Selected highlights of the latest ‘Popular Delusions’ note from Société Générale’s Dylan Grice:
Central bank hoarding of gold in 1970 ushered in the famous gold bull market. With central banks likely to be net gold purchasers in H2 2009 for the first time since 1988 the same starting gun is ringing out today. The price at which the USD would be fully backed by gold (as it was during the peak of the 70s mania) is $6,300. So there is a case for gold being “cheap.” Moreover, the 70s bull market was facilitated by tight energy markets, overly accommodative central banks and nervousness that policymakers had lost their way. Sound familiar?
If my “valuation” of gold strikes you as a desperate attempt to value something which can’t be valued, it’s no different from metrics such as the “market cap to clicks” or “ARPU” ratios which were used in the late 1990s during the technology bubble when demand for bullish “valuation analysis” mushroomed. They seem crazy now but speculators bought into them during the tech craze. And there may well be a bubbly parallel … Charles Kindleberger, drawing heavily on the work of Minsky, outlined the following “anatomy of a bubble”.
Stage 1 sees “displacement”. Frequently, this comes about through the introduction of a new disruptive technology (e.g. canals, railways, or the internet) although Kindleberger says it doesn”t necessarily have to come from such an innovation. It can arise on the back of greater market liquidity through, for example, financial deregulation.
Stage 2 is the “boom.” A convincing narrative gains traction (e.g. Asian economies are “miracle” Tiger economies; the Internet will change the world; sub-prime mortgages help financial institutions diversify risk). Price movements which seem to confirm the narrative are stoked by credit creation.
Stage 3 is “euphoria.” In the words of Kindleberger, “there is nothing so disturbing to one’s well-being and judgement as to see a friend get rich.” This greed sucks people who wouldn’t normally involve themselves in such practice into the mania. More and more people seek to become rich without understanding the process involved. Rationality becomes stretched and increasingly fanciful notions excuse what would ordinarily be considered irrational behaviour.
Stage 4 sees the “crisis.” The insiders originally involved start to sell. Prices level off and begin to fall. Those who bought at the top find themselves pushed out first and their selling eventually cascades down through the remaining believers. Speculators realise prices can no longer rise and the rush to exit is on. To the extent that leverage was used to finance any purchases at irrationally overvalued prices, savage price declines put banks in trouble too.
Stage 5 sees “revulsion” where prices likely overshoot fundamental values on the downside. Scams and frauds are uncovered. Scapegoats are found for the financial distress caused object so richly desired as the bubble inflated becomes an object of ridicule and disgust, along with anyone or anything associated with it.
With this in mind, consider the parallels between the 1st and 2nd phase of the 1970s gold mania with the situation unfolding today. Then, the “displacement” was the collapse of the Bretton Woods system, precipitated by central banks, distrustful of inflationary US policies buying of gold. This is very similar to what we are seeing today. Then, the liquidity turning “displacement” to “boom” came from central bank accommodation of the oil shocks. Today, central banks are monetising government deficits to accommodate the recessionary effect of the credit crisis. Then the convincing narrative was that with the Middle East controlling our energy from abroad and aggressive trade unions rampant at home, policymakers were no longer in control. Today, the perception of central bank infallibility has been permanently ruptured by their collective failure to see the 2008 crash coming. Nagging concern at their over-willingness to inflate, at the blurring of monetary and fiscal policy and over long-term government solvency (see chart below) gives traction to a similar narrative today.
On the Kindleberg-Minsky map as I’ve drawn it, therefore, we’ve had the “displacement” and are only now entering into the “boom” phase. The “mania phase” lies well ahead. Who knows what unknown unknowns might parallel the two oil shocks of the 1970s? The top of the gold bubble occurred when politicians won a mandate in the late 1970s/early 1980s to take painful decisions, to take on the trade unions, and to raise interest rates to tackle inflation. Only then, during the “crisis phase” did scams such as the Hunt brothers’ attempted corner of the silver market come to light. The parallel today would be governments winning a mandate to take the difficult decisions ahead on health care and pension entitlement, or even climate change. And who knows what yet-to-be-conceived frauds await? But that is a long way off. Governments only won such mandates because by the late 1970s, the “inflation fatigued” electorate was tired of lurching from one crisis to another. We’re several crises away from governments winning similar mandates. In the meantime, displacement has happened, liquidity is plentiful, and the compelling narrative is gaining traction. Oh, and gold is “cheap” …