Tuesday, July 21, 2015

Which Is A Bigger "Act Of Faith" - Owning Gold Or Stocks?........A MUST READ!

Which Is A Bigger "Act Of Faith" - Owning Gold Or Stocks?

The WSJ has released yet another gold hit piece calling it a "pet rock' and gold bugs "subjects of a laboratory experiment on the psychology of cognitive dissonance" just one day after the PBOC reveals it has added the biggest amount of gold in history in order to "ensure security." 

But the biggest irony is that none other than Citigroup made a far bolder case that it is not the ownership of gold but of stocks that is the ultimate act of faith: "investors remain united in their faith in the central banks – if not for their ability to create growth, then at least in their ability to push up asset prices. And yet the limits of that faith are increasingly on display." 

So who is right?

What is ironic, of course, is that it is the WSJ whose job is to rationalize how reality is wrong, because day after day we get reports how the economy is strong and getting better (except when it snows, of course, or when GDP needs double seasonal adjustments when it is below expected), and in the meantime one thing never mentioned is that the only thing keeping the system erect is that in 2015 the world will see the biggest intervention yet by central banks in the world's history, surpassing even the peak of the financial crisis!

Which is also why equity values are where they are: central banks have made sure there is nothing besides stocks that is left to buy - not our words, those of both evil gold bugs Morgan Stanley and Citigroup. So naturally, to "reporters" all one needs to evaluate the state of the economy is the manipulated level of the S&P 500 (ignore the $22 trillion in central bank liquidity injections that pushed it to that level) and the rest falls into place. For those who question that approach, they are promptly labeled gold bugs, and "you don't want to be one of these people."

There is also little point in pointing out to a WSJ "economics" reporter that by onboarding $22 trillion in risk, the "bad bank" hedge funds formerly known as central banks have explicitly made the quantification of counterparty risk impossible, which is precisely why to those not blinded by ideology, and whose view of the world is contingent on not spooking advertisers such as Wall Street's biggest banks, explaining anything is a moot point.

There is a story about a turkey that is fed quiet well for a 1,000 days in a row. The feedings reinforce the turkey's sense of security and well-being, until one day before Thanksgiving an unexpected and uninvited event occurs. All of the turkey's experience and feedback is positive until reality takes a turn for the worse. Recent comments by a senior executive at one of the world's largest banks evoke the turkey story: "Our losses from instruments based on U.S. subprime mortgages,greatly exceeded the profits we made in this field over several years."

Many complex systems, including markets, have critical points where small incremental condition changes lead to large-scale effects. Researchers in both the physical and social sciences have known about these critical points for a long time; so much so that terms like phase transition and tipping point have slipped into our day-to-day language. Still, critical points throw a monkey wrench into our mostly linear cause-and-effect thinking.

Critical points help explain our perpetual surprise at fat-tail events: We don't see them coming because the state change is much greater than the perturbation suggests. Water does not undergo a dramatic change as it drops from 35 to 33 degrees Fahrenheit, but two degrees of additional cooling changes its state from liquid to solid. Likewise, large changes can occur in markets without visible manifestation in asset price change, while small additional changes can flip the price switch.

Critical points are also important for proper counterfactual thinking. For every critical point we do see, how many were lurking but never triggered? Like water temperature dropping to 33 degrees and again rising, there are likely many near 
misses in the markets that elude our detection.

Here is the problem:

Rising asset prices provide investors with confirming evidence that their strategy is good and everything is fine. This induction problem lulls investors into a false sense of confidence, and sets the stage for the shock when events turn down. That nonlinearity then causes a sudden change that not only adds to the confusion but fuels it as the crisis plays out.


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