The types of bet a person can make can be categorised as follows:

1. A bet where a rational bettor hopes to win and has a reasonable expectation* of winning. For example, someone who buys a stock following careful analysis of potential risk versus reward hopes to obtain a profit and believes that they have put themselves in a position where the expected outcome is a profit. This type of bet is called a speculation or an investment.

2. A bet where a rational bettor hopes to win but knows that the expected outcome is a loss. For example, someone who bets on roulette at a Las Vegas casino should realise that the expected outcome is a loss, but people who bet on roulette are generally hoping to beat the odds. This type of bet is a gamble. Note that many of the people who claim to be speculating/investing are actually gambling, because they haven’t done sufficiently thorough analysis of risk versus reward for their bet to be categorised as a speculation or an investment.

3. A bet where a rational bettor hopes and expects to lose. This type of bet is called an insurance payment.

When you buy insurance you can be very confident that the expected outcome is a loss because anyone prepared to offer you insurance on any other terms will not stay in business for long. Furthermore, a rational and honest person who takes out insurance will be hoping that they will never actually need to cash-in their insurance policy; that is, they will be hoping to lose the money paid for the insurance. For example, someone who buys fire insurance for their home is, in effect, betting that their home will burn down, but this is a bet they will generally be hoping to lose.

Due to the expected outcome being a loss, you should never pay someone to take-on an insurance risk you can afford to take-on yourself. It will, however, make sense to pay for insurance in certain cases. This is because even though the expected outcome is a loss, the consequences of not having the insurance could be devastating. Many people, for instance, would be financially devastated if their home burnt down, so it would probably make sense for them to pay for fire insurance. But it probably wouldn’t make sense for Warren Buffett to have his modest Omaha residence insured against fire because the financial value of his home is miniscule compared to his net worth.

Managing risk in the financial markets is often equivalent to buying insurance. That is, it often involves making a bet you hope and expect to lose, but a bet that makes sense nonetheless because it will prevent you from experiencing severe financial pain if things don’t go according to your best-laid plans.

*When I say “a reasonable expectation of winning” I mean that the expected outcome is a win, which is different from saying that the probability of winning is greater than 50%. For example, a bet that has a 70% probability of yielding a 10% profit and a 30% probability of yielding a 50% loss has an expected outcome of minus 8% [0.7*10 + 0.3*(-50)]. In this case there’s a 70% probability of winning the bet, but a rational person will not make such a bet.

In many real-world situations the probabilities needed to calculate “expected outcome” will not be known, meaning that speculators/investors will be forced to use educated guesses (guesses made after carefully weighing the known facts). These educated guesses will sometimes be wrong, which is why risk management is crucial.

(This post is an excerpt from a recent TSI commentary.)

The stock market is not a machine that assigns prices based on a calm and objective assessment of value. In fact, when it comes to value the stock market is totally clueless.

This reality is contrary to the way that many analysts portray the market. They talk about the stock market as if it were an all-seeing, all-knowing oracle, but if that were true then dramatic price adjustments would never occur. That such price adjustments occur quite often reflects the reality that the stock market is a manic-depressive mob that spends a lot of its time being either far too optimistic or far too pessimistic.

The stock market can aptly be viewed as an emotion pendulum — the further it swings in one direction the closer it comes to swinging back in the other direction. Unfortunately, there are no rigid benchmarks and we can never be sure in real time that the pendulum has swung as far in one direction as it is going to go. There’s always the possibility that it will swing a bit further.

Also, the swings in the pendulum are greatly amplified by the actions of the central bank. Due to the central bank’s manipulation of the money supply and interest rates, valuations are able to go much higher during the up-swings than would otherwise be possible. Since the size of the bust is usually proportional to the size of the preceding boom, this sets the stage for larger down-swings than would otherwise be possible.

The following monthly chart of the Dow/Gold ratio (from Sharelynx.com) clearly shows the increasing magnitude of the swings since the 1913 birth of the US Federal Reserve.

In the real world there is money supply and there is money demand. There is no such thing as money velocity. “Money velocity” only exists in academia and is not a useful concept in economics or financial-market speculation.

As is the case with the price of anything, the price of money is determined by supply and demand. Supply and demand are always equal, with the price adjusting to maintain the balance. A greater supply will often lead to a lower price, but it doesn’t have to. Whether it does or not depends on demand. For example, if supply is rising and demand is attempting to rise even faster, then in order to maintain the supply-demand balance the price will rise despite the increase in supply.

When it comes to price, the main difference between money and everything else is that money doesn’t have a single price. Due to the fact that money is on one side of almost every economic transaction, there will be many (perhaps millions of) prices for money at any given time. In one transaction the price of a unit of money could be one potato, whereas in another transaction happening at the same time the price of a unit of money could be 1/30,000th of a car. This, by the way, is why all attempts to come up with a single number — such as a CPI or PPI — to represent the price of money are misguided at best.

