Can Financial Instrument Substitute Gold?

First of all, what would you expect from a safe haven asset? Should it trade without speculative parabolic upswings and subsequent corrections?

Such ups and downs will happen if a given asset is allowed to trade freely and independently from other ones. Bull markets and bear markets. Excessive optimism turns into excessive pessimism and vice-versa – at least when the markets are free, that’s how things work. That’s simply a realistic observation.

If the gold market is free (at least to a considerable degree), then we can expect it to move ahead of itself every now and then and to underperform at times. What does that tell us? That we should be careful not to view the cyclical downturn as anything more than it is. It is the way markets work and attributing such downturns to other – especially fundamental – factors, can be misleading.

Gold hasn’t really responded to the open-ended QE – it hasn’t skyrocketed. It didn’t even manage to hold a rally for long - the upswings that we saw when the key pieces of news were announced were temporary at best. Does that mean that gold is no longer a good way to protect oneself from the rapidly increasing money supply, which has to, eventually, trigger higher inflation? No, it means that multiple factors that determine the gold price ended up pushing it lower. We can’t tell what would have happened if we hadn’t had an open-ended QE in place for so long. Perhaps the price of gold would be a few hundred dollars lower. All we know is that given the cyclical, fundamental, and short-term emotional factors gold is where it is. Can we infer – based on gold’s decline in 2013 – that the fundamental situation has deteriorated? No. Gold has been rallying, with small pauses, for over a decade. We could have expected to see it correct eventually – it seems that this time is now. It doesn’t mean that it has stopped being a hedge against irresponsible monetary policy. That has not necessarily been the reason for gold not to rally in recent months.

Moving back to the topic – what does it mean for gold to be a safe haven? It means that it should appreciate – on average – when things go bad. Bad = high inflation or any other significant uncertainty. If it is allowed to trade freely (at least mostly), then we can expect it to form local bubbles and then to correct. Has gold more than quadrupled in the last decade? Yes, it has. This means that, on average, gold has been moving higher, most likely, on rising uncertainty and huge money creation. It has corrected in the recent years – ok, but it could be the case that it simply corrected just because it had to correct as this is just the way bull markets work.

Gold is still a hedge against turmoil (especially financial turmoil), but we just can’t expect it to respond to each and every piece of bullish news. If it is in a cyclical downtrend, it will not really respond to positive news. It will eventually, but not necessarily right away. It might need to correct first, and then it will likely come back with a vengeance.

Therefore, if something doesn’t happen right away, it doesn’t mean that it doesn’t work at all. In a loose analogy – you might not see an immediate benefit from education, yet you know that you are very likely to benefit from it in the end.

Then there’s the VIX. The VIX is a financial instrument, which will quite likely do a good job in case of small, day-to-day risks, but – unlike physical precious metals - it will not protect you if the financial system is destroyed. It’s not that we predict that to happen tomorrow or the next week, but something like that could very well take place eventually – within this decade or the next one.

The various decisions that the Powers That Be are making that limit the short-term risks (and the way the current financial system is designed), are actually increasing the systemic risk. In other words, all the insurance companies, reassurance companies, hedged risks via derivative instruments and so on, mean that unless the losses are really huge, the system will absorb it and move back to equilibrium. One company goes bankrupt? No problem. The system risk means a huge problem when a hundred companies go bankrupt at the same time which causes the companies that have been insuring them to go bust as well along with their reinsurers. At such time other companies would become vulnerable to default, which could spread given the overall panic in the market.

With the contagion effect, it wouldn’t take long before the stock market tanked on hundreds and hundreds of companies getting out of business. This is something that could collapse the financial system. That’s precisely the systemic risk. In fact, systemic risk is just a fancy term for “when all hell breaks loose”. Academics, and quite a few analysts, will tell you that systemic risk is here to stay and that you can’t do anything about it. However, we respectfully disagree. There is something that has preserved value for thousands years and endured more than tens of various fiat currency systems – precious metals.

The VIX, on the other hand, should seem excellent (as far as hedging the risk of plunging stocks is concerned) on a short-term and medium-term basis, but if the financial system collapsed, the VIX would likely not provide any protection whatsoever, as it’s just a quite sophisticated part of this system.

Gold is not a mathematical computation of variability of stocks’ returns, but an asset class of its own – a one with a few thousand years of history of serving as a true hedge against the massive fiat money creation.