make everything OK . Until it does, the outlook will remain favorable for gold. But eventually, majority opinion will accept the painful contractionary medicine because it will have to. That will be the time to sell gold." Courtesy of universal denial of our current predicament, we still have a long, long time before acceptance sets in.
Some would say the time to sell is now. Gold just isn?'t the misunderstood, widely shunned asset it was a few years ago. Isn?t the gold bull market now long in the tooth, with better opportunities to be found elsewhere? I can understand this view. Had you bought stocks at the bottom of the bear market in 1974 and held them for ten years you?d have seen them go from being hated to being loved. And as the number of mutual funds exploded you could have plausibly argued that since stocks were no longer the deeply contrarian plays they?d been, they should be sold. But you?d have missed spectacular gains over the next 15 years because the social contrarian indicators said nothing as to how favourable underlying conditions were for risk assets.
And even as insolvency is now a universal fact of life, the outcome, as Ebullio found out the hard way, is still either/or - with both hyperinflation and deflation likely (with a dash of stagflation thrown in for good measure).
Though developed market governments are insolvent by any reasonable definition, it?s far from inevitable that this insolvency will precipitate an extreme inflationary event ? it?s just that it might ... And although I've wondered aloud if Ben Bernanke is in fact the reincarnation of Rudolf von Havenstein ? the tragic president of the German Reichsbank who presided over the Weimar Hyperinflation (speculative evidence presented below) ? I don't think he actually is ... it?s just that he, and other central bankers, might be closer than they think ...
Gold, like all other commodities, is inherently speculative. Unlike well chosen stocks which you buy to hold to take advantage of their wealth-compounding properties, you only ever buy commodities to sell later. With this in mind, when should you sell gold?
The age old question - is gold a currency.
Willem Buiter called "?Gold - ?a 6000 year bubble?" -? ft.com. The late and great Peter Bernstein subtitled his book about gold “the History of an Obsession”. But much as I admire these two great minds, such loaded phraseology implies there to be something irrational about owning gold and I think that?s just plain wrong. The fact is that there is a fundamental need for a medium of exchange. Early civilisations used pebbles or shells. Prisoners have used cigarettes.
Having a medium of exchange makes life easier than under barter economy and societies have always organised themselves around the best monetary standard they could find. Until industrialisation of the paper printing process, that happened to be gold, which is small, malleable, portable and with no tendency to tarnish. Crucially, it's also relatively finite and this particular characteristic (in combination with the others) can be very useful in environments characterised by monetary mischief.
I view it primarily as insurance against such environments. It?s a lump of metal with no cash flows and no earnings power. In a very real sense it's not intrinsically worth anything. If you buy it, you're forgoing dividend or interest income and the gradual accumulation over time of intrinsic value since a lump of cold, industrially useless metal can offer none of these things. That forgone accumulation of wealth is like the insurance premium paid for a policy which will pay out in the event of an extreme inflation event.
Is there anything else which will do that? Some argue that equities hedge against inflation because they are a claim on real assets, but most of the great bear market troughs of the 20th century occurred during inflationary periods. A more obvious inflation hedge is inflation linked bonds, but governments can default on these too. More exotic insurance products like sovereign CDSs, inflation caps, long-dated swaptions or upside yield curve volatility all have their intuitive merits. But they all come with counterparty risk. Physical gold doesn?t. Indeed, during the “6000 year gold bubble” no one has defaulted on gold. It is the one insurance policy which will pay out when you really need it to.
There is nothing mystical about gold and I don't consider myself a gold bug. In fact, I'm not sure I'd even classify gold as an ?investment? in the strictest sense of the word. Well chosen equities (not indices) will act as wealth-compounding machines and are likely to make many times the initial outlay in real terms over time. These are ?investments? because so long as the economics of each business remain firm, you don?t want to sell. As they say in the textbooks, you ?buy to hold.? But gold isn't like that. Like all commodities, it's intrinsically speculative because you only buy it to sell it in the future.
There has never been a more appropriate time to be long gold than now, when every developed country is either insolvent or on the brink, and applying band aid measure to mask the facts.
The reason I own gold is because I'm worried about the long-term solvency of developed market governments. I know that Milton Friedman popularised the idea that inflation is ?always and everywhere a monetary phenomenon? but if you look back through time at inflationary crises ? from ancient Rome, to Ming China, to revolutionary France and America or to Weimar Germany ? you'll find that uncontrolled inflations are caused by overleveraged governments which resorted to printing as the easiest way to avoid explicit default (whereas inflation is merely an implicit default). It?s all very well for economists to point out that the cure for runaway inflation is simply a contraction of the money supply. It’s just that when you look at inflationary episodes you find that such monetary contractions haven't been politically viable courses of action.
Economists, we find, generally don?t understand this because economists look down on disciplines which might teach them it, such as history, because they aren?t mathematical enough. True, historians don?t use maths (primarily because they don?t have physics envy) but what they do use is common sense, and an understanding that while the economic laws might hold in the long run, in the short run the political beast must be fed.
I wrote about the Weimar Hyperinflation a few weeks ago and showed, for example, that Rudolf von Havenstein (Reichsbank president) was terrified of pursuing such a monetary contraction because he was so fearful of the social consequences rising unemployment and falling output would elicit. But the agonizing dilemma he faced, identical in principle if not in magnitude to that faced by policy makers today, is as old as money itself.
