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TheDumbMoney (58.55)

Two Models for Pricing Gold

Recs

19

August 25, 2011 – Comments (31) | RELATED TICKERS: GLD , SPY , IAU

A few weeks or a month ago, TMFBullnBear, in the comments to one of his great posts on gold, posted a link to a blog post that a commenter on his post on Economist.com had brought to his attention.  That blog post is a 2010 article by Eddy Elfenbein, who writes Crossing Wall Street.  The blog and the post and the model blew me away, reading it as I did, much farther into the trend than it was written.  You can find it here. 

I filed that away in my "classic posts" mental vault.

Then this week Peter Brandt, who is a long-time commodities trader (among other things) did a hugely positive review of the 2010 model post, which you can find here. 

That review was prompted by this model update that Eddy posted last week, which you can find here, and which is STUNNING.

I'm just the bearer of models.  But I suggest all gold speculators and investors, as well as haters, pay some serious attention to this model, to the Dominant Fundamental Theory idea that Brandt articulates, and to the model that Ray Dalio uses, as described by Brandt.  (Dalio, in case you don't know, is the founder and head of what I believe is the largest hedge fund in the world.)

Anybody interested in what the Bernanke's statement tomorrow might or might not do for real interest rates?  Anyone know any single institution with more influence on that vector than the Fed (this second question in this paragraph is a serious one)?  Other than those questions, I'll let you draw your own conclusions.

I also love the part in the Brandt piece about how you know someone is full of sh!t, and also this quote from the Brandt piece: 

"As a trader — and be honest about this — do you chase after all sorts of fundamental news in order to either understand the markets or justify your positions. If you do, you are wasting  your time. If this describes you, please know that your constant attempt to “put the pieces together” is wasted effort. Do yourself a favor and find a different hobby."

That's another quote written by a trader (like my previous Reformed Broker post), but that I think is highly applicable as well to those, like me, who style themselves long-term investors.

DTAF

31 Comments – Post Your Own

#1) On August 26, 2011 at 9:49 AM, TheDumbMoney (58.55) wrote:

Upshot on Eddy Model:  "In effect, gold acts like a highly-leveraged short position in U.S. Treasury bills and the breakeven point is 2% (or more precisely, a short on short-term TIPs)."

Upshot on Dalio Model:   "Ratio of Gold stocks above ground against the world’s reserve currency supply...at any given time."

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#2) On August 26, 2011 at 1:48 PM, Frankydontfailme (27.33) wrote:

Thanks for posting these.

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#3) On August 26, 2011 at 2:19 PM, TheDumbMoney (58.55) wrote:

No problem, and here is the link to EconompicData's even more elaborate elaboration of the Crossing Wall Street post, which spells out the conclusions in even greater detail, and explains how the model got updated all the way back to 1951 (one question in my mind is how he accounted for the 1972 "shift" or why one does not need to do so):

http://econompicdata.blogspot.com/2011/08/gold-model-still-rockin.html

 

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#4) On August 26, 2011 at 3:48 PM, TMFAleph1 (95.67) wrote:

(one question in my mind is how he accounted for the 1972 "shift" or why one does not need to do so)

One does not need to do so, because while the pre-1971 gold price may have been fixed in terms of the dollar on a nominal basis, the real price (i.e. inflation-adjusted) was floating, so to speak.

Alex Dumortier

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#5) On August 26, 2011 at 8:18 PM, TheDumbMoney (58.55) wrote:

A few more points:

1)  This isn't meant to be either a pro- or anti- gold post.  I just want to identify what is going on.  Personally, I think that unless we get real deflation, the Fed pretty much just told us that gold will be either be flat or up in two years, maybe significantly.  Even if we get some deflation, the Fed is likely to respond to it  by correspondingly lowering real interest rates, thus supporting the price of gold.  I also wonder though whether, because so many Wall Streeters are so significantly raising their estimates, the DFT is maybe being widely identified as we speak....

