Thursday, September 25, 2014

The Gold price conundrum and coming bout of inflation. Oh really?

Thursday, Sep 25, 2014 (2:10 pm) San Diego

For atleast past two and half years, equities world over in general and US in specific have been influenced to a large extent by the Central Bank action and speculations regarding the course of the non-conventional monetary policy and its ultimate outcome. Pundits on both side of the aisle have had their own opinion in support or against FED actions. Though both (for and against) arguments are equally logical and potent, it is hard to take sides. Remember how Gold first outperformed (until end 2012) and then underperformed, in absolute terms, based on which side of arguments the general consensus approved of at a point in time.

When money printing seemed like a habit with no end (between 2011-2012), inflation mongers took refuge in Gold to preserve purchasing power. Gold bug argued that Central Banks if, intent on debasing paper money, will eventually succeed in doing so. In which case, money will loose its purchasing power vis-a-vis Gold. The evidence presented to corroborate the argument being, historical periods of high inflation triggered by loose monetary policy and Gold coming out as a winner in term of preserving real purchasing power during such episodes of inflation. When fear ruled supreme, Gold continued to do well and the hypothesis being vindicated.

When former FED chairman Ben Bernanke hinted sometime in Sep of 2013 of rolling up the game over a reasonable period , Gold started loosing momentum. In fact by end 2013, the mighty Goldman Sachs termed short Gold position as a 'Slam dunk'. The argument being extinguishment  of actions to debase currency, takes the punch bowl away from inflation mongers and hence invalidates the hypothesis in favor of investing in Gold. A secondary and smaller argument, being rising value of USD post the QE era also subverting price growth in USD denominated assets such as Gold.

Gold lost some of its sheen in 2013 having provided negative returns for the first time in any calendar year since 2002. So where did the inflation mongers go wrong? Did they not expect FED to stop some day? Did they not expect inflation in the short term remaining subdued due to the moribund employment and economy, plus the deflationary impact of govt and private sector deleveraging?

Answer to all of the above question requires no special intellectual faculties. Simple common sense and simple logical inferences would suffice. Lets start with the first of the two: It was reasonable to expect the FED to stop somewhere and at sometime. Even if no view is taken on how long they go before they stop. To make this point of thinking intuitive, let us for a moment assume, that the FED does not stop ad-infinitum. That would be the case only when the argument for QE remained valid (that being a hypothetical scenario where the economy would never return to a state of full employment). Resultantly, if the economy never gains the traction as desired by public policy, it would be hard to find a argument for inflation running amok in such as scenario. So we can infer here that if FED were never to stop than inflation or Gold would never hit the roof.

Now, it is possible that the inflation mongers did anticipate FED to stop at some future date but also anticipated the interim term to be so long and the magnitude of debasing so high that inflation in future would indeed be a high probability event. However, in that case, they implicitly are maintaining the position that: 1) Both, inflation will be persistently quite high for given period of time and Central Bankers will not be able to control high inflationary expectation by any policy tool.

If their view on any of the determining factor such as: 1) level of inflation 2) The period of sustained high and uncontrolled inflation 3) Policy tool ineffectiveness, is inconsistent with the original argument (that FED will some day stop and we will still have high and uncontrolled inflation in future) than the whole hypothesis is again under the scanner of critical cross examination . Lets go a step forward and assume that the view on the above determining factors is consistent with the hypothesis. In such situation, the analytical framework beneath the hood becomes quite complex. As complex assumptions have to be made about time horizon (persistence), level of inflation (magnitude), what constitutes high inflation compared to normal inflation in some future environment, Government fiscal and monetary policy response and Global trade and currency dynamics.

Although this all may sound little verbose, in my opinion, anyone who think that inflation is coming but also opines that QE will stop some day, is in effect consciously or unconsciously having a position on the above further assumptions. That level of prediction is far more complex than the starting notion of monetary debasing leading to future higher inflation and loss in purchasing power of paper money. The more factors involved, the more interrelationships to think about and the more stochastic the range of ultimate outcome becomes (increases error rate).

Coming to the second question of expecting short term inflation to remain low due to moribund economy and deleveraging, but however, expecting high long run inflation; brings us to an important juncture in our analysis. That being whether sharply appreciating Gold prices between 2009-2012 could withstand the continuous negative reinforcement in the short run of low realized inflation? What would happen to mass psychology in that event, would they stick to the original hypothesis even when proved wrong (even if only in short run)? Where goes the consensus, so goes the price. And this is what has been observed in case of Gold prices and investor interest in Gold between 2012 and 2013 end.  Even though the hypothesis of long run inflation without short run inflation were to remain true, it is not a necessary condition for Gold prices to keep creeping up. As one group of investors would reverse the trade mainly because they cannot have the patience of waiting for the long run. For most investors on the periphery, if there is no inflation today than there is not reason to remain invested in Gold.

In my opinion, this is exactly where lessons from history diverge from investor mentality and asset return today. Investors get into the bandwagon giving historical evidence of why the thesis should work, but forget that historical time horizon of couple of years in making is different than the daily, monthly or at best yearly time horizon that consensus price determining opinion has.  Another way to put it is even if a particular view in context of historical study is logical and might well come to pass, investors also need to have time horizon in line with that view. A shorter time horizon can lead to being wrong in the interim. And being wrong can put immense peer pressure on changing the course (self doubt).

This also brings me to yet another insight. Given the dynamics and complexities involved, in determining long term future and all together different set of dynamics and challenges (both practical and psychological) involved in sticking to an investment strategy consistent with those long run expectation. I believe taking investment position based on such line of thinking can be self defeating. I however caution that does not mean a bias towards short-termism or prejudice against long term investment outlook. What I mean is that it can be very difficult to make accurate long term assumptions (no matter how cogent the argument may sound).. More so when implicitly you are unconsciously making further assumptions and unknowingly increasing the error rate. At the same time committing large part of the portfolio that is benchmarked incorrectly (by you or the outside world) to such a position.

To return to our Gold conundrum, I think Gold price will increase when there is an actual evidence of high and persistent inflation and failing policy tools to control it (irrespective of the starting price of Gold). That is to say, that currently high realized inflation will lead to current positive return on Gold prices without much ado about prognosis few years back. Or if the consensus opinion again shift in favor of coming bout of inflation, even if only for a while.

It is hard to say what determines consistent success in the field: Whether it is ability to correctly draw long term trends and forecast (from the above I think it ain't); Whether it is ability to patiently stick to your conviction without getting distracted with short term outcome (it could, but it also poses the threat of self confirmation bias) or Whether it is about understanding and correctly anticipating consensus fears and concerns?

(all feedback welcome)