In the 3rd century AD, as the Roman Empire became too large and unwieldy, its borders were consolidated and the great imperial expansion halted. Though necessary, this consolidation posed problems. While the Empire was in growth mode, driven by military conquest which strengthened public finances, the army paid for itself. It was an asset on the national balance sheet. But when that territorial growth was halted, a hole was created in the budget as while the army was still needed to defend the borders, it was no longer self-funding because there was no territorial expansion.
Roman emperors discovered that contracting expenditure to fit with new lower revenues was a difficult feat to pull off. So rather than contract military spending, public works or public entertainment ? long-term necessities which were painful in the short run ? they opted to buy time using successive currency debasements. Ultimately, this culminated in what would become the world?s first of many fiscally driven inflation crises (see charts below).
What the declining Roman empire was doing then is precisely what Ben Bernanke and all central bankers are doing now.
Two thousand years ago, the fiscal sobriety so clearly needed in the long run was subordinated to the short-run requirement to buy time. Hence the age-old short-term temptation to debase the currency and hope no one notices. Paring overstretched government balance sheets has never been easy. As the Romans should have done in the third century, developed market governments today will have to come clean to their citizens that since keeping the welfare promises they?ve made over the years will bankrupt them, those promises are going to have to be ?restructured? and government expenditure substantially tightened.
Alas, the sugar substitute of denial, especially when faced with mid-term elections, is easier to swallow than the bitter pill of acceptance.
But governments aren?t ready to take that step at the moment (the chart above shows just how painful the required measures could be). Indeed, the pressing fear among policy makers today remains that stimulus might be removed too soon. In the UK, policy makers refused to ?risk the recovery we've fought so hard for” to quote PM Gordon Brown ?fought so hard for?!). In the US, lawmakers have just expanded the most inefficient health care system on the planet (according to Peter Peterson ?- ft.com there are five times as many CT scans per head in the US as there are in Germany, and five times as many coronary bypasses as in France). It has been promised that the increase will be deficit-neutral (which I doubt) but even if it is, current period deficits aren?t the correct way to look at health and pension obligations which should be examined on an actuarial basis (and if expanding the program is so difficult, wait until they try contracting it!)
But they will face up to these problems one day, because they must. And the good news is that there are precedents for policy makers adopting the policy of short-term pain for longterm gain. In the UK in the 1970s, for example, the country tired of lurching from one crisis to the next, of militant trade unions and of high inflation. Eventually, they elected Margaret Thatcher who promised to control inflation and smash the unions even if the short-term pain would be severe. She did, and it was. But the rest (despite 364 economists petitioning her that such drastic measures threatened social stability ?- How 364 economists got it totally wrong - Telegraph) is history. The key point to bear in mind is that she was elected with a mandate for short-term pain which hadn’t existed five years earlier. The political winds had changed.
Ireland swallowing bitter fiscal medicine today offers a similar example. I?ve been over there a couple of times in the last few months and it?s heartbreaking. Its economy has contracted by nearly 10% since the peak of the credit bubble and my friends in Dublin tell me that, unofficially, house prices are down 60-70% from their peak. Unemployment has spiked to around 15%. The striking thing about being there, though, is that while no one is happy about them, and there have been strikes in protest at the distribution of the pain (which, in passing seems to be a feature of the political climate during such crises) on the whole there seems to be an understanding that such measures are unavoidable. These draconian fiscal policies wouldn’t have been possible five years ago. But the political winds have changed.
The reason why gold has been so popular lately is the combination of all the factors that make the mixture explosive, with just the ignition catalyst missing. That catalyst - government crises. And look no further than Europe to see what happens when an entire continent is on the verge of collapse as a flawed monetary and socio-economic experiment not only disintegrates, but takes down the bulk of the constituent countries down with it.
What causes the political winds to change? A government crisis. In 2008, Ireland came very close to going the way of Iceland. They had their crisis. And historians today still refer to the ?inflation fatigue? in Britain by the end of the 1970s. This was our crisis. So what we learn from these experiences and others like them is that a fiscal crisis is required to force a majority acceptance of the implications of an overleveraged government.
But the political winds in countries with central banks are a long way from blowing in the direction of fiscal rectitude. And while it?s true that more people are at least talking about it, talk is very cheap and no one is yet close to walking the walk. Such steps remain politically unpopular because we haven?t had our crisis yet. Given the clear unsustainability of government finances and the explosive path government leverage is on, a government funding crisis is both inevitable and necessary. Dubai and Greece are merely the first claps of thunder in what is going to be a long emergency.
Eventually, there will be a crisis of such magnitude that the political winds change direction, and become blustering gales forcing us onto the course of fiscal sustainability. Until it does, the temptation to inflate will remain, as will economists with spurious mathematical rationalisations as to why such inflation will make everything OK (witness the IMF?s recent recommendation that inflation targets be raised to 4%: IMF Tells Bankers to Rethink Inflation -? WSJ). Until it does, the outlook will remain favorable for gold. But eventually, majority opinion will accept the painful contractionary medicine because it will have to. That will be the time to sell gold.
In closing, we would like to add that one should also not ignore the technical pressures on the gold market, with price suppression by the Fed and JP Morgan proven beyond a doubt. Should a full blown government crisis develop and price supression mechanisms be removed, watch what happens when the rush to cover massive shorts ensues. Indeed, the time to sell gold is not now, nor any time in the future. The time to buy, however, will depend on fluctuating levels. A push by the central banks to break gold support and slide back into triple digit range will be as sure a buy signal asy.