Nassim Nicholas Taleb

Everybody loves a good story

bullfighting

 Vivek Kaul

I am writing this piece sometime in the middle of April 2014. The stock market in India has been on fire over the last one month, with the NSE Nifty and the BSE Sensex regularly touching new highs. Every time the market touches a new high, editors of newspapers/magazines/websites have to look for a new reason to explain the bull run.
Several reasons have been offered during the course of the last one month. First we were told that the stock market investors were betting on Narendra Modi becoming the Prime Minister. The numbers in this case didn’t really add up. The domestic institutional investors sold stocks worth Rs 13,130.77 crore during March 2014. Their selling continued in April as well. Till April 11, 2014, the domestic institutional investors had sold stocks worth Rs 3,728.06 crore. If these investors are really supporting Modi, then why are they selling out of the stock market?
Then we were told that the foreign investors were betting on Modi coming to power and setting the faltering Indian economy right. In this case, the numbers do add up. In March 2014, foreign institutional investors bought stocks worth Rs 25,376.45 crore. In April, the trend continued and by April 11, they had bought stocks worth Rs 3,658.21 crore.
But is the logic as simple as that? It is worth remembering here that the Western central banks have been running an “easy money” policy for a while now. The Federal Reserve of the United States, has been reducing the amount of money it has been printing since the beginning of the year. But at the same time it has reiterated time and again that short term interest rates will continue to be close to 0% in the near future.
Interestingly, the Fed repeated this in a statement released on March 19, 2014. The foreign institutional investors invested Rs 4,222.10 crore on March 21, 2014, in the Indian stock market. This is the highest amount they have invested on any single day, since the beginning of this year. So, are the foreign investors investing in India because they have faith in Modi? Or are they simply investing because “easy money” continues to be available to them at rock bottom interest rates? The stories appearing in the media haven’t got around to explaining that.
Another theory that went around briefly was that the stock market is rallying because India’s economic data had been improving. Inflation was down. Industrial output as measured by the index of industrial production had marginally improved. And the current account deficit had been brought under control. This theory lasted till the index of industrial production for the month of February 2014 was declared. Industrial output for the month was down 1.9%.
The conspiracy theorists also suggested that it was the black money of politicians coming back to India. They needed that money to fight elections. Well, if they needed that money, they would have sold their stock market holdings, and the stock market would have fallen. But that hasn’t really happened.
So what is happening here? As Ben Hunt writes in a newsletter titled Epsilon Theory and dated February 28, 2014 “Ants, bees, termites, and humans – the most successful species on the planet – are constantly signaling each other so that we can make sense of our world together. That’s the secret of our success as social animals.”
The point is that everybody loves a good story. We want coherent explanations of what is happening in the world around us. As Nassim Nicholas Taleb writes in The Black Swan—The Impact of the Highly Improbable “We love the tangible, the confirmation, the palpable, the real, the visible, the concrete, the known, the seen, the vivid, the visual, the social, the embedded, the emotionally laden, the salient, the stereotypical, the moving, the theatrical, the romanced, the cosmetic, the official…the lurid. Most of all we favour the narrated.”
And this is where the media comes in, which tries to give us convincing explanations of what is happening in the world around us. Whether the reason behind a market movement is the real reason or not, does not really matter, as long as it sounds sensible enough. Taleb gives an excellent example of the same in The Black Swan.
“One day in December 2003, when Saddam Hussein was captured, Bloomberg News flashed the following headline at 13:01: U.S. TREASURIES RISE, HUSSEIN CAPTURE MAY NOT CURB TERRORISM,” Taleb writes.
Basically, what Bloomberg was saying was that the capture of Hussein will not curb terrorism and hence, investors had been selling out of other investments and buying the safe US government bonds, thus pushing up the price.
Around half an hour later, Bloomberg had a different headline. As Taleb writes “At 13:31 they issued the next bulletin: U.S.TREASURIES FALL: HUSSEIN CAPTURE BOOSTS ALLURE OF RISKY ASSETS.”
What had happened was that during a period of half an hour the price of the US government bonds had fluctuated. First they had risen as investors had bought the bonds. In half an hour’s time some selling had happened and the prices were falling. Bloomberg now told its readers that prices were falling because investors were selling out of US government bonds and looking at other investments given that with the capture of Hussein, the world was a much safer place.
Hunt offers a similar example in his newsletter. On November 28, 2008, Barack Obama, who had just been elected the President of the United States, appointed Tim Geithner, the President of the Federal Reserve Bank of New York, as his Treasury Secretary. The S&P 500, one of America’s premier stock market indices, rallied by about 6% on that day and Geithner’s nomination was deemed to be the major reason behind the same. As Hunt writes “All of the talking heads on the Sunday talk shows that weekend referenced the amazing impact that Geithner had on US markets, and this “fact” was prominently discussed in his confirmation hearings. Clearly this was a man beloved by Wall Street, whose mere presence at the economic policy helm would soothe and support global markets. Yeah, right.”
Geithner’s nomination was good news, but was it big enough to drive up the stock market up by 6% in a single day? As Hunt explains “So long as Obama didn’t nominate a raving Marxist I think it would have been a (small) positive development in the context of the collapsing world of November 2008. Was the specific nomination of specifically Tim Geithner WHY markets were up so much on November 24th? Of course not.”
The moral of the story is that first things happen and then people go looking for reasons. Hunt calls it “the power of why”. As he writes “It is the Power of Why, and it has no inherent connection to any true causal connection or the way the world truly works. Maybe it’s all true. Probably it’s partially true. But it really doesn’t matter one way or another.”
What is true of the financial markets in particular is also true for the world at large in general. As Taleb puts it “It happens all the time: a cause is proposed to make your swallow the news and make matters more concrete. After a candidate’s defeat in an election, you will be supplied with the “cause” of the voters’ disgruntlement. Any conceivable cause can do. The media, however, go to great lengths to make the process “thorough” with their armies of fact-checkers. It is as if they wanted to be wrong with infinite precision.”
So what is the way out? Taleb has an excellent suggestion in his book Fooled By Randomness—The Hidden Role of Chance in Life and in the Markets “To be competent, a journalist should view matters like a historian, and play down the value of the information he is providing, such as by saying “Today the market went up, but this information is not too relevant as it emanates mostly from noise.””
But that is easier said than done.

The article originally appeared in the May 2014 issue of the Wealth Insight magazine

 (Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected]) 

The curious case of Mr Jain

prashant jainVivek Kaul

 Sometime in late October I went to meet my investment advisor. During the course of our discussion he suggested that my portfolio was skewed towards HDFC Mutual Fund and it would be a good idea to move some money out of it, into other funds.
“Don’t put all your eggs in one basket” is an old investment adage. While, I try to follow it, I also like to believe that if the basket is good enough, it makes sense to put more eggs in that basket than other baskets.
HDFC Mutual Fund has been one of the few consistent performers in the Indian mutual fund space. And a major reason for the same has been Prashant Jain, the chief investment officer of the fund, who has been with it for nearly two decades.
Jain has been a star performer and due to his reputation the fund has seen a huge inflow of money into its various schemes. Some of these schemes HDFC Prudence, HDFC Equity and HDFC Top 200 became very big in that process.
These schemes haven’t done very well over the last three years. Their performance has been significantly worse in comparison to other schemes in their respective categories(Value Research has downgraded them to three star funds from being five star funds earlier). And this has surprised many people. “How can Prashant Jain not perform?” is a question close observers of the mutual fund industry in India have been asking.
One explanation that people seem to have come up with is the fact that the size of the schemes have become big, making it difficult for Jain to generate significant return. This is a theory that is globally accepted, where the size of a scheme is believed to be inversely proportional to the return it generates.
As Jason Zweig points out in the commentary to Benjamin Graham’s all time investment classic, The Intelligent Investor, “As a (mutual) fund grows, it fees become more lucrative – making its managers reluctant to rock the boat. The very risk that managers took to generate their initial high returns could now drive the investors away — and jeopardise all that fee income. So the biggest funds resemble a herd of identical and overfed sheep, all moving in sluggish lockstep, all saying “Baaaa” at the same time.”
While this may be a reason for the underperformance of the schemes managed by Jain, it is not easy to prove this conclusively. Jain feels there is no correlation between size and performance of a scheme, or so he told the Forbes India magazine in a recent interview. He pointed out that there are no large mutual fund schemes in India, and the largest scheme is less than 0.2% of the market capitalisation, which I guess is a fair point to make.
So how does one explain the fact that Prashant Jain is not doing as well as he used to in the past. John Allen Paulos possibly has an explanation for it in his book A Mathematician Plays the Stock Market. As he writes “A different argument points out to the near certainty of some stocks, funds, or analysts doing well over an extended period of time.”
Paulos offers an interesting thought experiment to make his point. As he writes “Of 1000 stocks (or funds or analysts), for example, roughly 500 might be expected to outperform the market next year simply by chance, say by the flipping of a coin. Of these 500, roughly 250 might be expected to do well for a second year. And of these 250, roughly 125 might be expected to continue the pattern, doing well three years in a row simply by chance. Iterating in this way, we might reasonably expect there to be a stock (or fund or analyst) among the thousand that does well for ten consecutive years by chance alone.”
But one day this winning streak comes to an end. And the same seems to have happened to Prashant Jain. In fact, William Miller who ran the Legg Mason Value Trust fund in the United States, beat the broader market every year from 1991 to 2005. In 2006, his luck finally ran out. Miller once explained his winning streak by saying “As for the so-called streak…We’ve been lucky. Well, maybe it’s not 100% luck—maybe 95% luck.”
If Miller was lucky so was Jain. Any significant deviation from the norm does not last forever. As Nassim Nicholas Taleb writes in Fooled by Randomness “In real life, the larger the deviation from the norm, the larger the probability of it coming from luck rather than skills…The “reversion” for the large outliers is what has been observed in history and explained as regression to the mean. Note the larger the deviation, the more important its effect.”
This is not to suggest that Jain’s performance has only been because of luck. Not at all. But it was luck that pushed him up to the top of the charts. Luck was the “icing” on the cake.
Michael Mauboussin discusses a very interesting concept called the paradox of skill in his book The Success Equation – Untangling Skill and Luck in Business, Sports, and Investing. “As skill improves, performance becomes more consistent, and therefore luck becomes more important,” is how Mauboussin defines the paradox of skill.
The Olympic marathon is a very good example of the same. Men run the race today about 26 minutes faster than they did 80 years back. Also, in 1932, the difference between the man who won the race and the man who came in twentieth was 40 minutes. Now its less than 10 minutes.
Now the question is how does this apply to investing? “As the market is filled with participants who are smart and have access to information and computing power, the variance of skill will decline. That means that stock price changes will be random and those investors who beat the market can chalk up their success to luck. And the evidence shows that the variance in mutual fund returns has shrunk over the past 60 years, just as the paradox of skill would suggest,” says Mauboussin. “I want to be clear that I believe that differential skill in investing remains, and that I don’t believe that all results are from randomness. But there’s little doubt that markets are highly competitive and that the basic sketch of the paradox of skill applies,” he adds.
And that is what best explains the curious case of Prashant Jain and the recent non performance of the mutual fund schemes that he manages.
The column originally appeared in the Wealth Insight magazine edition of December, 2013 

(Vivek Kaul is the author of Easy Money. He tweets @kaul_vivek) 