2)  I also recall one of Buffett's more profound but somewhat overlooked quotes, derived from Graham I think, that stocks are really nothing more nor less than bonds of infinite duration.  With that in mind, I wonder if one can explain the divergence of gold miners from gold in that way.  I was thinking one could superimpose that concept of stocks/companies/bonds on this model, and one could view gold miners as part of the theory described by Elfenbein above, but operating in part as a really, really extended longer-term futures market on gold -- i.e., incoporating the profits of today's happy-happy-joy-joy gold market, but also what comes later.  If that is true, the divergence of gold miners (which have lagged gold recently), supports an inference that while the market is bullish on gold at this level or higher in the short-term, the long-term picture is at minimum much muddier, and possibly much more bearish.  Of course, the market can be wrong.  That view also corrolates with expected Fed policy in the near versus the longer term.  An interesting project would therefore be to look for divergences between the prices of gold miners and gold prior to the early-80's peak.

3)  I disagree with Brandt's conclusion that Bernanke is incompetent.  I didn't want to give anyone the impression that by approving of the remainder of his post I also approved of that.  I think an incompetent Fed chairman would have allowed us to spiral into real deflation last year, as we almost did.  I think the most incompetent thing Bernanke has done in the last couple of years since the crisis was saying he was helping support the stock market.  I think he meant that that was a second-order effect of his policies, which it is, but of course tons of people took that to be the main purpose of QEII, and thus focused on "fakeness" and "asset inflation."  In reality the focus of QEII was preventing deflation, that's it.  We as a country seem just like BofA, muddling through, knowing that if we can just-oh-please carry our losses over a long enough period, we should be able to work them through our system over a long-enough period that we can do so without greater collapse.  That's what Ben's trying to allow us to do.  And meanwhile, he's pleading again today in his apolitical Fedspeak for the idjuts in Congress to do what we need:   1) significant short term stimulus; 2) simultaneously combined with credible, enforceable cuts to long-term spending.  Republicans are idjuts about #1, and Democrats are idjuts about #2.  Yet still Ben pleads, again today, and meanwhile they all take potshots at him either to deflect from their own incompetence or to excuse it.

4)  Alex, I think you are correct about your point, thank you.

5)  Anyone, what do you think the Dominant Fundamental Theory is, with regards to the market for stocks?  I agree with Brandt that the DFT since March 2009 seems to have been increasing corporate earnings.  But has this been replaced by the DFT of over-indebtedness and deleveraging?  Not sure. That's why I buy some stocks every month.  You have to tie your DFTs to the appropriate time period.  I think in the super-long term, regardless of what underlying DFTs may hold sway for months or yeas, I think the broadest of all DFTs is that in America we progress, we solve problems, we innovate, and as a consequence, long-term holders of stock in our companies do OK.  This good news is it's such a long term view that I won't know if I'm potentially wrong until I'm practically dead, in which case I won't have to beat myself up over it for too long, and neither will I likely care that I've gotten it wrong.

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#6) On August 26, 2011 at 8:58 PM, ETFsRule (99.90) wrote:

The whole "value of gold" question has already been solved by Paul van Eeden. End of story.

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#7) On August 26, 2011 at 9:02 PM, Frankydontfailme (27.33) wrote:

I like your thoughts on the miner's dumberthan, and have thought similarly. Short term trends like hedgies shorting the stocks and long gold don't fully explain it. Miner's breaking the habit of being penny-pinching gold hedgers don't fully explain. The widespread belief that gold is in a bubble (or will be soon) explains it. Stocks should represent long term earnings. If gold bubbles over then the miner's are fairly valued. 

That being said, gold is not in a bubble, and the miner's are absurdly undervalued and this will not last. Heck (circular logic I know) the fact that their is been no mania in these miner stocks all but proves gold is not in a speculative bubble.

More importantly, these miner's WILL start to hedge when gold gets well over 2,000 dollars an ounce. It will be up to the investor at that point how to diversify between miner's that are hedged to different degrees to get the full upside of the gold potential while also protecting from downside. WHEN gold is around 2,750 companies like GG, AEM and AUY will have guaranteed absurd market caps with heavy hedging. By this point investors will have missed the upside (just saying....).

