In his book "The Alchemy of Finance," George Soros revealed his theory of "reflexivity," a major prong of his investment strategy. In finance, a "reflexive" process is one where the underlying fundamentals of a company or investment are affected by the perception of the market participants. While Soros believed most investments were subject to "reflexive" processes, he believed some investment classes were particularly susceptible to "self-reinforcing" processes that led to boom/bust cycles.
The earliest two examples Soros could give were conglomerate boom of the ‘60s and REIT boom of the ‘70s. Conglomerates would see their shares rise on high earnings per share numbers. They would then use this "cheap currency" (cheap because the shares were overvalued) to buy other companies, which would then boost their earnings figures even more. It became a "self-reinforcing process" in Soros terms, allowing a bubble to form. Eventually, it reached a breaking point and then the "self-reinforcing process" moved in the opposite direction.
Soros viewed mortgage REITs as having the same potential for a boom/bust cycle as the conglomerates. The mortgage REITs came in at a time when there was a lack of financing, so they filled a void. As their earnings and share prices went up, they could issue more equity to have more cash for loans. These new equity issuances, above book value, then drove the book values of the companies higher, which made their true value greater. This process went on until it hit its breaking point as well. It then reversed and turned into a bust.
If you understand Soros’ views on reflexivity, then you can better understand his seemingly contradictory view on gold. Soros has proclaimed that "gold is the ultimate bubble," while at the same time, Soros Fund Management has been making astronomically large bets on gold. Some have called Soros a hypocrite, but the reality is that Soros has always bet on bubbles.
Gold and Reflexivity
What makes gold even more subject to "reflexive" processes than conglomerates, the mortgage REITs, and most other investments is that there are no market forces that tend to pull it back down. With the mortgage REITs and with the banks, as well, once the markets became saturated, companies are forced to make less-than-ideal loans in order to sustain earnings momentum. Once these loans start going bad, the market gets jittery. The banks have to write-down their loans; this hits earnings per share, which then causes the market to panic, setting in motion a rapid bust cycle.
Gold has no similar natural correction mechanism. Unlike with banks and mortgage REITs, there are no loans to go bad. While there are a small number of industrial applications for gold, the demand for this is so small as to be meaningless. Indeed, almost all of gold’s comes from investment and jewelry users.
As consumers of gold jewelry tend to be less price-sensitive than your average consumers, this makes the metal inherently more volatile and "reflexive." Jewelry demand does have its limits, though. Even if the demand might be relatively inelastic, it will start to drop significantly after prices start to push to extremely high levels. We can see this happening in the market already.
Investment demand, on the other hand, is almost completely inelastic and is based purely on investors’ perception of the yellow metal. Investment users are also the least price-sensitive group out there, because they are under the belief that they will make a positive return on their purchase.
For this reason, Soros’ claim that gold is "the ultimate bubble" is completely accurate. No wonder he’s betting so heavily on it, because it is about as a purely reflexive investment as one could find. At some point, the momentum will shift the other way, however, and it can be subject to a rather violent correction. Given that the cash costs for most mines are well below the spot rate of over $1400/ounce, it’s not completely unrealistic that gold to drop all the way down to $700/ounce at some point. For now, the momentum still seems to be with gold.
A quick look at the futures chart also suggests that the market expects gold to continue climbing for the next several years.
Silver and Price Sensitivity
Silver, on the other hand, is a different beast than gold. Approximately 50% of demand for silver comes from jewelry, silverware, and investment. The other 50% comes from industrial uses. This makes silver a rather unique metal.
From the perspective of "reflexive" markets, silver is driven by reflexive processes, just like gold. Yet, unlike gold, silver may have a check on its prices, in that industrial users are much more likely to be cost-sensitive than jewelry consumers or silver investors. Moreover, silver is much more affected by weakening demand from market downturns. While silver speculators can create a self-reinforcing process for the metal, at some point, the prices become high enough so that the industrial users get squeezed and reduce their consumption. Or alternatively, perhaps commodity prices in general become too high, reducing overall demand for the end-products of silvers’ industrial purchasers.
