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Fat-Tail Fatigue

Back to early 2007, only with gold's fair value now at $3844 per ounce...

Four years ago it felt like most finance journalists didn't know gold's color, let alone why their readers might want to read about it.

Come Sept. 2007 however, and the credit crunch - first in Europe's money markets and then on Britain's High Streets as Northern Rock collapsed - made gold's rare indestructibility all too alluring. Within 18 months, Lehmans had gone but AIG had survived, as central banks moved from zero rates to money printing, and "Is gold a bubble?" had become a regular columnist's stand-by. That headline soon mutated into "Gold is clearly a bubble" as stock markets bottomed, quantitative easing worked its magic, and commodities began racing back to their record highs.

Yawn...Next! Personal finance reporters in especial have since lost all interest in gold, pretty much taking us back to where we began. Only with gold prices three times higher and more.

"We have been arguing that tail risk remains and is unusually realistic given the potential sources of shocks," says Citigroup currency strategist Steven Englander, quoted at length by the FT's Alphaville. "[Yet] we have also found that in many cases clients are reluctant to buy into these fat tail scenarios.

"Actually, 'reject' may be more accurate than 'are reluctant'..."

Englander calls this Black Swan Fatigue - a teenager's groan-and-shrug at the risks of rare-but-earth-shattering events, such as those we apparently hit during the financial crisis. Black swans, however, weren't just considered unlikely before their discovery by Dutch sailors in Australia in 1697. In fact, "a black swan was a metaphor for the impossible," as The Australian neatly puts it. Whereas the looming collapse of leveraged debt worldwide was patently obvious four years ago.

Never mind. "The argument is basically that [sophisticated professional investors] have heard it many times before in the last two years," says Englander, "and asset markets have continued to flourish." For Citi's FX man, this complacency borders on bloody-mindedness. Yet over in the equity markets, the same story.

"The money managers who picked the global stock market bottom say now is no time to sell as the biggest equity rally since 1955 starts its third year," reports Bloomberg, naming two asset managers who either told clients to buy or piled them into the S&P roundabout two years ago (Laszlo Birinyi and Barton Biggs), as well as...erm...Ken Fisher, the Forbes' columnist who's motto pretty much remains "You gotta be in it to win it!" when it comes to stocks. Which works just fine if stocks don't dump, say, 40% without pause. Like in Oct. 2007 or early 2001. Or 1973, 1969, 1937, 1932, 1931, 1930 or late 1929.

Ditto in government bonds, where Portugal managed to raise €1bn in new loans on Wednesday, but only by paying nearer 6% than the 4% it had to pay last time around. Bond-fund giant Pimco is quitting US Treasuries, so far as anyone can make out. But someone keeps bidding them higher, putting a cap on yields (the interest rate offered moves inversely to price, remember) and more firmly than the Fed alone could surely achieve with its second-round of quantitative printing. And nevermind the risks of excessive government debt or a Eurozone failure anyway. For where the big institutional funds can find only sub-zero real returns - post inflation - from 2011's record-high government debt, Wall Street and the City are only too happy to provide new and exciting ideas. Such as the synthetic investments, now offering investors enhanced yields - thanks to the magic of leverage - on corporate bonds already classed as "junk" by the ever-cautious ratings agencies.

"With the Federal Reserve providing liquidity, default rates low and yields falling, the synthetic market is a way to increase returns," says one US-bank derivatives trader to the Financial Times. "Investors are looking to take credit risk."

The chief mischief of cheap money is back, in short - the idea that, with low-risk returns at zero and less, it's safe to seek a little fillip from leveraging what would otherwise be higher-risk trades, but which the guarantee of ultra-low interest rates somehow seem to make tame. Right until they blow up. Jaded investors thus take disproportionate risks to squeeze out an incremental return, herding together with that same reckless caution which keeps Joe Public's money in managed funds, insurance and pensions, and - of course - cash in the bank.

What's your true level of risk today? No idea. But the least your fund manager, advisor or favorite financial columnist can do today is remember the lesson of 2007, and highlight the range of risks and possible fall-out which might lie ahead. Take inflation, for instance. Though small, the risk of currency devaluation and hyper-inflation in the developed West is still "materially underpriced" by gold bullion, reckons Paul Tustain, CEO and founder here at BullionVault, in his new "Gold: Where to now?" presentation.

"Our governments have behaved very irresponsibly," says Paul, "and we're now not so different from the 'banana republics' which have lurched from crisis to crisis over the last 100 years. I think our future is likely to look a bit like their past."

That may sound like a "fat tail" threat to you, an outlying risk unlikely to strike. You might well disagree with Paul Tustain's math, as well. Because his personal "fair value" for gold does stand at $3,844 after all. But that's not a prediction of gold's future price level; it is what his analysis says the precious metal is worth today on a risk-adjusted basis, calculated as an actuary would price insurance. And while Paul's calculation is derived from the probability of various inflation outcomes over a 15-year period, based on two centuries of historical data, you can at least judge how you see the risks - inputting your own view of inflation, interest rates, and their effect on gold prices - using the same Gold Value Calculator which Paul has created.

No doubt you'll get a different value, since you'll no judge judge the risks differently. But either way, those risks do need judging, by and for yourself. Because the finance industry is behaving like risk isn't a worry.

 

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