 

The DFT for the next three years (at least) is without a doubt excessive debt and de-leveraging. This is absurdly bullish for gold and silver. It's also bullish for equities that aren't tied to input costs.  

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#8) On August 26, 2011 at 11:13 PM, TMFAleph1 (95.67) wrote:

5)  Anyone, what do you think the Dominant Fundamental Theory is, with regards to the market for stocks?

Over the longer term -- which is the only appropriate timeframe for investing in stocks -- the  Dominant Fundamental Theory for stocks as an asset class is invariant: The combination of valuation and mean reversion. There is nothing else.

Alex Dumortier

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#9) On August 27, 2011 at 12:31 AM, TheDumbMoney (58.55) wrote:

"The combination of valuation and mean reversion."

I would have to agree.  Though I also liked all my hopey-lovey-hopey stuff about America!  :-)  I say that a bit flippantly, but also because I think in the super-long-term, even certain valuation and mean reversion concerns are somewhat smoothed out by the general upward slope (at least at the market level).  In other words, the hypothetical dude who backed up the truck to the stock market on 9/1-3/1929 and held the market for 70 years still made out okeydokey. 

DTAF 

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#10) On August 27, 2011 at 1:13 AM, TMFAleph1 (95.67) wrote:

but also because I think in the super-long-term, even certain valuation and mean reversion concerns are somewhat smoothed out by the general upward slope (at least at the market level).

The third factor you're referring to here is companies' capacity to produce value and generate earnings growth; I'd say that's a fundamental characteristic/ assumption for stocks.

In other words, the hypothetical dude who backed up the truck to the stock market on 9/1-3/1929 and held the market for 70 years still made out okeydokey.

My objection here is that 70 years exceeds the length of the accumulation phase of virtually investor. Also, the idea is not simply to earn a positive return (even a positive real return), but to earn a return that is at or above the minimum level given the risk you're bearing.

The good news is that, according to Mark Hulbert's calculations, a hypothetical investor investing at the top of the market in 1929 would have broken even in 4 1/2 years.

25 Years to bounce back? Try 4 1/2, NYT, Apr. 25, 2009

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#11) On August 27, 2011 at 10:09 AM, Frankydontfailme (27.33) wrote:

http://politicalcalculations.blogspot.com/2007/02/worst-returns-ever-for-s-500.html

Real returns (worst case scenarios)

Also the point that 20-25 year holding period has gauranteed decent real returns in the past (might not in the future though) 

 

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#12) On August 27, 2011 at 10:29 AM, TMFAleph1 (95.67) wrote:

Also the point that 20-25 year holding period has gauranteed decent real returns in the past (might not in the future though)

Not guaranteed. According to the blog post you link to, the worst performance over a 20-year period is a slightly negative real return, and over 25-year periods, it's 2.2% (real). Neither of those are acceptable performances.

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#13) On August 27, 2011 at 10:36 AM, Frankydontfailme (27.33) wrote:

Yeah agreed. And since I think we're in a depression and Alex doesn't (right?) you can guess where we are investing for the long term.

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#14) On August 27, 2011 at 10:48 AM, TMFAleph1 (95.67) wrote:

I don't think we are in a depression, no, but that's only due to monetary and fiscal stimulus. But even in the Great Depression, there were multiple opportunities to buy stocks extremely cheaply. Right now, the broad market isn't particularly cheap, but there are certainly opportunities to buy individual stocks at good, and in some cases, excellent prices.

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#15) On August 27, 2011 at 11:46 AM, Frankydontfailme (27.33) wrote:

Agreed again. I think they may very well get much cheaper nevertheless. Also, I am sure gold mining stocks (maybe even gold itself) will outperform many of the brightest value investors in the coming years :)

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#16) On August 27, 2011 at 11:59 AM, TheDumbMoney (58.55) wrote:

"The good news is that, according to Mark Hulbert's calculations, a hypothetical investor investing at the top of the market in 1929 would have broken even in 4 1/2 years."

