Gold and The Interdependence of Prices

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1 Gold and The Interdependence of Prices Jason Ruspini, Vice President, Conquest Capital Group

2 When Does Gold Rise? When people are irrational or have irrational expectations of societal breakdown? When people have rational fears about policy failure and default? When people anticipate inflation? When gold is money and people anticipate deflation? When liquidity is not tight? When real returns are low? What about sentiment and seasonality?

3 Is Gold A Fear Gauge? On average, no. Gold acts as a fear gauge periodically, but just as often it trades with risk and the global growth trade. One Month Rolling Correlation of Gold to VIX Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10

4 Is Gold A Fear Gauge? Averages can be deceptive and gold s correlation shifts tend to be sudden. Correlation of Gold to Dollar, "Fear Gauge" Indicators and S&P 500 January 2000 Present Daily Correlation of Returns Average Absolute Value of 10-day Rolling Correlation Dollar Index -41.9% 57.8% VIX 0.2% 41.0% High Yield Spreads -0.7% 37.7% S&P % 41.0%

5 Does Gold Hedge Against Inflation? You often hear that it does not because the CPI has outrun gold since This is a cherry picked statistic corresponding to gold s 1980 peak. Pick any other look back: Cumulative Increase Through December 2009 From: CPI Gold Gold/CPI Increase Ratio Jan % % 6.53 Jan % 514.8% 1.61 Jan % 143.8% 0.78 Jan % 254.2% 2.41 Jan % 176.3% 2.45 Jan % 197.8% 4.44 Jan % 298.5% Jan % 155.6% 11.74

6 However, Gold Does Not Display A Strong Relationship with Inflation Expectations In Short Time Frames Gold has low daily correlation to TIPS implied inflation rates. By month, gold does not do particularly well when inflation is relatively high: Monthly Gold Price Changes By Inflation Rate, Apr Dec 2009 Sum Number of Months Average Months where inflation: > 4% 180.4% % <= 4% 232.3% %

7 Gold Does Show A Strong Relationship With Real Rates of Return Interest rates must be taken into account, not just inflation. Rates also reflect the long term growth prospects of the economy. Real rates represent the opportunity cost of holding a relatively useless asset. Monthly Gold Price Changes By Real Rate Apr Dec 2009 Sum Number of Months Average Months where real rate: < 3% 414.0% % >= 3% -1.3% %

8 Gold as Money In the 2010s, gold s relative uselessness is a political boon. Unlike other commodities, very few folks are hurt by rising gold prices. What is the use of paper money that pays near zero interest? You can t use Yen at the deli either. Gold, a negative carry currency, is again more attractive when rates are low. While gold does well when real rates of return are low, to the extent that it is monetized, it can do well in deflation as well. This is what happened in the 1930s and prior depressions. Central bank actions and gold as a percentage of global fx reserves, which is still especially low in China, suggest that, at the margin, gold is being and will continue to be monetized.

9 Gold s Dirty Secrets? Monetary base and bank excess reserves charts are actually not that scary. The inflation implicit in government debt is, however. There are approximately 160,000 metric tonnes (5.2 billion ounces) of mined gold on earth, and approximately 2,500 tonnes are discovered each year. But this rate may be slowing, and there is approximately 2,500 tonnes per year of non speculator demand for jewelry and industrial use. Have a sell bias when liquidity dries up. Monitor LIBOR or LIBOR OIS. A drop in liquidity in financial markets is not the same as general price deflation. Have a sell bias when real returns rise, e.g. when bond vigilantes become active in a depressed economy. (Will this always work?) Lots of fake cover story indicators. Gold has been a crowded trade since the high 800s. Talking head pseudo sagacity. But crowded trade can be quantified to some extent through DSI and CFTC COT data.

10 Is Gold a Bubble? It will become a bubble at some point, but there is little comparative evidence of this now. Household gold assets are not out of control. Tulip Bubble: 6000%, South Sea Bubble: 733% ( Index had 131 year drawdown).

