Monday, December 8, 2014

Attention Traders: The Value Of Cash Is Not Absolute

Over the last few years, as the price of Gold declined, several professional traders and financial commentators have taken it upon themselves to unleash their wisdom about the metal being "just a trade". They've decided that everyone should see the financial world through their narrow lens and have used it's declining price as "proof" you should always have a stop and be prepared to exit your position.

The way I've framed the above might suggest I have a problem with their view. In fact I don't, it's one way of looking at the assets in your investment portfolio. However, to take their view you also have to give thought to ALL positions and that includes cash, which should also be considered a trade as it's value can change.

Earlier this year I wrote about Ritholtz's position on gold bugs ('Barry Ritholtz Mischaracterizes Gold Bugs'), one of the rules in his article was:
The Danger of One-Way Trades: What would make you reverse your biggest present holding? What facts or situations would force you to change your views and sell? If your answer to that question is, “Nothing,” you have a huge, devastating flaw in your approach to investing.
I hear traders talking day in and out about 'going back to cash' or 'sitting in cash' after exiting all positions, but if a trader was to think about what they are doing logically, as they would any other position, they are simply moving from one asset which fluctuates in value to another.

What facts or situations would force a trader to consider a position in cash being unsafe? Answer that and you might be on the path to understanding the reasons that some investors choose to hold physical Gold.

A reader of my Ritholtz article commented: "Ritholtz essentially supports his analysis by treating fiat currencies as a bedrock, i.e. asset changes are all relative to this unchanging fiat value." I agreed: "Ritholtz claims to be ‘asset class agnostic’, but then measures the performance of other assets back to fiat which doesn’t have static value."

Newsflash: Cash / fiat currency is not a neutral position.

There is no asset which remains absolute in it's price or value relative to everything else (and yes that includes cash or Gold).

I tried to explain this briefly to one trader (Mark Dow) who regularly has a crack at gold bugs on Twitter, to my amusement he suggested that you don't have to hedge against fiat currency because it's "legal tender".

Click Image to Enlarge
How could anyone think that a currency being legal tender protects the holder from changes in it's value?

Sure it's a unit of account and may remain a constant relative to some assets, for example a $10,000 loan will always require $10,000 in cash (+ interest) in order to repay it, but the value of currencies can be affected in various ways, sometimes to devastating effect.

So how does one hedge or insure themselves against fiat currency and the financial system?

This question reminds me of a discussion that took place in the comments on Cullen Roche's site (comments since disabled, but they were here) a couple of months back when he suggested that those wishing to hedge against the financial system should take a short position on the finance sector. 

Imagine taking out insurance against your house burning down and then leaving the only paper work you could use to make a claim inside the very same house.

That is basically what Cullen proposed. Some of the sensible responses below his suggestion included:
“Gold like cash is a unique hedge because unlike options, or bonds or financial hedges it has infinite duration.”

“I have an allocation to gold and silver because its the only way that I can be 100% sure that my “insurance” isn’t someone else’s liability.”
Precious metals are unique in the sense that they are one of few assets which can be held physically outside of the financial system & can't be diluted in the same way as fiat currencies.

Some traders might argue that significant changes in the value of cash occur so infrequently that it's not worth worrying about (tell that to someone living in Russia, Japan, Cyprus, North Korea, Venezuela), but that's exactly the mindset that some of these traders criticise others for, that is, having a baked on view that holding an asset poses no risk. 

Holding a 100% position in any asset is risky, whether that's cash, Gold, Silver, property or anything else. Diversify or be prepared to wear the consequences if the value of that position moves against you.

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  1. that's why the market keeps going up.. because every day, a few more people who've been fighting the tape and trying to hold out from buying "overpriced stock" give up and re-allocate out of cash and into stocks...

    and when the last Zerohedge reader does this, it will be the top of the market.

    aside, I think Barry's point is an essential one: if you ask someone "at what price will you sell your gold?" and they say "never," well, there's no sense in trying to have an intelligent conversation with that person If you'll never sell it, the price doesn't matter.

    anyway - to the point of your post: when people are *desperate* to allocate out of cash you get... pop quiz.. ???

    A: hyperinflation

  2. While I don't agree with Ritholtz's characterisation of gold bugs (at least not all of it), I do agree with his point that having a baked on view is dangerous, but that goes for gold bugs and paper bugs. If you were to ask someone who owned none prior, "Under what circumstances would you buy physical Gold?", then likewise you are going to have an unproductive conversation.
    I think most gold bugs who respond that they'll "never sell" just have a stubborn personality, in reality there would be circumstances that would result in most selling (or at least lightening their position), they just can't envisage the set of events required for that to taking place. Try asking the next stubborn gold bug you come across whether they would sell their Gold if (over the next decade) the government reigned in the TBTF banks (e.g. jailing senior staff who oversaw illegal activity), started running a budget surplus, managed to halve the public debt to GDP ratio and normalised interest rates without incident. Maybe they'll surprise you ;)

  3. Hi BB.

    I have never actually recommended hedging against equity exposure with a short on the financial sector. I am not sure where you got that idea from.

    I've stated that you might consider using non-correlated assets, options, and (perhaps) shorting indices, but that's very different from shorting a specific industry.

    Thanks for letting me clarify.

  4. No problems. As the comments on your site are now turned off I can't quote the exact wording, but I recall (& made note at the time) that you specifically mentioned a short on the finance sector in response to a comment or question about hedging against the financial system (not equities in particular).

  5. I don't have the comments on my site any longer so I can't verify what was or wasn't said. But I have personally never believed in/used industry short positions as forms of insurance so that doesn't make a lot of sense to me.

    More importantly, I'd argue that gold is a form of insurance, but it's generally a poor form of insurance because there are some very serious underlying risks involved in its price. The most important of which is what I refer to as a "faith put", ie, the idea that gold is a currency that warrants a price premium well above its cost of production. Insurance should provide the holder with a reduced sense of uncertainty. Gold value is not only extremely valuable, but it's extremely uncertain. It's nothing like buying options or an insurance policy on an asset which provide you with a certain future value in the case of catastrophe. So yes, gold can be used for insurance purposes, but there are much better ways to insure against financial asset risk than to own high risk non-financial assets.

    That's my view anyhow, Not that I expect you to agree. :-)

    Take care.

  6. "...which provide you with a certain future value in the case of catastrophe."

    They may provide you with a certain future payout in a particular currency, but not certain future value. I'll refer you back to the post:

    "There is no asset which
    remains absolute in it's price or value relative to everything else (and
    yes that includes cash or Gold)."

    I'm not saying physical Gold will always be the best or least volatile insurance asset, but I think it's one worth having for many.

    Few people are as financially sophisticated as the average financial blogger or commentator and they're more likely to make a mistake buying options than a few Gold coins. I recall reading a saying, "Buy only as much gold as you understand." I think that's a great way to put it for any asset and let's face it, a lot more people are going to understand Gold than a complex financial derivative regardless of how volatile it's price can be at this point in time.

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