The illusion of control

book cover 1Vivek Kaul  
By the time you are reading this my first book would be out. Writing a book is an extremely strenuous and lonely exercise, with huge opportunity costs. And very few writers actually make any money out of their writing. Even fewer writers become famous.
Nevertheless, despite the near zero chance of success, people continue to write and publish books. Why is that?
I have been thinking about this for the past few weeks. What made me leave my job, sit at home and slog away on my laptop for the last 18 months to write a book, which possibly very few people are going to read?
Nassim Nicholas Taleb has answer in his book Anti Fragile. He attributes this to what he calls the fooled by randomness effect. As he writes “Information has a nasty property: it hides failures. Many people have been drawn to, say, financial markets after hearing success stories of someone getting rich in the stock market and building a large mansion across the street – but since failures are buried and we don’t hear about them, investors are led to overestimate their chances of success.”
This is precisely the way it works with people who go about writing books as well, feels Taleb. As he writes “The same applies to the writing of novels, we do not see the wonderful novels that are now completely out of print, we just think that because the novels that have done well are well written(whatever that means), that what is well written will do well.”
This explanation clearly summarises my state of mind when I decided to write a book. There was a confidence in my ability to write a good book, which would do well. But as has been proven time and again there is very little link between the quality of a product and how well it does.
Hence, it is safe to say that those who write books are “mildly delusional” and at the same time have an “illusion of control”. Given that the odds of a book succeeding are close to zero, anyone in their right mind would never get around to writing a book.
But that is not the way it works. People take on risks like these because they often underestimate the odds of success. As Daniel Kahneman, a Nobel Prize winning economist, writes in Thinking Fast and Slow “The evidence suggests that an optimistic bias plays a role – whenever individuals or institutions voluntarily take on significant risks. More often than not, risk takers underestimate the odds they face, and do not invest sufficient effort to find out what the odds are.”
And this is what leads to individuals taking the plunge inspired by the stories of success they see all around them. As Spyros Makridakis, Robin Hogarth and Anil Gaba write in Dance with Chance – Making Luck Work For You “We hear a lot about people who are successful, but very little about those who fail to realize their dreams. The press makes sure that we’re all familiar with the achievements of Sir Richard Branson, Warren Buffett, Bill Gates, Tiger Woods,or Nicole Kidman. While we’re dimly conscious that these people are exceptional, we rarely hear about the entrepreneurs, sports people, or actors who fail – or the sheer scale on which they do so.”
Entrepreneurship is another good example. People continue to take the plunge despite the odds of success being very low. “For example, did you know that in the USA there were more than 55,000 bankrupt firms and over 1.4 million bankrupt individuals in 2009? And the great majority of these involved believed it would never happen to them,” write Makridakis, Hogarth and Gaba.
In fact, a majority of the entrepreneurs are convinced that they will make it big. As Kahneman points out “ A survey found that American entrepreneurs tend to believe they are in a promising line of business: their average estimate of the changes of success for “any business like yours” was 60% – almost double of true value. The bias was more glaring when people assessed the odds of their own venture. Fully 81% of the entrepreneurs put their personal odds of success at 7 out of 10 or higher, and 33% said their chance of failing was zero.”
This optimism helps keep capitalism going as people try and launch new businesses, and some of them ultimately succeed. But there are situations when the illusion of control comes with costs attached to it. An excellent example is when a lot of people in the United States stopped taking flights and started driving, in the aftermath of what happened on September 11, 2001.
Flying remains the safest form of travelling. And the numbers prove it. In 2001, nearly 483 people died in the US in air crashes. Of this nearly half of them died on 9/11. In 2002, not a single person died in an air crash. And in 2003 and 2004, the number of deaths stood at 19 and 11, respectively. Now lets compare this to the number of deaths in car accidents. “In the same period, however, 128,525 people died in the US in car accidents. Moreover, it has been estimated that – in the year following 9/11 – some 1,600 deaths could have been avoided if people had not driven but instead carried on taking the plane as usual,” write the authors of Dance with Chance. 
This happened because drivers have an illusion of control. They have more faith in their driving than they have in the ability of the pilot to fly a plane safely. What also does not help is the fact that any plane crash makes it to the top of the news headlines whereas most car crashes don’t.
Also, no media reports about the thousands of planes that land safely every day. Given this, people have a tendency to think that flying is riskier in comparison to driving, and that is clearly not the case.
The dotcom bubble which ran from the late 1990s to the turn of the century is another brilliant example of the negative effects of the illusion of control. As Robert Shiller writes in the second edition of Irrational Exuberance, “Using the internet gives people a sense of mastery of the world. They can electronically roam the world and accomplish tasks that would have been impossible before. They can even put up a website and become a factor in the world economy themselves in previously unimaginable ways…Because of the vivid and immediate personal impression the Internet makes, people find it plausible to assume that it also has great economic importance.” While using the internet people felt in control. And then they bought dotcom stocks, thinking that the companies would make a lot of money in the days to come. That never happened and most of the companies went bust.
The illusion of control plays a very important part in our lives. And hence, it is important to figure out which it is leading us to.
The article originally appeared in the Wealth Insight magazine dated November 1, 2013 
(Vivek Kaul is the author of Easy Money. He tweets @kaul_vivek) 
 

