Investor Sentiment and Systematic Investing in the Gold Sector

By Steve Ellis

November 2013

Ben Bernanke, Chairman of the US Federal Reserve, recently said he didn’t understand gold prices. What we believe Bernanke struggles with is how one values an ounce of gold, and if so, he has a point. Gold pays no dividend, and produces no free cash-flow, so how do investors arrive at its net present value per ounce?

Most investors claim they analyse supply and demand. But how much can one day’s incremental supply versus demand affect the global supply/demand balance for a non-perishable asset whose supply has increased in glacial increments over thousands of years?

What gold investors are really driven by are gold price patterns. This applies not only to investors, but to central banks and also to gold miners themselves. These “industry insiders” were rushing to sell gold and hedge forward for USD300/oz at the end of gold’s 20 year bear market in the late 1990s. As gold reached subsequent highs close to USD2000/oz in 2011 they were adding to their vaults and mine reserves without a hedge book in sight. That is why following financial market patterns can be fraught with danger.

Instead, successful investors focus on being on the right side of probability not patterns. A recent RESEARCH Magazine article* illustrates just how much the average person struggles to think in terms of probability:

“In multiple studies (most prominently those by Edwards and Estes, as reported by Philip Tetlock in his book Expert Political Judgment), subjects were asked to predict which side of a “T-maze” held food for a rat. The maze was rigged such that the food was randomly placed (no pattern), but 60% of the time on one side and 40% on the other. The rat quickly “gets it” and waits at the “60% side” every time and is thus correct 60% of the time. Human observers keep looking for patterns and choose sides in rough proportion to recent results. As a consequence, the humans were right only 52% of the time—they (we!) are much dumber than rats. We routinely misinterpret probabilistic strategies that accept the inevitability of randomness and error.”

Even rats get probability better than people! It is for this reason that a systematic investing process can be so valuable. Away from the “noise” of the markets and the perceived patterns, strategies can be researched and probabilities investigated and calculated. Only then can exposure levels be managed systematically on the basis of probability. By admitting the dominance of randomness and positioning yourself inversely to the pattern chasing “clever consensus”, you maximise your chance to out-perform.

Ironically, because humans have sophisticated pattern recognition skills built in, we see patterns in probability terms where in fact there are none. Roulette players in casinos routinely stare at the digital board displaying past results to somehow divine the next spin, despite the obvious fact that a ball spun at 60km/h in the opposite direction of the spinning wheel cannot possibly have any correlation with the previous spin, let alone a series of previous spins.

A systematic investment process can reduce or eliminate the “overinterpretation” inherent in our own ingenuity. When we can base our decisions only on the actual probabilities embedded in the data, the outcome of those decisions can be improved over a large number of trials. In the gold market, for example, I am convinced that the gold price makes the news, and not the other way around. In the morning gold is up 1%, so Bloomberg reporters scramble to publish a news story that Chinese jewellery demand is increasing, only for the price to finish the day down 1% and the same reporters to issue another article referring to weakening Indian demand due to a delayed monsoon season.



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