11 Seasonality of Gold Gold exhibits strength in September. Why? How significant? Seasonality, Jan May % 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00% -2.00% -3.00% Gold Wheat S&P 500 Dollar Index

12 Interdependence of Prices To what extent does gold appear irrational because its value is mainly extrinsic, that is, it reflects relatively low real returns and opportunity cost? This way of thinking is natural in the fx world where all trades are two sided, and the idealized one sided currency, e.g. Dollar Index, is a weighted average of two sided rates. [Fed model ] The misallocation in the housing bubble was to some extent already a mispricing of money in the form of interest rates. What was the right price for housing given the price of money? Do people who claim that assets exhibit irrational moves have a clear idea of what level of volatility would be rational, especially given such cross influences?

13 How Volatile Should Stocks Be? The Dividend Discount Model predicts that stocks should become more volatile as interest rates decline. When (dividend) growth rates and interest rates are both stuck near zero, this fundamental model predicts very high volatility. With 10 year rates at 3.0% and growth near 1%, a 0.20% change in dividend (earnings) growth rate expectations is sufficient to provoke a one day 10% decline. Stocks tend to extrapolate the last data point into perpetuity, and twopart dividend models try to correct for this, but to what extent does the rate term already act like a long term reversion term, reflecting average economic growth? When stocks are driven by top down policy, they are more likely to behave idiosyncratically and wildly, as opposed to the more predictable average of many bottom ups. There is a wealth effect and natural self perpetuation in stock prices through consumption. Why shouldn t stocks be commoditized as a relatively risky asset? Why is strong dollar / weak stocks unnatural?

14 Is There a Long Termism Fallacy? Luis Lowenstein: ''you will have made a judgment about that company and its businesses over the long term: what kind of products they make, who the management is, what kind of competition there is. No sensible investor would change his mind in a few days or a few weeks.'' One absolutely wants to minimize transaction costs of all kinds and avoid over trading, but beyond that, might there be a fallacy here, covered over by sagacious sounding, politicized rhetoric? Even if prices change glacially, if you want to maintain a portfolio limited to 30 stocks out of a universe of 6000, it is easy to see how a sensible person might change the "best ideas" list with some frequency. The more prices change, the more frequent portfolio changes would be in order from a valuation standpoint. To what extent can asset prices ever represent some hermetically sealed, one sided meaning or value? There is always some discount factor or relative valuation at play. Crucially, such statements make the assumption that one is smarter than the market, and so if prices move against you, it's just irrational "noise". Short termism incentive effects have little to do with short term trading. Quite the opposite.

15 Would a Transaction Tax Make Stocks Less Volatile, or More? A transaction tax might decrease daily volatility, but, politically speaking, folks do not actually care about daily volatility. They care about longer terms booms and busts in asset and useful commodity prices that short term trading naturally has less to do with since such traders both buy and sell. If buying and selling are more expensive, trends should be more persistent. This is intuitive, but also makes sense insofar as autocorrelation rises when liquidity declines. Booms and busts will cause longer lasting pain and dislocation. The easiest way to achieve a shock 20 standard deviation move is to just not mark (or mis mark) for a while. Deferral of pricing is vastly more likely to originate an explosion large enough to affect the underlying economy. (Flash Crash only hurt those who were stopped out.)

16 Would a Transaction Tax Make Stocks Less Volatile, or More? Deferral of pricing, not active trading, played a large role in the corporate credit crisis. Social security and entitlement programs are also off balance sheet debt. At least banks failed to predict the future. Governments failed to predict the past. The basic demographic and longevity trend has been apparent since at least the 1960s. Each case had deferral and agency problems. Would taxing transactions discourage the formation of self fulfilling prophesies? Unlikely, as one way nature of the trade would still be clear. [Krugman quote ] Traders would actually be less willing to take profits, and would have less incentive to catch falling knives.