Why Congress has learned the wrong lessons from India Shining

Manish-Tewari
Vivek Kaul
Human beings love a good story. And a good story is complete. If something has happened then there is needs to be a ready explanation available for it. Nassim Nicholas Taleb writes about this in Fooled by Randomness. Taleb recounts watching Bloomberg TV, sometime in December 2003 around the time Saddam Hussein was captured in Iraq.
At this point, American government bond prices (commonly referred to as treasury bills) had gone up, and the caption on television explained that this was “due to the capture of Saddam Hussein”. Some thirty minutes later, the price of the American treasury bills went down, and the television caption still said that this was “due to the capture of Saddam Hussein”.
The question is how could the capture of Saddam Hussein lead to have two exactly opposite things? That is simply not possible. But there is a broader point here. If something happens, the human mind needs a reason, an explanation or a cause for it. Without it, the loop is not complete. Hence, the human mind actively seeks causes for events that have happened, whether those causes are the real reasons for the event happening is another issue all together.
As Ed Smith former English cricketer wrote in a recent column “The point, of course, is that causes are being manipulated to fit outcomes. They weren’t causes at all, merely things that happened before the defeat. The ancient Romans had an ironic phrase for this terrible logic – post hoc, ergo proper hoc, “after this, therefore because of this”.”
An excellent example of this phenomenon in an Indian context is the defeat of the Bhartiya Janata Party (BJP) led National Democratic Alliance (NDA) in the 2004 Lok Sabha election. Of the explanations that followed the one that gained most credibility and is still holding on strong, is the India Shining Campaign.
Since the results of the 2004 Lok Sabha elections came in, it has been widely held that BJP lost the elections because of the “insensitive” urban centric India Shining advertising campaign, which ignored the aam aadmi. The irony is that even the BJP came to believe this.
As Arati R Jerath points out in a recent column in The Times of India “Significantly, L K Advani was to acknowledge later that the India Shining slogan was “inappropriate” for an election campaign. In hindsight, many in the BJP realized that the tone and tenor were arrogant and insensitive and that it glossed over prevailing social and economic inequities that the NDA government had failed to address.”
This logic doesn’t hold true against some basic number crunching. The difference in vote share between the Congress led UPA and the BJP led NDA was a little over 2%. The NDA got 33.3% of the vote whereas the UPA won 35.4% of the vote. As economist Vivek Dehejia, the co-auhtor of Indianomix – Making Sense of Modern India, said in an interview to Firstpost “That 2% difference in vote share can equally be attributed to a number of other explanations, such as bad luck, as it is to anything else. Or let me put in another way; if you look at those results, basically it came down to a coin toss. A third of the voters voted for the NDA, another third voted for the UPA and a third voted for somebody else.”
Hence, if the NDA had got 1% more vote and UPA had got 1% less vote, the situation would have been totally different. And maybe in that situation, people would have been talking about how the India Shining campaign really worked. Given this, it is not always possible to figure out why something happened. The broader point is that India is too diverse with too many issues at play to attribute the win or a loss in Lok Sabha elections to one cause, which in this case happened to be the India Shining campaign.
But such has been the strength of this explanation that it continues to prevail. In fact, the Congress party has gone at length to explain why there recently launched Bharat Nirman campaign is totally different from the India Shining campaign of 2004. “India Shining was hype, hoopla and spin. Our campaign is different. Bharat Nirman is not a poll campaign, it tells the India story of the past nine years,” the information and broadcasting minister Manish Tewari was recently quoted as saying.
