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Gold: Assumptions vs Reality

Expected Returns's picture




 

From Expected Returns Blog

One of the hardest things to do as an investor is to think through investments without presuming anything. The data will tell a story and paint a picture for you that you can  then interpret. Most people shun this obvious approach to investing and instead choose to invert the process by allowing their assumptions to cloud their analysis. This is simply not a sophisticated approach to investing.

A combination of history and quantitative data analysis will give you a perspective that 95% of investors do not have. For example, most people alive today have not lived through the gold exchange standard, and therefore have no clue how it functions. To most, it is a peculiarity of our ancestors; a relic of the past; and a product of a crude economic system. They cannot imagine the possibility of gold playing a role in the global monetary system. Their knowledge of history is small, and so is their sense of economic possibilities.

It is presumptuous to assume that gold will not eventually play a role in the international monetary system since it happened before in history. It is also presumptuous to assume sovereign nations will not default since sovereign defaults are prevalent throughout history. Most of the anti-gold arguments are based on assumptions that simply aren't true. Here are a few.

Jewelry Demand?

It is incredibly difficult to argue with someone who pulls the "jewelry demand" card on you. Why? The jewelry demand argument is so false that its defenders are invariably a special breed of stubborn. You can never win these kind of arguments.

Now as investors, let's test the assumption that there is some kind of relationship between jewelry demand and gold prices. As you can see below, if there is a relationship, it is a negative one.

 

 

If you invested based solely on an assumed relationship between gold and jewelry demand, you would have lost money 9 out of the past 10 years. While the data suggest we should change our assumptions, most people won't. This is the irrationality of human nature at play that allows a minority of investors to profit.

Investment Demand, Anyone?

The real demand is coming from institutional investors, retail investors, and governments. Chinese, Russian, and Indian central banks have recently become major buyers. This is a positive trend for gold since these governments hold so small a percentage of their reserves in the form of gold.  Since the dollar dominates foreign reserves, diversification into gold equivalent to dumping dollars.

 

 

 

Retail investors have also begun to protect themselves from spendthrift governments. Objectively speaking, retail investment is a far better indicator of gold prices than jewelry demand.

 

Marginal Demand, Human Irrationality, and Gold

A fundamental tenet of economics is that humans act rationally. Why I have no clue. Nothing in my experience has shown that people act rationally and to their best interest at all times.

Understanding human irrationality is central to understanding the future price movements of gold.  For example, are people more likely to buy gold at $250 dollars after 20 years of being the most hated asset in the world or at $2500 dollars? You don't see lines around the block at gold shops at bottoms; they are an indicator of tops. This is a reflection of both gold's unique marginal demand characteristics and the nature of bubbles in general.

The marginal demand aspects of gold run contrary to those of most other assets. Generally speaking, a rise in price results in a decline in demand. For gold, a rise in prices results generally in an increase in demand. This is its natural state. Add to the mix human irrationality and the panic buying that is bound to come and you start to understand that the monster moves in gold are still ahead.

Financial experts are telling us the gold trade is crowded. Ironically, gold will become a crowded trade only when the "gold bubble" experts start buying. Not to be flippant, but this is one of the top 3 indicators I'm looking for to signal a top in gold. Fortunately, the gold bubble experts are still out in force expounding on the threats of deflation-  an argument so riddled with holes that it should not be taken seriously. Making linear comparisons between fixed exchange and floating exchange systems is like comparing apples and oranges: It makes no sense and it is bound to result in flawed conclusions.

We should all try to test our assumptions against facts. That most investors don't is great news for gold bulls. We are on the precipice of a major move in gold that will make all blind assumptions concerning gold look foolish.

 

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Mon, 06/28/2010 - 19:22 | 440009 Johnny Bravo
Johnny Bravo's picture

I've posted charts before.

Most of the other arguments are common sense ones, unlike the "goled to 50000 bitchez" arguments.

Mon, 06/28/2010 - 18:44 | 439912 Johnny Bravo
Johnny Bravo's picture

As price increases, the possibility of it being extracted also increases.

Or what is the "smart argument" about price that you have that trumps mine?

I mean, since you know it all, and everything, Mr. "I worked in the gold industry servicing gold miners".

