The Interdependence of Prices and Gold

I gave a talk on Thursday night at the New York Investing Club meeting.

The basic points:

Gold does well when real rates of return are low. Real rates describe the price of gold much better than inflation alone. This is because real rates reflect the opportunity cost of holding a relatively useless asset. Part of the reason gold seems irrational is that this extrinsic pricing is unintuitive and largely unappreciated.

Gold does well when liquidity, measured for example by LIBOR, is not especially tight.

Sentiment can be predictive with gold.

The &#8220-extrinsic&#8221- 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. Other examples: the Fed Model and Dividend Discount models explicitly tie together the pricing of equities and interest rates. 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? I do not endorse the Dividend Discount Model, but no-one can deny that it is a fundamental model, and it predicts higher volatility when rates are low. Given current levels, a 10% one day drop of the market is by no means absurd. The stock market should also have more idiosyncratic volatility when it is driven by &#8220-top-down&#8221- policy, rather than averaging many &#8220-bottom-ups.&#8221-

There is perhaps a &#8220-long-termism&#8221- fallacy. 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 &#8220-best ideas&#8221- list with some frequency. The more prices change, the more frequent portfolio changes would be in order from a valuation standpoint. Again, asset prices are not hermetically sealed, one?sided meanings and values. There is always some discount factor or relative valuation at play.

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 much more likely than active trading to originate an explosion large enough to affect the underlying economy. 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.

Demographic trends suggest lower real returns than those seen in the 20th century. Do economists have a demographic blind spot?

A Note on the Impotence of the Efficient Market Hypothesis

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No one who makes a living trading really cares about EMH, but I&#8217-m not sure why failure to predict under EMH is that surprising. Markets do more discounting than predicting. That&#8217-s part of the reason why stocks are volatile &#8212- the last data point tends to be extrapolated into perpetuity. It is true that factors like emotion and momentum additionally move prices, but to me this points to a fundamental challenge in valuation: the idea that there is an &#8220-intrinsic&#8221- value, when in fact all values interact, with prices reflecting structural realities and other prices. The misallocation in the housing bubble was to some extent already a mispricing of money in the form of rates. What was the &#8220-right&#8221- price for housing given the price of money?

The price of money in turn was influenced by the demographic savings glut that previously fueled the tech bubble. At this point, governments failing to predict the past &#8212- the trend of increased longevity &#8212- seems like the biggest problem. The escalated contentiousness in the Senate is, in part, a symptom of this slow motion failure and the &#8220-lower stakes&#8221- for all of us.

Managed Futures is the one category that consistently benefits from volatility AND has positive expectancy, unlike short-sellers.

No GravatarInsteresting comment from Jason Ruspini.

Jason, the high-end event derivative traders at BetFair (and probably at TradeSports and Betdaq) do benefit from volatility &#8212-they would trade thousands of times on one prediction market, back and forth, taking advantage of small price moves. Any related thought about that, with respect to your comment at Potfolio?

Previous blog posts by Chris F. Masse:

  • “Is Clinton’s Pennsylvania Lead Really 20 Points?”
  • The Most Surprising Piece Of News I’ve Heard Today
  • My first prediction market plugin for WordPress
  • Self-Serving Prediction Market Of The Day — Unlawful Internet Gambling Enforcement Act of 2006
  • Prediction markets tend to be so illiquid, though, that mere activity looks like volatility.