We should listen to what gold is really telling us
By Mohamed El-Erian
Like Apple, valuation has become divorced from fundamentals, writes Mohamed El-Erian
here is no better topic than gold to polarise an investment discussion. So the recent sharp drop in the metal’s price has pushed to fever pitch the debate between two camps with deeply held convictions: those who view gold as overvalued and lacking both income and capital appreciation attributes; and those who feel it is only a matter of time before others appreciate again gold’s unique role as an antidote for virtually any economic ill that could hit a diversified investment portfolio.
As interesting as this debate is, it understates the potential significance of what has taken place. The recent volatility speaks to a dynamic that has played out elsewhere and, more importantly, underpins the gradually widening phenomenon of western market-based systems that have been operating with artificial pricing for an unusually prolonged period.
The consensus gold narrative is a familiar one. In an increasingly fluid ecosystem, and a world in which a growing number of central banks have ballooned their balance sheets aggressively, investors rushed into gold as a means to hedge against identifiable risks (inflation), as well as to counter nervousness about big uncertainties (including previously unthinkable disruptions to economic systems).
Rising prices generated even higher prices, significantly disconnecting valuation from underlying fundamentals of physical demand and supply – that is until an otherwise insignificant bit of news pulled the rug from under the operating paradigm.
While lower inflationary expectations and surging equities played a role, the real catalyst for the dramatic price drop was a rumour that Cyprus could be forced to sell its holdings by its European partners. This involved a tiny amount of gold (valued at less than $1bn at the time), but it made investors suddenly pay attention to the possibility of significant supply hitting the markets from other European economies (particularly Italy with holdings of some $130bn).
This simple change was enough to bring the price of gold down 15 per cent in less than a week. Since then, the metal has struggled to re-establish a firm footing, (it is currently trading at about $1,345 an ounce).
In corporate terms, think of the underlying dynamic as one of a powerful brand where valuation has become completely divorced from the intrinsic attributes of the product – thus rendering it vulnerable to any change in conventional wisdom (or what economists would characterise as a stable disequilibrium).
Over the past year, a similar dynamic has played out in Apple and Facebook shares.
After a steady increase to just over $700, Apple’s share price hit a dramatic air pocket. Its price collapsed to less than $400. Today, it trades at around $435. Why? Basically because, as powerful as it is, the brand’s “enchantment” (to use a term coined by author and former Apple employee Guy Kawasaki) ended up inducing investors (inadvertently) to disconnect valuation from the reality of the furious catch-up on the part of Apple’s competitors.
In the case of Facebook, it was widespread familiarity with the name, and the associated hype, that persuaded investors to oversubscribe to an IPO that valued the company at $38. The stock traded up briefly before dropping below $20 as a large number of professionals resisted the massive and blatant disconnect between valuation and fundamentals. Today it is trading around $26.
Of course, these are name specific examples; and, to the extent that insights can be generalised, they point to the fact that financial markets overshoot on both sides. Yet, today, I believe there is an additional insight from gold in a world where central banks, pursuing higher growth and greater job creation, have inserted a sizeable wedge between financial markets and economic fundamentals.
Firm and repeated central-bank commitment to asset purchases has done more than push a growing number of investors to add portfolio risk at ever-more elevated prices. It has also repressed market volatility, lowered correlations and given the illusion of stability –all in the context of a complicated ecosystem characterised by unusual sovereign dynamics, changing regulations, considerable tail risks, widespread need for new growth and job models, and innovation that accentuates rather than contains worrying inequalities.
Essentially, today’s global economy is in the midst of its own stable disequilibrium; and markets have outpaced fundamentals on the expectation that western central banks, together with a more functional political system, will deliver higher growth. If this fails to materialise, investors will worry about a lot more than the intrinsic value of gold.
Mohamed El-Erian is chief executive and co-chief investment officer of Pimco