So you're saying increases in price won't increase the supply?  I don't get it.

Mon, 06/28/2010 - 18:59 | 439945 Johnny Bravo
Johnny Bravo's picture

Oh yeah, I forgot, nobody who claims to "know" will ever defend their position when called out about it.

They just cite bullshit they heard on the comments section of random blogs.

I am Johnny Bravo. 

Mon, 06/28/2010 - 21:14 | 440262 Devore
Devore's picture

Oh yeah, I'll just start up a mine over here, and get back to you in.... uhm, a decade?

Mon, 06/28/2010 - 15:54 | 439552 idea_hamster
idea_hamster's picture

A fundamental tenet of economics is that humans act rationally.

That is incorrect. The fundamental tenet of economics is that people respond to incentives. Their responses are often expected to be well informed and rational but there is no assumption that they need be so.

Mon, 06/28/2010 - 23:24 | 440525 StychoKiller
StychoKiller's picture

The MARKETS are perfectly rational, it's only limited Human abilities to perform > 2nd degree Non-linear differential equations that makes them appear to be irrational.

Mon, 06/28/2010 - 21:41 | 440313 Close 2 the Edge
Close 2 the Edge's picture

That isn't how it was taught to me...

Mon, 06/28/2010 - 15:55 | 439550 Temporalist
Temporalist's picture

In a somewhat related event that may lead more people out of the equities and to PMs:

Boeing Shares Tumble 44% Before Exchanges Cancel Trades

http://www.bloomberg.com/news/2010-06-28/boeing-shares-tumble-as-much-as...

Mon, 06/28/2010 - 17:36 | 439796 MayIMommaDogFac...
MayIMommaDogFace2theBananaPatch's picture

Can anyone speak to whether the frequency/quantity of cancelled trades over the last 60 days or so is historically out-of-line? 

I guess I mean to say: number of incidents.

Mon, 06/28/2010 - 16:56 | 439717 RockyRacoon
RockyRacoon's picture

Another canary dead in this maze of a mine.

Mon, 06/28/2010 - 16:20 | 439609 Amish Rake Fighter
Amish Rake Fighter's picture

that's the kind of crap that made me pledge never to buy a US stock ever again, can't trust a balance sheet, can't trust the market makers, can't trust the big hands, can't trust the regulators

Mon, 06/28/2010 - 15:57 | 439543 chumbawamba
chumbawamba's picture

There isn't going to be a top because this is not a bubble, and to speak of it in terms of the current market paradigm is indicative of ignorance and a lack of imagination.

The old ways are collapsing and a new age is upon us.  Fiat currencies will ultimately be considered for what they are: worthless ethereal digital blips or printed pieces of paper.

Think of a large body of water nestled in a great canyon, kept in place for millenia by a ridge that is now weathered and crumbling.  One day, lightning strikes and hits just the right keystone and the ridge gives way.  The large body of water is now a torrential river escaping out into the countryside wreaking havoc and reshaping the landscape where ever gravity takes it.  Finally, it settles, the former lake having drained to a puddle, while its water is now a series of smaller lakes and rivers throughout the valley.

There is no returning the water to the great lake high up in the mountains.  It has given way to a new environment and there's no going back.  The creatures that stayed or got trapped in the former great lake are doomed to extinction, while the ones that rode the rapids will settle and ultimately prosper in their new evirons.

Such is gold.

I am Chumbawamba.

Mon, 06/28/2010 - 19:14 | 439986 idoubtit
idoubtit's picture

"no bubble"

Tell that to the guy that bought in 1980.

http://www.tradingreview.com/images/gold-chart-june06.gif

Just like every bus, there's a time to get on and a time to get off.

Your post made me want to go camping.

 

Mon, 06/28/2010 - 21:18 | 440268 akak
akak's picture

"no bubble"

Tell that to the guy that bought in 1980.

What is with this disingenuous "argument", such as it is, that constantly brings up a VERY brief price spike as some sort of iron-clad reference point?  Do you realize how FEW people bought gold at that peak in 1980, and how many fewer were not daytraders who probably did not own it past the next day or week?  Really, it is all but meaningless to even bring up, except as an example of a mania --- a mania that was a flash in the pan as well.