In fact, the India Shining campaign had put too much emphasis on India, people came to believe, and missed out on Bharat. So the Congress has taken great care that the Bharat Nirman campaign caters to Bharat.
That difference notwithstanding prima facie there doesn’t seem to be much difference between India Shining and Bharat Nirman. Both are campaigns launched to highlight the achievements of the incumbent government. India Shining was launched well before the Lok Sabha elections and at that point of time, the BJP leaders maintained that the campaign was meant to attract international investment and beyond that nothing more should be read into it. The Congress seems to be doing the same. As Tewari said “Elections will be held on time. There is no need for speculation.”
Eventually, the BJP got caught into its marketing blitzkrieg and advanced elections by six months. The extent to which Congress wallahs have gone to deny the link between Bharat Nirman and the Lok Sabha elections being advanced, leads this writer to believe that most likely elections will be advanced. As the line from the great British political satire Yes Minister goes “The first rule of politics: Never believe anything until it’s been official denied”. The Congress, like BJP, is in the danger of getting caught in its own spin.
India Shining cost the taxpayer around Rs 150 crore. Bharat Nirman has already spent around Rs 200 crore of the taxpayer money. As an article in the Brand Equity supplement of The Economic Times points out “Sources close to the campaign say that close to Rs 200 crore has been spent on this campaign under various heads. So large is the campaign that in recent months the government has been the single largest consumer of air time and media space on many of the major channels in volume terms.”
What hurts is the fact that the revenue stream of the government at this point of time is stretched. The Ministry of Finance has even gone to the extent of running an amnesty scheme for service tax defaulters. A defaulter can declare and pay his taxes and thereby avoid any fines or even other penal proceedings. If finances are so stretched, why is money being wasted on an advertisement campaign like Bharat Nirman?
More than anything else this government has lost so much credibility that any advertisement campaign cannot help. As Jerath puts it “The campaign is a pathetic attempt to sweep the controversies of the past three years under the carpet. A slick film and a lyrical jingle cannot erase the stench from various corruption scandals or make up for non-performance as food prices rise and the economy slows down.”
The lesson drawn from India Shining should have been that feel good advertisement campaigns run by the government and paid for by the taxpayer, do not really matter in an electoral democracy as diverse as India. Instead the government, which is seen tom-tomming its own achievement, comes across as arrogant. But the parties in power love it. As the Brand Equity points out “The temptation has been too great and a campaign of similar proportions has been released. Perhaps the only difference is that ‘India’ has been replaced by ‘Bharat’ and ‘Shining’ by ‘Nirman’. While the Congress insists that this is not a political campaign (just as the BJP insisted with India Shining), the timing and the quantum of spends seem to belie that.”
The only person Bharat Nirman benefits is the information and broadcasting minister Manish Tewari (and the media houses which get paid for carrying these advertisements), who after taking over as the I&B Minister had to show that he was doing new things that could revitalise the image of the Congress party and he has done precisely that. But this benefit might be short lived because in the days to come if the Congress led UPA loses the next Lok Sabha elections (as it is likely to), then Bharat Nirman will be held responsible for it, like India Shining was.
And then Manish Tewari, might become the new Pramod Mahajan, the man behind the India Shining Campaign.
To conclude, what happens to the taxpayer who finances these expensive campaigns? Well all he can do is sing the old Mukesh song (sung in the style of KL Saigal) “dil jalta hai to jalne de. aansoo na baha, fariyad na kar”.
The article originally appeared on www.firstpost.com on May 20, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)