Yes, for an interesting comparison, where are we now from March 10, 2000?  :-)

Also, Franky, it's not like there is a set of a,b, c criteria for a depression, so what definition are you using?  I very much recommend the now-famous recent book by Reinhart and Rogoff.  I think we are muddling through with sluggish growth and sluggish return to full(er) employment, after a massive financial crisis.  I think Obama's stimulus was hugely beneficial in preventing worse, and I think the Fed's policies since 10/2008 have been nothing short of heroic.   

As far as individual opportunities, this week for the first time, the yield on Intel stock exceeded the yield on ConEdison stock.  Think about that for a minute.  The earnings yield on J.P.morgan stock is 14.3%.  Wells Fargo trades at a PEG ration of 0.5.  Exxon trades at a (cyclically somewhat high) earnings yield of over 10%.  

And of course my personal favorite, Microsoft, trades at an earnings yield of 10.7%, a PEG ratio of 0.7, a forward P/E of 8 (without even backing out the cash), has grown strongly over the past five years (a drop in 2009, temporary), upped its dividend by 23% last year, grew both the top and bottom line at double digits last year, and is about to introduce within the next six months the most significant revision to Windows since Windows was created.  And nobody seems to care.

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#17) On August 27, 2011 at 12:13 PM, whereaminow (61.20) wrote:

It's funny that Eddy is saying a very similar thing to something I just wrote, only from a different perspective.  Here's Eddy:

The final point is that the price of gold is essentially political. If a central banker has the will to raise real rates as Volcker did 30 years ago, then the price of gold can be crushed.

Here's an exceprt of an email I sent to friends a few days ago:

Much of the value of a fiat currency extends from the viability of the issuing State in regards to the value scales of the holders of that currency.

In other words, Eddy sees the value of gold as determined by politics, but I see the value of the dollar as determined by politics and thus the price of gold in dollars is determined that way.  It's a nuance, but an important one. 

Yet it leads to similar conclusions and I don't think he's very far off.  But you could see how two ideologically opposed individuals could essentially agree on an outcome but talk past each other the whole time.

David in Qatar

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#18) On August 27, 2011 at 12:52 PM, whereaminow (61.20) wrote:

Of course, my view is not original :)

"It should be clear then, that the demand for paper money, in contrast to gold, is potentially highly volatile. Gold and silver are always in demand, regardless of clime, century, or government in power. But public confidence in, and hence demand for, paper money depends on the ultimate confidence—or lack thereof—of the public in the viability of the issuing government." Rothbard, Mystery of Banking pp. 65-66.

David in Qatar

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#19) On August 27, 2011 at 1:49 PM, TheDumbMoney (58.55) wrote:

David, I don't think there was a whole lot of demand for gold in 1999, which is why then was a great time to buy it.  That was a time when central banks, most famously the U.K. under Gordon Brown, were selling it.  Excellent market timers, central banks. What are central banks doing now?

I think that both Eddy and certainly me would agree with you that the value of the dollar is to some extent determined by politics, just note.*  The difference is not there.  The difference is that we embrace a certain amount of flexibility, if done properly.**

*Not entirely, because natural disasters and the actions of other countries can have a have a huge impact.  A currency is always a relative beast, so no country entirely controls its own currency, except at the extreme bounds, such as when pushing it to hyperinflation.

**In my view, that is the difference between Greenspan and Bernanke.  Greenspan's actions in response to the events of 1999-2001 are easily viewed (at least in retrospect) as too extreme.  That creates a facile analogy to what Bernanke is doing now.  But the difference is that Greenspan was not actually responding to deflation, as he should have limited himself to, whereas Bernanke is.  If Greenspan were in charge at the Fed today, I would be vastly less of a fan of the Fed.  I think he was too political, and I would even go so far as to suspect that he deliberately juiced markets in order to aid in Bush's reelection in 2004.  Bernanke I believe is much more of a non-ideological technocrat; all he cares about is preventing deflation.

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#20) On August 27, 2011 at 2:17 PM, whereaminow (61.20) wrote:

Bernanke I believe is much more of a non-ideological technocrat; all he cares about is preventing deflation.

