Commentary

A Value Proposition

By Gary Tanashian

November 3, 2007

As the rot in Wall Street's dark alleys works its way from the inside out, from the seediest hedge funds' leveraged 'investment' vehicles to Main Street's financial institutions (pensions, 401K's, savings, etc.) gold has taken center stage, closing above $800 for the first time in its still young bull market. Fear and anxiety are increasing as the US Dollar falls further below serious long term support and in this environment, gold is an emotional conduit through which growing fears of fiat monetary instability pass. Picture a burning building with a limited number of exits and a large crowd trying to pile through the door. Let's call it a... oh I don't know... let's call it a casino.

Gold is the object of many strange and varied perceptions, perhaps because it is an ancient asset that has always stirred basic human instincts for wealth, good fortune and even survival. But in light of the perverted and multi-headed monster we call a financial system - with seemingly infinite instruments of 'profit' limited only by the imagination of financial engineers - perceptions toward gold have become distorted, helped by an enabling Wall Street and mainstream financial media.

The main point to remember is that gold does nothing; it just sits there and does not care about the crazy gyrations going on all around it. But to understand and accept this, casino patrons must first accept that the metrics they have been schooled in and the rules they have been taught over the fiat decades to play by are not applicable. Filling the void that this lack of understanding creates is a whole host of opinions, many disparaging and/or dismissive. Others simply attempt to fit this "asset class" into conventional metrics. The inspiration for this missive was a recent SeekingAlpha piece by Brad Zigler called All That Glitters May Not Be So Golden. Mr. Zigler did not write a 'hatchet piece' on gold but what I find interesting is his and many other financial media correspondents' analysis of gold as a return (or lack thereof) instrument.

Gold pays no risk premium as it carries no default risk. But in the world of financial media-fed perceptions that is a bad thing. No return you say? No markup? No leverage? Who needs that?! Gold is about value and nothing more in my opinion. That is why I refuse to get excited when its fiat currency denominated price goes up and why I also remain at a normal pulse rate when said 'price' declines sharply. I do agree that when trading or investing in the gold miners (as I do) it is important to keep traditional metrics in mind. But the miners are my casino of choice and I most certainly do not see the gold miners as gold, a gold equivalent or anything other than a potentially hugely leveraged play on an enduring asset of value.

Back in the real world, players are just beginning to get the hint that the risk they have taken on in the hunt for return in some very dark corners has come at a price and the price is a massive debit against the entire system of something for leveraged nothing. Yes, gold pays no premium but neither is it subject to this debit because it never went anywhere to begin with. It Is What It Is and as a barometer of global financial sentiment its exchange value is rising versus a whole host of paper promises not to mention many hard assets. So what many investors now need is a sort of 12 step program as they attempt to 'put down the crack pipe' and come to an understanding that real value has nothing to do with return (unlike modern portfolio and asset allocation theory) and it certainly has nothing to do with leverage.

Mr. Zigler's assertions and my responses:

Debate has raged for some time now about the utility of gold in a portfolio. Forget, for a moment, the breathless claims of infomercial touts and Parade magazine advertisers. Think, instead, of asset class selection.

Why should anyone add gold—or, for that matter, any asset—to a portfolio? The answer that comes immediately to many people's minds is "return." It's the promise of outsized, and often outlandish, returns that entices people to call that 800 number in the wee hours of the morning to get their hands on the yellow metal.

There should be no debate. An asset of historic value belongs in a portfolio if debt obligations (bonds) and calls on corporate earnings (stocks) belong there. I agree, the 800 number pitch men are seedy characters capitalizing on fear and insecurity, but why are they part of the conversation? Have you ever seen the movie Boiler Room? The world of stock scams dwarfs that of unscrupulous precious metals dealers.

Gold isn't the end-all, be-all, however. In the long term, the metal's price is notoriously unstable. Since gold's price was allowed to float in 1970, its annualized standard deviation—its price variance—has been clocked at nearly 20 percent, versus 15 percent for blue-chip stocks. And in that time, gold's return has only averaged 8 percent. The S&P 500 earned 11 percent per year.

There is the word "return" again. The reason gold has under-performed over the measured time frame (minuscule in the context of history) is because contrary to what some gold bugs may think, there certainly was upside to the fiat money system. This upside was manifested in liquidity to build out all manner of productive enterprise. The United States for example spent the majority of the 20th century on the upside of this build-out. The question now becomes 'do we remain on the upside or have the secular changes beginning in and around 2000 marked a decided switch to the inevitable payment to the piper (of the debt used to keep the dream alive)?' If you think there is still productive upside, you will see gold's 'return' as sub-par. If you believe that secular changes are at hand, you are looking for that exit door in a crowded casino and you don't give a damn about return. You want to stay whole.

So what return can we expect from gold? Well, financial theory says you can't expect any increase in an asset's value without growth prospects. Stocks' expected return derives from earnings growth. Issuers of corporate securities can create things and grow. There's a real prospect for a company trading its shares or warrants to be worth more and more as the result of management decisions. Gold itself doesn't produce earnings, and for that reason its expected return can be approximated as zilch. Nada. Bupkis.

Mr. Zigler is correct. Gold provides no 'return' in the modern asset allocation theory sense of the word. But in bringing the word 'value' into the equation he again shows how modern portfolio theorists are trained; no return, no 'growth' = no value proposition. Gold does not stand at $806 this morning because of its growth but rather because of its retained value vs. paper instruments - USD first and foremost - which are coming under heavy questioning. It should be noted that in the US the stocks of these growth entities are denominated in USD.

Appreciation in the price of gold, of course, does occur. History attests to that. There's just no reason to expect it. What influences the price of gold are external, not intrinsic, forces.

It appears Mr. Zigler and I have been watching two different financial systems over the last several years but I certainly agree that gold's value is affected by external forces.

He then goes on to write about the gold miners which is my usual subject matter on the TA Blog, so I will just end here this critique of modern portfolio theory as it applies to gold. I hope it helps shed a little light on an alternate way of thinking for a few people.

I will leave you with a final thought that I was taught early on in a school of decidedly unconventional asset theory. Price is price and value is value. They are not one in the same. Unfortunately that simple thought has been schooled out of the masses. I have no doubt that pitchmen of all types will come out of the woodwork to hawk the golden solution to an awakening public. A fortunate few will keep it simple however and remember that real value is enduring and real value is not a pitch. I find value splitting wood at my wood pile. I find value in jamming loudly on guitar. I find value in Google. I find value in the air I breathe. I find value in remaining financially whole. I do not find value in debits attached to an unpayable black hole.

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