Don’t count gold out: it may be the last man standing

goldVivek Kaul
At the very outset let me confess that this has been a difficult piece to write. When everyone around you is shouting the same thing from their rooftops, it is very difficult to say something which happens to be exactly the opposite.
Gold over the last one week has turned into a four letter word. Last Thursday (i.e. April 11, 2013) the closing price of the yellow metal was $1564.2 per ounce (one troy ounce equals 31.1 grams). A week later as I write this gold is selling at around $1375 per ounce. The price has fallen by around 12.1% over the period of just one week.
And this fall has suddenly turned investment experts (at least the ones who appear on television and write and get quoted in newspapers) all bearish on gold. They have been giving different reasons to stay away from it. But if they were so confident that the price of gold would fall, as it has, why didn’t they warn the investors before fall? Everything is obvious after it has happened.
But as the Nobel Prize winning economist Daniel Kahneman writes in Thinking, Fast and Slow “The ultimate test of an explanation is whether it would have made the event predictable in advance”. Those offering the explanations now, clearly did not predict the massive and sudden fall in price of gold. What is interesting is that before the price of gold started to fall the Bloomberg consensus forecast for gold by the end of 2013 was at $1752 per ounce. Hence, the broader market did not see this coming.
So why is the price of gold falling? One conspiracy theory doing the rounds has the investment bank Goldman Sachs at the heart of it. As John Cassidy of the New Yorker magazine puts it “Last December, Goldman’s economic team turned bearishon gold, saying the multi-year upward trend in gold prices “will likely turn in 2013.” And last Wednesday,(i.e. April 10, 2013) the bank’s commodities team advised its clients to start shorting gold.” Short selling refers to a scenario where investors borrow gold and sell it with the hope that as the price falls they can buy it back at a lower price and thus make a profit.
Goldman Sachs was not the only big bank turning negative on gold. On April 2, the French bank, Societe Generale, the also issued a report titled The end of the gold era, and turned bearish on the yellow metal.
This many believe is a conspiracy on part of the big banks to drive down the price of gold. As Paul Craigs, a former assistant US Treasury Secretary told Kings World News “This is an orchestration. It’s been going on now from the beginning of April…Brokerage houses told their individual clients the word was out that hedge funds and institutional investors were going to be dumping gold and that they should get out in advance. Then, a couple of days ago, Goldman Sachs announced there would be further departures from gold. So what they are trying to do is scare the individual investor out of bullion. Clearly there is something desperate going on.”
Nevertheless, conspiracy theories are easy to talk about but difficult to prove. There are several other reasons being offered on why the price of gold will continue to fall. A major reason being offered is the improvement in the American economic scenario and that leading to the Federal Reserve of the United States, the American central bank, printing lesser money in the days to come.
The Federal Reserve currently prints $85 billion every month in the hope of reviving the American economy. Societe Generale in its report The end of the gold era believes that this will continue till September and come down to $65 billion after that, until being fully terminated by the end of the year.
The Federal Reserve on its part has guided that money printing will come down if it sees a ‘significant improvement in the outlook for employment’. The latest U3 rate of unemployment in the United States for the month of February 2013 stood at 7.6%. U6, a broader measure of unemployment, was at 13.8%. Both numbers have declined from their peaks. U6 touched a high of 17.2% in October 2009, when U3, which is the official unemployment rate, was at 10%. In December 2012 U6 stood at 14.4% and U3 was down to 7.8%.
So yes things have improved but they are still far away from being fine. U3 in the pre-financial crisis days used to be at around 5%. Also long term unemployment (where people are out of work for 27 weeks or more) has changed little and is at at 4.6 million or 39.6% of the unemployed people(U3).