I bought two Krugerrands only about 16 months before that peak, at just under $200 an ounce, and I am still nicely ahead on them, even accounting for the intervening inflation and devaluation of the US dollar.  THAT is a much more relevant example.

Mon, 06/28/2010 - 21:04 | 440230 RockyRacoon
RockyRacoon's picture

The key to your graph being irrelevant is the "non adjusted" notation.

I direct you to this reading, but more particularly to the graph:

http://www.usfunds.com/investor-resources/frank-talk/?i=2751

Mon, 06/28/2010 - 22:32 | 440405 idoubtit
idoubtit's picture

Thanks for the chart.  I fail to see your point.  Here is an even clearer adjusted chart.

http://goldprice.org/aden/uploaded_images/gold-price-adjusted-inflation-715269.png

Like I said, there's a time to get on the bus and a time to get off.  I'm inching my way to the front of the bus. 

Tue, 06/29/2010 - 01:08 | 440682 RockyRacoon
RockyRacoon's picture

Goes to show ya -- TA is trash.   Don't skin your knees jumping off the bus.

Mon, 06/28/2010 - 18:08 | 439786 Geoff-UK
Geoff-UK's picture

I have no idea what his analogy means, but Chumbs is right about this being a paradigm shift in thinking--it's not a bubble, it's a re-making of the world.

The world-wide paper currency experiment is nearing its conclusion.  There will be no return to "normality."  Gold will return to its rightful place as the currency that can't be inflated. 

 

Mon, 06/28/2010 - 18:28 | 439885 Johnny Bravo
Johnny Bravo's picture

"Gold will return to its rightful place as the currency that can't be inflated."

Any commodity, currency, bond, stock, etc can be inflated.

Look at AAPL.  Look at USO circa 2008.

Retail investors signal the end of the party.  The end can go on for a while, but make no mistake about it, the end will come.

Nasty rising wedge on the gold charts, isn't it?

1300 is the top.  Maybe 1310.  LOL

Mon, 06/28/2010 - 18:41 | 439896 akak
akak's picture

What a sad and pathetic troll.  Like a psychotic moth to the golden flame.

Your flippant and purposely ignorant comments take no account for the arguments raised here, and so are nothing more than antagonistic mental masturbation.

Mon, 06/28/2010 - 18:42 | 439906 Johnny Bravo
Johnny Bravo's picture

Yes, only the pro-gold argument has merits, and anybody who disagrees with you is all one person disguised as several different posters.  What was his name, Nadler or something like that?

I'm surprised I haven't been junked 1700 times by crybabies that can't take an opposing argument.

Mon, 06/28/2010 - 23:01 | 440475 lawrence1
lawrence1's picture

Please provide what you consider your best anti-gold argument and I and others will respond. Fire ...

Mon, 06/28/2010 - 23:42 | 440556 akak
akak's picture

Lawrence, you are naively assuming (as I originally did) that this JohnnyCowardo is trying to engage in honest or sincere debate.  However, his purpose here is nothing of the sort, but merely to antagonize, flame, attack, harass and insult anyone who is a proponent of owning gold.  Trying to hold a meaningful discourse with him has been repeatedly shown to be a fool's errand, as he will just evade or deflect any logical arguments or challenges to his anti-gold trolling (which, by the way, he has freely admitted is his intention here on more than one occasion).

Mon, 06/28/2010 - 18:46 | 439916 akak
akak's picture

I cannot judge the merits of any argument of yours, as you have never deigned to make any here --- you just maliciously attack, ridicule, flame and harass the advocates of gold over and over and over and over, like the despicable troll that you are.

Mon, 06/28/2010 - 18:49 | 439921 Johnny Bravo
Johnny Bravo's picture

Seems to me that the only person "maliciously attacking" others is you.

Names you've called me in the last 20 minutes: like 20

Names I've called you in the last 20 minutes: 0

Hmmmm...

And of course your estimates of the gold extraction price (based on nothing) trump my arguments pertaining to macroeconomics, technical analysis, and market sentiment.

Tue, 06/29/2010 - 02:21 | 440754 A Nanny Moose
A Nanny Moose's picture

Ah....the old "I'm the victim" tactic. Nice try.