Yep, Bernanke's Apoplithorismosphobia, has been a significant reason for adding to gold holdings.

David in Qatar

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#21) On August 27, 2011 at 2:20 PM, whereaminow (61.20) wrote:

My bad, this paper is the proper link for Apoplithorismosphobia. (My fav word ever)

David in Qatar

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#22) On August 27, 2011 at 2:37 PM, TheDumbMoney (58.55) wrote:

"The housing bubble was the result of the Federal Reserve tricking people into housing malinvestments."

Is all of the analysis on that website of such deep penetration?  I'm sure the people of the libertarian and mainstream Right who advocated the repeal of Glass-Steagall, the bipartison creaters of Freddie/Fannie, the people of the Progressive Left who pilloried banks in the early 2000's as "racist" for not lending to socioeconomic groups with on-average lower credit scores, the Bush-era pluto-conservatives at the SEC who allowed Lehman to leverage up 33-to-1, the nexus of Clinton-Summers-Greenspan who faught like cats to keep the derivatives markets totally unregulated, the parents and (to a lesser extent) teachers across America who never educated people about basic finance, and many more, will all be thrilled to hear that it's all the Evil Fed's fault.

Sigh.  We've had the deflation discussion before, and I'm sure we're just not ever going to agree on that.  "If the Federal Reserve and other forms of government "stimulus" curtail the deflation of producer goods...., then the process will be slower and more painful."   Slower, yes.  More painful?  I think there is absolutely no basis for that statement.  I know that starting with Amity Shlaes and spreading out across the non-libertarian right mostly, there is a vast effort to re-write the popular history of the Great Depression and what got us out of it (re-writing history is always easier once most of the people who lived through it are dead, making the timing of this effort non-coincidental), but I think the deflation of the Great Depression was more "painful" than what we are experiencing now, and that deflation was an enormous part of what caused that pain.  Deflation disincentivezes investment.  I know you think otherwise.

 

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#23) On August 27, 2011 at 3:25 PM, Frankydontfailme (27.33) wrote:

DFAT. All intelligent points in this thread until your last reply. I don't even understand it's purpose... mostly ad hominem and straw man (who said anything about the non-libertarian right?)

You didn't even begin to address any of the ideas in the paper David alluded to.

http://mises.org/journals/qjae/pdf/qjae6_4_2.pdf 

Oh and about the fed:

"To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."

Paul Krugman

(Source: http://www.nytimes.com/2002/08/02/opinion/dubya-s-double-dip.html) 

 

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#24) On August 27, 2011 at 4:12 PM, TheDumbMoney (58.55) wrote:

Franky, do you honestly think that the Fed is solely responsible for the house bubble?  Do you honestly think there is any part of society that does not bear some blame?

Also, I wrote my post after looking at David's first link, and the paper you are noting he posted while I was writing my reply? 

I love that Krugman quote though.  That whole piece looks delightfully boneheaded, looking back on it now. 

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#25) On August 27, 2011 at 4:41 PM, Median1234 (< 20) wrote:

Interesting article, DTAF, and very nice discussion.

The relationship between the price of a commodity and that of the equity of the commodity producer is, or in most cases should be, rather complex.

To first order, you'd think that the latter should behave much like a leveraged position on the former, in that the producer is long the commodity and short debt. However, that is the story down to skin depth. On top of that, there are several complexities to appreciate. For one, the better approximation of the commodity producer in terms of the commodity they produce would be in terms of a call in the commodity rather than long a forward, that is, the producer pays a premium amortized over time (=capex; debt) to secure the right to produce the commodity at a fixed strike (=operational costs).  If prices collapse beyond the point of operational profitability, the producer shuts down production - theoretically at least - rather than continue to produce the commodity below cost. To further complicate things, an even tighter model for the exposure of the producer to the underlying asset is that of a holder of a swing option on the commodity rather than simply a call, since the producer has the option to choose when to mine a limited quantity of material (=mine reserves). If prices are low, the producer "stores" the commodity by deferring production. 