(There are various ways in which the bureau of labour standards in the United States measures unemployment. This ranges from U1 to U6. The official rate of unemployment is the U3, which is the proportion of the civilian labour force that is unemployed but actively seeking employment. U6 is the most broad definition of unemployment and includes workers who want to work full time but are working part time because there are no full time jobs available. It also includes “discouraged workers”, or people who have stopped looking for work because the economic conditions the way they are, make them believe that no work is available for them.)
Another measure of the US economy turning around is the increase in real estate prices. As per the S&P Case-Shiller 20 City Home Price Index, real estate prices have gone up by 8.1% between January 1, 2012 and January 1, 2013. This after falling by 3.9% between 2011 and 2012.
One of the reasons the Federal Reserves prints money is to ensure that there is enough money going around in the financial system and interest rates continue to remain low. This ensures that people borrow and spend more. Hence, the low interest rates have helped in reviving the real estate sector in the United States.
But lets think for a moment on what will happen if the Federal Reserves stops printing money? Interest rates are likely to go up. People will take on fewer home loans to buy homes and that in turn will mean the real estate sector will go back to the dumps that it was in. So will the Federal Reserve take the risk of going slow or stopping money printing? Also, economic growth for the three months ending December 2012, was at -0.1%. So much for the American economy improving.
In this scenario it is unlikely the Federal Reserve will go stop money printing anytime soon, even though its Chairman Ben Bernanke, its Chairman, may keep dropping hints about doing the same.
As Stephen Leeb writes on www.Forbes.com “The Federal Reserve also wants to beat up on gold, via its drumbeat, suggesting that liquidity may be drying up and monetary easing might end soon. Never mind that recent economic data, on the whole, appears much weaker than expected, or that any halt to U.S. monetary easing could only follow higher inflation and commodity prices.
And as long as United States keeps printing money gold will remain a good investment bet, its current huge fall notwithstanding.
The last bull market in gold ended soon after the legendary Paul Volcker took over as the Chairman of the Federal Reserve in August 1979. As economist Bill Bonner wrote in a recent column “Paul Volcker replaced G. William Miller as chairman in August 1979. A loose money policy became a tight money policy. Volcker jacked up interest rates…But what’s the Fed doing now? Has it reversed course? Has Ben “Bubbles” Bernanke been replaced with a tough-as-nails inflation fighter? Has the Federal Open Market Committee(FOMC) vowed to stop printing money? Has the loosest monetary policy in US history given way to a tight policy?”
And the answer on all the above counts is a big no.
Moving on, another reason given for the gold price falling is that Cyprus is selling gold worth $500 million in order to raise cash to pay its debt. As Peter Schiff president of Euro Pacific Capitalwrote in a recent column “Concerns quickly spread that other heavily indebted Mediterranean countries with large gold reserves like Greece, Portugal, Italy and Spain would follow suit. The tidal wave of selling would be expected to be the coup de grace for gold’s glory years.”
The stronger countries of the euro zone (the countries which use euro as their currency) led by Germany have been rescuing the heavily indebted weaker ones for a while now through multi billion dollar rescue packages. In case of Cyprus the rescue came with terms and conditions which included seizing a part of its banking deposits and selling its gold.
This experts feel is likely to be repeated in the days to come with other countries as well. What they forget is that if the euro zone makes a habit of seizing deposits and selling gold, countries are likely to opt out of the euro and move onto their own currencies. As James Montier writes in a recent research paper titled Hyperinflations, Hysteria, and False Memories “If one were to worry about hyperinflation anywhere, I believe it would have to be with respect to the break-up of the eurozone.” Another reason to keep holding onto gold. If there is even a slight whiff of a euro breakup gold is going to fly.
