Two weeks ago, Bare Talk wrote that investor behaviour is pro-cyclical. It amplifies both booms and busts by buying into rising prices and selling into falling prices. It went without saying that investment recommendations are pro-cyclical too. Nonetheless, it is good to find vindication before readers forget what they read. The price of gold is down 24% in dollar terms from the peak price of $1,900 per ounce. It is both unsurprising and wrong that epitaphs are being written on gold now. The writers did not have the courage to do so when gold was trading at $1,900 per ounce. The time to sell an asset is at its peak. No one dared to speak ill of something that was rising then. Leaning against the wind is lonely and it takes intellectual courage.
One of the criticisms against gold is that it is apparently a cyclical asset. Which asset is not? Are stocks perpetually rising? Only investment advisers who want to generate trading commissions generate charts of 120 to 130 years of trends in US stock indices with a perpetual upward trajectory. These charts with long histories successfully hide several periods of negative returns, especially when they are adjusted for inflation. Those periods were frustratingly long and came at regular intervals: 1929-45, 1967-1982 and from 2000 until now. The situation is no better in India. From 1992 until 2001, the Sensex index lost 4.3% per annum. The average annual inflation rate in that period was 9%. So, in real terms, investors lost more than 13% every year in Indian stocks. It is worse since December 2007. The Sensex is down 12% from the peak in December 2007 until last week. The cumulative inflation since then is about 70%. So, investors in Sensex stocks are down more than 80% in real terms in little over five years. Hence, all investment assets are cyclical and that is how they should be treated.
The price of gold went up in the 1970s because the US was rudderless in that decade. The US had ended convertibility of dollars into gold. There was economic stagnation and inflation. Gold was an insurance against the erosion of US’s economic might. In the 1980s, the US recovered its poise thanks to Paul Volcker. Technology boom, budget surpluses and positive real rates of interest buttressed the dollar in the second half of the 1990s. Gold languished. In the new millennium, terrorists attacked the US. The technology bubble collapsed. US entered into two costly wars. The Federal funds rate was down to 1%. The US dollar collapsed against all currencies. Gold soared.
It is clear that gold comes into play when the US dollar is vulnerable and it retreats when the latter is strong. Now, the perception in the marketplace is that the US has turned the corner and is on the way to a self-sustaining recovery. Europe is in doldrums. In fact, it is not just southern Europe that is in trouble. China and India are teetering on the edge of precipice and Japan is betting on massive asset purchase to turn things around. Switzerland does not want the Swiss franc to be strong. The US has found oil and gas, and manufacturing is returning to the country. The economy is creating jobs. Hence, the US is the new safe-haven and the dollar is the stable store of value. If you believed this fairy tale about the US, then gold has no use for you.
Bare Talk sees a different reality unfolding in the US. The US economy is losing steam even as you read this. Corporate profit growth is down almost to zero and accretion to net cash flows is actually negative. Hence, a stock market that is rich (if not downright expensive) in valuation and unsupported by earnings growth is poised for a significant correction, if not a crash. Professor Robert Shiller has computed the “cyclically adjusted price earnings (CAPE) ratio” for US stocks all the way from the year 1881. All past values of the S&P Composite Index and earnings numbers are adjusted for current prices. The average of last 10 years’ earnings is used to calculate the price-earnings ratio. That is why it is called “cyclically adjusted”. The current ratio is 22.6 whereas the long-term average (1881 January to 2013 March) is 16.5. US stocks are rich if not in bubble territory.
What will the Federal Reserve do in the event of a market crash and economic downturn? In fact, will it extend QE3 and boost asset purchases to more than $85 billion per month? Or, will it continue to manipulate stock prices up and gold prices down? If central banks are so omnipotent, why did we get into the crisis and why do we have to accept zero per cent rate of interest on our savings?
If you have such questions that policymakers do not want you to ask because they have no answers for them, then you must look beyond and see through the current sell-off in gold.
V. Anantha Nageswaran is the co-founder of Aavishkaar Venture Fund and Takshashila Institution. Comments are welcome at firstname.lastname@example.org. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk-