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Friday, January 24, 2014

Why gold having zero yield is good


I woke up this morning with an idea about something.

I'm not an economist, so this might all be rather wrong. But it seemed like an interesting idea, and I like sharing those with you if for no other reason than to stimulate your own internal discussion. So bear with me while I lay it all out for you:

What is an equity or bond worth? What is a piece of real estate worth?

You could say "well, they're worth what someone will pay for them", but that's what people also say about gold, and thus they assert gold is really worth $0. Therefore, by their own logic, equities and bonds and real estate are also worth $0, right?

But they're not, right? Or at least nobody on Wall Street ever asserts this, right?

Leaving equities aside, you can easily figure out a cash value for a bond, can't you? It's worth the principal, plus the sum of yield, right?

OK, not exactly. If it's not inflation-linked, then I'd assume the bond is worth the discounted future value of the principal, plus the discounted coupon. (Follow the link and read the article if you're not familiar with discounted cash flow analysis, which would be funny since you're reading this blog and I'm always going on about DCF.)

Rental real estate would be like this as well, no? It's worth the discounted future value of the net income, no? Plus maybe some salvage value of the property, I dunno. For a primary residence, I guess there's also a utility value, which would be something like the NAV of the savings over rental versus the cost of maintenance.

Here's a funny thing about that real estate value. I forget his name, but a few years ago when I got into the doomer blogger world, there was some blogger I followed who grew up in Argentina or Chile (forget which) during the big LatAm crisis of a few decades back. He had a story about someone who, during the hyperinflation spiral, traded his scooter to someone for a plush downtown apartment.

How did that apartment collapse in value to be worth only the price of a scooter? Well, the apartment owner wasn't making any immediate money off the apartment, and I guess he needed cash, so he traded it for a scooter so that he could go into business making deliveries for cash. Obviously, the apartment was suddenly worth a lot less to him than immediate income from doing cash business.

Seems to me like an apartment's value could collapse if the owner's discount rate shot up. When you jack up discount rate, future cash flows quickly vanish. This guy suddenly needed money immediately, and was willing to trade away the future DCF value of his apartment because it was worth nothing to him compared to immediate cash flow from doing business on a scooter. So the future DCF was worth almost zero to him, which meant he must have been discounting future cash flows from the apartment at an incredibly high rate, no?

Bonds seem to be similar. Ritholtz noted during the 2008 crisis that the MBS bonds weren't worth $0; they were still worth what people were willing to pay for them. But since the market realized all of a sudden that these securities had a much higher default risk than anyone had thought before, the discount rate used to determine that security's value shot up, including the discount rate on the return of principal at maturity, and so the MBS market had to collapse until the securities reached a price that put supply and demand back into equilibrium at the new discount rate, right?

And a similar thing happened with Euro periphery government bonds: all of a sudden a default risk exploded, so Greek government bonds had to collapse. However, they couldn't go to $0, because they still had a coupon and a principal: the discount rate had to go up strongly, but it never went to infinity.

Seems the discount rate never goes to infinity: I read a few years ago that there was still a market for the Cuban government securities that were defaulted on by Castro after the revolution was successful. They traded at a massive discount, but they never became toilet paper. Maybe the market in aggregate decided that there was still some small but nonzero chance that they could still collect on those bonds in the future.

So, what about equities? I have a hard time figuring them out, but I'm guessing the value of an equity to a shareholder (i.e. its market price) must be something like that share of a company's net liquidation value, plus (in the case of shares with dividends) the discounted sum of future dividends. In which case, the liquidation value component of an equity price can go to $0 in a crisis if it's bankrupt (since shareholders lose everything); but assuming no bankruptcy, the future cash flow to shareholders value can still vary as the discount rate varies, right?

As I said, I'm no economist, but it seems sensible.

And discount rates jack up in a crisis. That's why CAT and AT&T shares crashed 50% during the crisis: it's not that the market could sensibly expect their future dividends to disappear forever, it's just that the market put a higher discount rate on their future dividends. Discount rate is a function of fear.

Now here's the thing.

What's the market's implied discount rate on gold at any time, compared to equities and bonds and real estate?

If gold is some sort of constant currency, and there's no yield to gold, then discount rate =$0, right?

So in a market crisis, while the discount rate equilibrium changes for other goods, it shouldn't change for gold, right?

OK fine: in reality, things don't work that way, because in a liquidity crisis people are willing to dump anything for any price; if gold's price manages to hold up versus equities, that relative outperformance would get arbed away by liquidity-strained investors looking to get the best price possible for whatever they're trying to dump to raise cash.

Nevertheless, ignoring the liquidity crisis problem, by Wall Street Whitey's own logic gold is still an asset class that has no discount rate. An ounce of gold today doesn't become tomorrow 1.02 ounces times 1 over 1 minus the discount rate. Gold's value doesn't go down versus inflation (supposedly - you know that I feel gold has nothing to do with inflation, but we're arguing from Wall Street Whitey's point of view so we're stipulating most of what he mistakenly believes about gold), its maintenance cost is simply the cost of storage; but one ounce of gold today equals one ounce of gold 10 years from now, and one ounce of gold in Canada is the same ounce of gold as one ounce of gold in Bahrain or Thailand or Singapore.

So how can you possibly discount flows on gold? Principal is constant (in gold terms, if not in cash terms), and future cash flow is constant because future cash flow is zero.

So therefore, gold is a magical asset class whose market value (theoretically) doesn't collapse when discount rates go up.

So therefore, gold is a magical asset class whose market value (theoretically) doesn't collapse when fear goes up.

So therefore, quit selling gold you morans.

I know that was a weak ending to an otherwise brilliant article, but I really have to get to work now.

Oh look, gold is $1269.10 this second.


1 comment:

  1. Glad you got that off your chest....I guess you should be able to sleep better all weekend now

    ReplyDelete