Another logic being bandied around (especially by some of the Indian analysts) is that with the price of gold falling the investment demand for gold is likely to go down. Fair point. But a falling gold price can also push up the jewellery demand for gold. In 2011, gold jewellery consumed around 1972.1 tonnes of gold. This was down to 1908.1 tonnes in 2012, as prices rose.
A slowdown of Chinese growth has been offered as another reason for gold prices falling. As Cassidy of New Yorker writes “Many of today’s news storiesabout the gold price emphasized disappointing economic figures from China, which showed economic growth slowing down slightly in the first three months of 2013. China is a big consumer of virtually all natural resources, and gold was but one of many commodities that fell sharply after the report from Beijing.”
But this theory doesn’t really hold either. “The purported slowdown in the Chinese economy was very slight. First quarter growth came in at 7.7 per cent, compared to 7.9 per cent in the last three months of 2012. Allowing for the vagaries of the statistics, the difference is inconsequential,” writes Cassidy.
Also the gold bears who have suddenly all come out of the closet are not talking about what is happening in Japan. Japan has decided to double its money supply by printing yen to create some inflation. The hope is hat all this new money will create some inflation as it chases the same amount of goods and services, leading to a rise in prices. When people see prices rising, or expect prices to rise, they are more likely to buy goods and services, than keep their money in the bank. This is the logic. And when this happens businesses will do well and so will the overall economy.
A side effect of this money printing which is expected to be thrice as large as that in the United States, is the Japanese yen losing value against other major currencies because a surfeit of yen is expected to flood the financial system.
A weak yen also makes Japanese exports more competitive. (For a detailed argument click here). But it puts countries like Taiwan, South Korea, China and even Germany in a spot of bother. As Societe Generale analysts write in a report titled How to make profits from the Sushi-style QE in Japan “In effect Korea, Taiwan and China are losing competitiveness while Japan regains it.”
Printing money is not rocket science, if Japan can print money, so can the other countries in order to weaken their currency and thus keep their exports competitive. Hence there are chances of a full fledged global currency war erupting. And this is another reason to own gold.
The final argument against gold has been that central banks have been printing money for more than four years now. But all that money has not led to high inflation, as the gold bulls had been predicting that it would. So central banks have managed to slay the inflation phantom. “After more than four years of quantitative easing in the United States, the inflation rate, as measured by the consumer price index, is running at just two per cent…In Britain, where the Bank of England has followed policies similar to the Fed’s, the inflation rate is 2.8 per cent—a bit higher, but hardly alarming,” writes Cassidy.
But just because money printing hasn’t led to inflation till now doesn’t mean we can rule out that possibility totally. There is huge historical evidence to the contrary. Let me quote Nassim Nicholas Taleb here, something that I have done in the recent past. As Taleb writes in Anti Fragile “Central banks can print money; they print print and print with no effect (and claim the “safety” of such a measure), then, “unexpectedly,” the printing causes a jump in inflation.” James Rickards author Currency Wars: The Making of the Next Global Crises says the same thing “They can’t just keep printing…All major central banks are easing…Eventually so much money will be printed that this will lead to inflation.”
And in a situation like this, gold will be the last man standing.
To conclude, this is how I feel about gold. I maybe right. I maybe wrong. That only time will tell. Hence its important to remember here what John Kenneth Galbraith, an economist who talked sense on most occasions, once said: “The only function of economic forecasting is to make astrology look respectable.”
Given this it is important that one does not bet one’s life on gold going up. An allocation of not more than 10% in case of a conservative investor is the best bet to make. And if you are already there, stay there.
The article originally appeared on www.firstpost.com on April 18, 2013.
(Vivek Kaul is a writer. He tweets @kaul_vivek)