If money “velocity” doesn’t exist in the real world, why do so many economists and commentators on the economy harp on about it?

The answer is that the velocity of money is part of the very popular equation of exchange, which can be expressed as M*V = P*Q where M is the money supply, V is the velocity of money, Q is the total quantity of transactions in the economy and P is the average price per transaction. The equation is a tautology, in that it says nothing other than the total monetary value of all transactions in the economy equals the total monetary value of all transactions in the economy. In this ultra-simplistic tautological equation, V is whatever it needs to be to make the left hand side equal to the right hand side. In other words, ‘V’ is a fudge factor that makes one side of a practically useless equation equal to the other side.

Another way to express the equation of exchange is M*V = nominal GDP, or V = GDP/M. Whenever you see a chart of V, all you are seeing is a chart of nominal GDP divided by some measure of money supply. That’s why a large increase in the money supply will usually go hand-in-hand with a large decline in V. For example, the following chart titled “Velocity of M2 Money Stock” shows GDP divided by M2 money supply. Given that there was an unusually-rapid increase in the supply of US dollars over the past 17 years, this chart predictably shows a 17-year downward trend in “money velocity”.

Note that over the 17-year period of downward-trending “V” there were multiple economic booms and busts, not one of which was predicted by or reliably indicated by “money velocity”. However, every boom and every bust was led by a change in the rate of growth of True Money Supply (TMS).

Chart source: https://research.stlouisfed.org/

In conclusion, “money velocity” doesn’t exist outside of a mathematical equation that, due to its simplistic and tautological nature, cannot adequately explain real-world phenomena.

Although it is not possible to determine an objective value for gold (the value of everything is subjective), by looking at how the metal has performed relative to other things throughout history it is possible to arrive at some reasonable conclusions as to whether gold is currently expensive, cheap, or ‘in the right ballpark’. In particular, gold’s market price can be measured relative to the prices of other commodities, the stock market, the price of an average house, the earnings of an average worker, and the real (purchasing-power-adjusted) money supply. In a recent TSI commentary I looked at the last of these, that is, I looked at gold’s price relative to the real money supply, and arrived at the conclusion that gold’s current price was about 20% above ‘fair value’. I’ll now take a look at gold relative to other commodities.

As illustrated below, over the past 20 years — with the exception of a short-lived spike in 2011 — major swings in the gold/silver ratio have bottomed at around 45 and peaked at around 80. The ratio is currently near the top of its 20-year range, which means that gold is expensive relative to silver.

As a consequence, to argue that there has been a successful long-term price suppression scheme in the gold market you must also argue that there has been a successful long-term price suppression scheme in the silver market. Such arguments have, of course, been put forward, with one analyst claiming that JP Morgan has managed to do the impossible by amassing a large long position in physical silver while simultaneously suppressing the price of silver by selling futures contracts.

The next chart shows that gold is also near a 20-year high relative to platinum, the implication being that gold is expensive relative to platinum.

Consequently, to argue that there has been a successful long-term price suppression scheme in the gold market you must also argue that there has been a successful long-term price suppression scheme in the platinum market. Again, such arguments have been put forward. For example, one analyst has suggested that the daily platinum ‘fix’ in the London market was used to manipulate the price downward over the long-term, even though there was an overall upward bias in the price over the period under analysis. For another example, an analyst has argued that the platinum price has been persistently reduced by the short-selling of platinum futures, an outcome that would only be plausible if every sale of a futures contract didn’t subsequently have to be closed-out via the purchase of a contract and if automotive companies had figured out a way to replace the physical platinum used in catalytic converters with paper contracts.

The final chart shows that gold is presently near an all-time high relative to the CRB Index (an index representing a basket of 17 commodities). This chart therefore shows that gold is expensive relative to commodities in general.

As far as I know, nobody has yet tried to argue that the prices of most commodities are being suppressed as part of a grand plan to conceal the long-term suppression of the gold price. Instead, gold’s expensiveness relative to commodities in general is studiously ignored.

To summarise the above: gold is currently expensive relative to many other commodities.

Almost regardless of what gold is measured against, it does not look cheap at this time. However, given what is happening to money and economies around the world, there is logic to the fact that gold is relatively expensive right now. Also, it is logical to expect that gold is going to get a lot more expensive within the next few years.

As I’ve explained in the past, gold is not now and has never been a play on “CPI inflation”. Of course, on a very long-term (multi-generational) basis the gold price will tend to rise by enough to offset the decline in the purchasing power of money, but so will the prices of many other assets. What makes gold special is that it is the premier long-term hedge against bad monetary and fiscal policies.

Gold isn’t cheap right now, but in a world that is rife with bad monetary and fiscal policies it is destined to become a lot more expensive.