Point remains...well, you have never made a point or even attempted to, as far as I have read.

Mon, 06/28/2010 - 20:16 | 440122 dnarby
dnarby's picture

If you think retail is buying gold, then you've been in a cave...  CASH4GOLD windows are sprouting like mushrooms.

Retail is SELLING gold.

Sorry.

Mon, 06/28/2010 - 16:50 | 439700 akak
akak's picture

"There isn't going to be a top because this is not a bubble, and to speak of it in terms of the current market paradigm is indicative of ignorance and a lack of imagination."

You beat me to it, Chumba, and took the words out of my mouth.

Yes, I strongly suspect that anyone looking at gold (and maybe silver too) as being in some sort of bull market or typical asset cycle are going to greatly surprised by upcoming monetary events over the next few years.  This is almost certainly NOT a "gold bull market" we are seeing, but a reintroduction of gold into the world monetary system.  As such, any predictions based on TA or other standard market analytical tools are fundamentally meaningless in this context.

Mon, 06/28/2010 - 23:23 | 440519 AUD
AUD's picture

Gold needs no reintroduction to the world monetary system because it never left. It is only the continuing redeemability of paper gold (government bonds, bullion bank notes, gold futures etc) that has kept the existing monetary system alive for so long.

Central banks have been loaning their gold reserves for years, keeping the gold circulating. Don't believe me? Check the link at the bottom of this article;

www.goldstandardinstitute.com/sections/articles/nature_of_money.html

and please feel free to read the article, I went to a lot of trouble to write it.

Mon, 06/28/2010 - 23:34 | 440547 akak
akak's picture

Of course, you are correct, on a much more fundmental level than that of my prior comment.  Perhaps I should have originally stated that gold is increasingly being reacknowledged as part of the world monetary system instead.

Mon, 06/28/2010 - 22:55 | 440457 lawrence1
lawrence1's picture

Exactly ... this is a systemic change, not another market variation. And gold doesnt even meet any of the criteria of bubble. So forget the banker bubble blather that bamboozle bozos and buy blissfully bullion. Another shot please.

Mon, 06/28/2010 - 16:54 | 439713 RockyRacoon
RockyRacoon's picture

...and you beat me to the TA argument being invalid. 

Charts don't trump a knowledge of history in this circus.

Mon, 06/28/2010 - 18:26 | 439880 Johnny Bravo
Johnny Bravo's picture

Yes, TA is completely invalid, and to quote Chumba "Gold will never have a top.""

Sounds rational to me.

Goled to 50000, bitchez!  It's shiny, pretty, and you can hold it in your hand!

Mon, 06/28/2010 - 22:47 | 440435 Client 9
Client 9's picture

...and they're not making any more of it!

Oh wait, that was 'LAND' circa 2001-2006.

Got my too-obvious-to-contradict asset bubbles confused. My apologies.

Mon, 06/28/2010 - 18:35 | 439892 akak
akak's picture

Hello Herpes!

And here I thought the last outbreak just might have been the last.

Mon, 06/28/2010 - 18:52 | 439924 RockyRacoon
RockyRacoon's picture

He's more like a hemorrhoid -- drops in to cause a little pain and suffering and then disappears for a while.  You never know when it will inflame to irritate in the middle of a rational discussion.

Mon, 06/28/2010 - 18:54 | 439932 Johnny Bravo
Johnny Bravo's picture

Nothing says rational like everybody agreeing with each other that the gold price will increase by 4000%.

akak is the herpes master.  Don't ever question his knowledge about herpes, again.

Mon, 06/28/2010 - 20:13 | 440121 dnarby
dnarby's picture

Not 4000%, but 3500% (or a 35x price increase).  Based on the percentage of gold and gold stocks historically held during 'stress periods' and the percent being held now.

Mon, 06/28/2010 - 20:07 | 440105 akak
akak's picture

"Nothing says rational like everybody agreeing with each other that the gold price will increase by 4000%."

I seem to have missed that conversation.  In fact, you have a knack for referencing such non-existent statements, agreements and factoids --- like your "$2000 gold by June" prediction that 69% of those here did NOT make or agree with!

