Sprott versus the Central Gold Trust

June 17, 2015

Late last month Sprott Asset Management made an offer to acquire all of the units of the Central Gold Trust (GTU), a gold bullion investment fund, in exchange for units of Sprott’s own gold bullion investment fund (PHYS) on a net asset value (NAV) for NAV basis. This implied — and still implies — a small premium for GTU unitholders, the reason being that GTU units were — and still are — trading at a discount of several percent to their NAV. GTU’s Board of Trustees subsequently recommended that its Unitholders reject the Sprott Offer for reasons that were outlined in a Trustees’ Circular, which was followed by dueling press releases. What’s the average retail GTU unitholder to do?

To answer the above question it is necessary to consider the benefits, if any, of exchanging GTU units for PHYS units. As far as I can tell and despite the numerous reasons given by Sprott for voting in favour of the proposed unit exchange, there is just one benefit: PHYS, the Sprott bullion fund, offers a physical redemption facility that — although it can only be used by large investors — prevents the units from trading at a sizable discount to NAV.

The thing is, the historical record indicates that GTU units only ever make significant and sustained moves into discount territory during multi-year bearish trends in the gold price. In other words, the historical record indicates that Sprott’s benefit only applies during gold bear markets.

Of course, there’s no guarantee that past is prologue in this case and that GTU’s discount will disappear in the early part of a new multi-year upward trend in the gold price, but recent performance suggests that nothing has changed. As evidence I point to the following chart comparing the US$ gold price and GTU’s premium to NAV (a negative premium is a discount). Notice that the bounce in the gold price from last November’s low of around $1140 to January’s high of around $1300 caused GTU’s discount to shrink from 12% to 4%. It’s not hard to imagine that if the gold price had extended its rally to $1350-$1400, GTU’s discount would have been eliminated.

gold_GTUPREM_160615

Also of potential interest is the next chart showing a comparison between the gold price and the GTU/PHYS ratio. This chart shows that GTU has generally performed better than PHYS in strong gold markets and worse than PHYS in weak gold markets. Again, we can’t be sure that the past is an accurate predictor of the future, but there is no evidence at this stage that anything has changed.

gold_GTUPHYS_160615

Returning to the question “What’s a retail GTU unitholder to do?”, I think the right answer depends on the unitholder’s timeframe. Someone planning to hold GTU during the remainder of the gold bear market and well into the next gold bull market should reject the Sprott offer by taking no action, whereas someone planning to exit within the next few months should accept the Sprott offer.

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A rational bet you hope to lose

June 15, 2015

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.

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The Emotion Pendulum

June 14, 2015

(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.

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There’s no such thing as “money velocity”

June 10, 2015

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).

M2_velocity
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.

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