Gold: Irrational Exuberance And Sentiment Trumping Fundamentals

| About: SPDR Gold (GLD)


Gold's value is imputed and this, in tandem with it being sentiment-driven, makes it difficult to forecast its value.

The reaction of gold in the wake of Trump's victory proves just how volatile and difficult it is to predict its value.

Sentiment over the short term trumps any fundamentals that drive gold.

This sentiment is heavily ingrained in half-truths and falsehoods relating to gold.

In recent months, I have focused on trying to understand what drives the value of gold (NYSEARCA:GLD)(NYSEARCA:IAU) and whether fundamentals have any real effect on its value. Those fundamentals, according to the typical pundits, center on its role as a hedge against inflation, its recognition as a safe-haven asset, as a hedge against fiat currencies and the impact of interest rates on its value. In many cases, there was little support for those claims, particularly that geopolitical as well as economic crises and lower interest rates are good for gold.

What happened to gold?

It was in recent days that investors witnessed one of the greatest contradictions to occur with the price of gold, its massive reversal after the shock victory of Donald Trump in the presidential race.

A large number of analysts and economists were proclaiming, quite loudly, that a Trump victory would be good for gold and had the potential to push it to over $1,800 per ounce. Once it was clear that Trump had secured his seat in the Oval Office, gold rallied briefly surging to $1,338 per ounce and then it entered a terminal decline. This now sees it losing 12% from its post-Brexit high to be trading at $1,208 per ounce.

For a range of reasons, this trend will continue for the foreseeable future.

You see, all of this is predicated on Trump's victory speech, where he made a few statements aimed at calming nervous financial markets. This suddenly saw many pundits view his policies, especially those centered on fiscal stimulus, as being good for the economy.

Surprisingly, those pundits championing his economic policies are those that were extremely pessimistic and were predicting doom and gloom should Trump win the election.

If anything, it highlights just how fickle financial markets can be and how difficult it is to predict the direction that gold will move based solely on fundamentals.

What drives the value of gold?

Forecasting gold has become something akin to an esoteric and arcane art, which for some amplifies its attractiveness. Gold can turn on a whim making it unpredictable and volatile with much of its value being imputed rather than based on tangible factors such as cash flows.

This certainly lends support to the claims that the value of gold is solely driven by sentiment and that sentiment is incapable of being quantified. And this makes it extremely important for investors to understand what sentiment is, where it comes from and how it influences financial markets, particularly precious metals because of their imputed value and qualities.

Social psychologist Steven L Gordon in his book 'Social Psychology: Sociological Perspectives' defines sentiment as a socially constructed pattern of sensations, expressive gestures and cultural meanings organized around a relationship to a social object.

In his book 'An Introduction to Social Psychology' William McDougall, an influential leader in the fields of instinct and social psychology, stated:

. . .sentiment is an organised System of emotional dispositions centred about the idea of some object.

And he went on to point out that sentiment does exist independently but rather is a construct with:

. . organisation of the sentiments in the developing mind is determined by the course of experience. . .

Essentially sentiment is formed from experience, societal conditioning and culture.

In the case of gold, it is easy to see how sentiment influences the yellow metal's value with a range of attributes that are accepted in markets even if they are not wholly true:

  • gold is the ultimate safe-haven asset, this is first and foremost its most widely recognized role with it having been ingrained into the psyche for millennia;
  • gold because of its finite quantity and inability to be fabricated at will, like fiat currencies, makes it a hedge against fiat currencies and inflation;
  • as a zero-yield asset, high interest rates are bad for gold.

While each of these characteristics may not be entirely true, they form the basis of the conditioning that investors receive and how they perceive gold, essentially making them the fundamentals that influence its value and market sentiment towards gold.

These characteristics mean that investors expect the following events to influence the value of gold and for it to react in certain ways: economic and geopolitical crises are good for gold, with it rising value when they occur;

  • rising inflation and the debasement of fiat currencies is good for gold causing it to appreciate;
  • low interest rates are good for gold, whereas high interest rates negative.

Because all investors and to a lesser extent members of modern western societies have been overwhelmingly culturally conditioned to accept these fundamentals and how they influence gold, they are the key drivers of sentiment that determines gold's value and outlook. The influence of these fundamentals on investors' sentiment becomes even more powerful when we consider that there is really no fundamental means of valuing gold.

Unlike precious metal silver (NYSEARCA:SLV) and other industrial metals such as copper, zinc, lead and tin it does not have any utility, nor does it have the ability to generate cash flow.

This means that its value is solely imputed by the market, based on the accepted understanding of how those fundamental drivers influence the investing environment and ultimately gold.

In an August article, I found that there was a linkage between crisis and the value of gold.

Nonetheless, it didn't always exist and the crisis had to be of a deep enough nature to be perceived as having a profound influence on the economy and create considerable fear.

The most prominent example of this were the early 80s' recession triggered by energy shocks and a substantial rise in Cold War Tensions. The global financial crisis is also another example.

Both crises ended up sparking the biggest gold bull markets in modern history.

Despite finding that there was no clear correlation between gold and interest rates in my last article, the majority of investors believe that because it is a zero yield asset, higher interest rates are bad for gold. Now with the Fed musing about a much-needed rate hike, gold has come under considerable pressure. In that same article, I found that there was some negative correlation between gold and the U.S. dollar.

A stronger dollar, not all of the time but at least some of the time, was bad for gold and considering how this belief influences sentiment, the spike in the dollar since Trump's victory has contributed to gold's recent demise.

What I find interesting about the current slump in gold is that in my first article exploring gold's fundamentals I found that over the long term, there is a correlation between gold and inflation. It is not always present but it certainly exists, yet despite the optimism surrounding Trump's economic policy and fiscal stimulus, pundits have failed to recognize their inflationary nature, with gold's characteristics as a hedge against inflation failing to support its price.

What does it all mean?

The ability of sentiment to turn on a pinhead and behave unpredictably as evidenced by how gold reacted when a Trump victory was clear, indicates just how difficult it is to prognosticate on what the future holds for the yellow metal. What is clear is that the optimism surrounding Trump's plans to stimulate real economic growth through a $1 trillion investment infrastructure, promoting investment in energy, particularly shale oil and tax cuts is placing considerable pressure on precious metal prices.

If Trump's plan is successful then it would cause gold to fall further, with higher interest rates, stronger economic growth and a higher dollar the order of the day.

However, there is a considerable degree of uncertainty surrounding his plans and the ability to implement them and gaining the desired effect is questionable. What is more likely is that markets will be disappointed and that the irrational exuberance being felt in markets at this time, which is driving the negative sentiment towards gold, is extremely unrealistic.

Over the short term, this sentiment will cause gold to keep falling but once there are signs that Trump's economic policies are not achievable or are not delivering the expected growth, gold will rally. Some pundits are already predicting that the markets' enthusiasm for Trump's policies is overdone and they will wind up disappointed.

This is highly likely given how long it can take to wind up the Federal policy machine and just how much of an unknown fiscal policy will be in a world where the damage caused by unconventional monetary policy remains unquantifiable. But what is certain is that markets are extremely bad at factoring in unquantifiable risks and sentiment, which has the potential to turn in a split-second and will rule the short term.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I/we have extensive investments in physical gold and silver bullion as well as collectible antique gold and silver coins.