If you are going to lie, and repeatedly, you might want to create falsehoods that are less easily disproven:

http://www.zerohedge.com/content/spot-gold-june-1-2010-200000

 

 

Mon, 06/28/2010 - 18:36 | 439895 Johnny Bravo
Johnny Bravo's picture

You should really stop selling yourself for crack if you have a herpes problem.

Mon, 06/28/2010 - 18:03 | 439843 DoChenRollingBearing
DoChenRollingBearing's picture

+ $1230 to Chumba, akak, and Rocky!

...

Chumba is kind of metaphoring fofoa's idea that gold at some point (soon?) will very quickly move to its historical role of being the best wealth protector (msg to Geoff just below).

$3000?  $5000?  $20,000?  $55,000?  $100,000?  Who knows?  I hope we can meet up, gents above, when we get to $50,000...  I promise not to talk about Middle East stuff...  But, we CAN talk about guns if you want!

Mon, 06/28/2010 - 20:11 | 440113 dnarby
dnarby's picture

$44k, $55k+ on an overshoot.

Mon, 06/28/2010 - 18:57 | 439942 Johnny Bravo
Johnny Bravo's picture

"$3000?  $5000?  $20,000?  $55,000?  $100,000?  Who knows?"

Oooohhhh, oooohhh... I do!!!  My guess is 50 million bajillion by August.

Psyche!  Actually, I meant 1304, and then the rising wedge breaks down.

Tue, 06/29/2010 - 01:08 | 440680 Geoff-UK
Geoff-UK's picture

It won't hit $50 MB until December, and more likely will take until Feb.

Mon, 06/28/2010 - 18:07 | 439847 akak
akak's picture

If gold ever reaches or exceeds, say, $25,000 an ounce (in today's dollar terms), I say we hold a national ZeroHedge convention and celebration somewhere to toast the new paradigm, and our good fortune.  After all, ANYONE holding more than an ounce or two of gold will be able to afford it!

Mon, 06/28/2010 - 23:39 | 440554 DoChenRollingBearing
DoChenRollingBearing's picture

akak, I believe I already invited you to the party that Gordon_Gekko and I first agreed to in order to have a few drinks to celebrate if/when gold sets to $50,000 / oz (close enough to fofoa's $55,000 average probability price).  Chumba said he wanted to come too (I believe he said: "Phuck yeah!".  As did Hulk, RockyR and a few others.

Hulk wanted a party at $1500, but I told him 1 drink only, and at home.

$50 k we should all meet somewhere central (meet me in St. Louis?) and have a raucous fiesta baby!  I promise no Middle East talk though.  Guns, yes.  ZeroHedge and gold haters, yes. 

Bravo you're welcome to come, I will not harm you at all, but I cannot say what the fanatics will do...!

I am going to invite fofoa too, it was HIS prediction that gold will LEAP to the moon as gold returns to its historical role: best wealth protector there exists.

Tue, 06/29/2010 - 07:20 | 440905 zhandax
zhandax's picture

If we get to $50,000 I don't suggest any travel without a lead implantation device.

Tue, 06/29/2010 - 01:05 | 440673 RockyRacoon
RockyRacoon's picture

I'm a charter member of the $15K Club.  Anonymity be damned.

If we get $50K there won't be any passable roads without Road Warriors ruling passage.

Tue, 06/29/2010 - 01:12 | 440686 akak
akak's picture

We will buy the road warriors off with 1/10 oz. Maple Leafs, maybe even some silver Eagles or MLs.  Of course, we'll still need one of those armored gasoline tankers to get there.  We can let Johnny come along and ride on the roof.  It'll be pretty uncomfortable in the wind and the rain, but I hear that suffering is good for the soul.  (That's presuming one has a soul, I guess.)

Tue, 06/29/2010 - 00:46 | 440648 akak
akak's picture

I'm there --- count me in!

Never been to St. Louis; Chicago would be a great rendezvous too.  It would be awesome to meet you guys, and relive the bad ol' days of fiat! Yes, GG, FOFOA, Nuinut, Rocky, Hulk, Chumba, maybe we can even invite Peter Schiff, Ron Paul, James Turk, Ted Butler, John Embry, Eric Sprott, and Jim Sinclair, and make it a REAL bash!

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