The only way for prices to continue to go up in this situation is for the speculative investors to gobble up an increasingly large share of the silver pie. If that doesn’t happen, reduced industrial demand may push prices back down rapidly, which then could create a self-correcting, self-reinforcing process in the opposite direction. In this sense, silver’s "boom/bust cycle" may be more typical than gold’s, as there is at least one major check on it.
We saw these exact dynamics play out in 2008 as silver and other metal prices crashed to the floor after spending a brief time at extremely elevated price levels. Whether this renewed boom market results in another dramatic bust remains to be seen. There are slightly different circumstances this time around.
For one, there is no financial crisis to scare the market. The collapse of ’08 was rapid and once it gained momentum, it affected nearly every industry and asset class. As industrial demand collapsed rapidly, silver had nowhere to go but down. Once it was on a downward trend, it stayed on that path, collapsing all the way down to near the average cash costs of miners.
What Will Happen This Time?
It’s unlikely that silver will experience precisely the same result this time around. I would argue that the downside is actually greater this time around, but a collapse is less likely to be quite as rapid as the collapse in metal prices in ’08. There are a few things that could drive a drop in silver prices:
- An economic collapse in China would destroy demand rapidly, potentially causing silver to plunge in the same way it did in ’08,
- Austerity in Europe and lower spending in the US could cause GDPs in the developed world to start shrinking again, putting downward pressure on silver prices,
- A continued economic recovery in the US weakens speculative demand for silver and causes a shift towards other asset classes. This scenario would be more likely to result in a gradual decline for silver, since demand wouldn’t necessarily be undermined dramatically.
Likewise, there are a few bullish scenarios:
- Investment demand continues to increase, while industrial demand tapers off slowly, allowing silver to potentially display the same sort of self-reinforcing "reflexive" characteristics of gold.
- Investment demand increases for silver, but industrial demand holds steady or increases due to new applications. This is not all that far-fetched, as silver is much cheaper than palladium and platinum and some automakers have experimented with using silver as a replacement for those two metals in catalytic converters. In such a scenario, silver would actually be "cheap" to the end users, whereas palladium and platinum would be more likely to take the hit on the demand side.
Overall, I view silver as having the best long-term fundamentals of any metal, but I also view it as the second most vulnerable metal due to the historically high prices, coupled with more cost-conscious user base that comprises 50% of demand. (In case you’re wondering, copper is the most vulnerable metal, in my view.)
It’s also interesting to compare silver and copper with gold. The gold futures chart above shows that people are still expecting gold prices to increase at least a few years into the future. The silver and copper markets both have inverted futures curves, however:
This might be a sign that the market is skeptical of the current prices. Given the nature of boom/bust cycles and the issues in China, I am even more skeptical. I don't know when a collapse will happen, but I would look at it in terms of probability. I believe there is about a 50% chance of a major Chinese real estate crash in the next two years. If this occurs, silver and copper will both get obliterated.
Given the historically high prices right now, I am not a buyer of silver. I see it as having too much down-side vulnerability. Which isn’t to say that we couldn’t see a brief surge up to $50/ounce or even $100/ounce, before demand eventually collapses. In fact, a sudden spike is more likely to breed a rapid retreat. The "bearish China" thesis, best articulated by hedge fund manager Jim Chanos, is the most likely scenario for a silver crash to occur, in my view.
I have decided to buy long-dated put options on silver and a few silver miners. I use these options mostly as a hedge on the more bullish aspects of my portfolio, as I believe a general market decline could expose silver’s vulnerability.
This is not a major position for me, as I view it as dangerous to put too many chips on the table for a process that could continue to churn along for another 2 years. However, if the market does tumble, these bets should pay off and increase my cash position, in order to scoop up more stocks at discounted valuations in the future.
My biggest concern is not that I’m wrong, but that I am early. At least I have 22 months to wait it out.