Furthermore, as hinted at by a previous poster, the effect of hedges on the miner's economics is extremely significant. It was not uncommon during the commodity rally abruptly ended by the credit ciris for miners to decline in value just as the commodity they were producing was spiking, as some had hedged (or, in cases, overhedged) forward production and on production outages found themselves net short with a need to cover deliveries in a rallying market.This volumetric risk (and the often nasty, albeit weak, correlation of mining outages to commodity prices on the back of increased production stress at high price environments) has seen many a miner to an early grave...

Lastly, the spot price of the commodity is a good gauge of revenues for the producer, but my no means the whole story. For precious metals like gold and platinum, where the term structure of forward prices is trivial (indeed, as noted already, precious metals are more akin to currencies), this is not a particularly relevant consideration, however, for energy commodities, ags etc forward prices become relevant, at the very least as a - tenuous - indicator of future spot price expectation.

On the general topic of gold valuation, the empirical approach proposed in Elfenbein's article is intriguing, but, in my personal opinion (which I hope to expound on in a full post, if my blog application is approved!), empirical relationships are not sufficient grounds to consider gold an investment. A spec play, maybe, but not an investment.   

 

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#26) On August 27, 2011 at 4:41 PM, whereaminow (61.20) wrote:

dumber,

 I'm sure the people of the libertarian and mainstream Right who advocated the repeal of Glass-Steagall,

Can you ever put your political axe aside and just study the opponent's argument? 

Let me say this as f*cking loud and clear as I can:

I DON'T GIVE A F*CKING RATS A** FOR REPUBLICANS AND WOULDN'T MIND IF EVERY ONE FELL INTO THE DEEPEST PART OF THE OCEAN.

Does that make it clear enough to you that I don't give a sh*t about your Democratic politics?

David in Qatar

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#27) On August 27, 2011 at 4:57 PM, whereaminow (61.20) wrote:

Of course I could and should add (so I will =D) that not one political axe grinder has ever read Glass Steagal or knows all that it actually did. (or the act that essentially replaced it, the CFMA) 

David in Qatar

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#28) On August 27, 2011 at 5:05 PM, TheDumbMoney (58.55) wrote:

Ok, take out the examples.  Do you think the Fed is solely responsible for the housing bubble?  That was my only real point, and the question.  

Also, I'm not a Democrat.  I'll say that again, too, though without all-caps, bold or swearing.  I am a registered Independent.  But more to the point, I support abolishing all public-sector unions, so if you can find me a portion of the Democratic party that would accept me, please send me a link.  (I suspect that is one research project that even you would not succeed in.)

I'll take a look at your Thornton piece, I wasn't responding to that, as I explained to dear Franky.  I won't have time to get back here today though.

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#29) On August 27, 2011 at 6:07 PM, Frankydontfailme (27.33) wrote:

Of course the fed was not SOLEY responsible. It (along with government backed fannie and freddie) was the root cause nevertheless...

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#30) On August 27, 2011 at 7:03 PM, whereaminow (61.20) wrote:

Do you think the Fed is solely responsible for the housing bubble?

No, and neither would Murray Rothbard nor Ludwig Von Mises.  The ultimate source of the housing bubble (and in fact, all malinvestment) is the government.  It just so happens that one of its creatures, the Fed, plays the most prominent role in the boom/bust cycle in the current manifestation of the state/banking relationship.  And I'm sure if asked to clarify, the anarcho capitalist Thornton would agree with that qualification.  But I can't speak for him.

Sorry for the all Caps. I'm just so freaking sick of the Yahoo-comment-section-style of debate that has to always involve the fake Left/Right paradigm.

The Fed's policies affect one half of every transaction in the United States (at least).  To deny their overwhelming culpability in the boom/bust cycle would indicate that you believe the dollar's role in exchange is limited.  And if it is, then the Fed could be dismantled without little affect is not worth defending.

David in Qatar

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#31) On August 29, 2011 at 12:58 PM, TheDumbMoney (58.55) wrote:

Here, for gits and shiggles, is the real yield curve, published every weekday by the Treasury Department.

I'm mainly posting this here so that I can refer back to it.

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