The Case For Gold In The Era Of Financial Virtual Reality

On the holodeck the markets are telling us something…but we know not what.

"John Locke, the British philosopher whose ideas fueled the American Revolution, had a theory of knowledge and perception, which I always found annoying. Asked if we have an idea of the substance behind our perceptions, he said we had 'no such clear idea at all, and therefore signify nothing by the word substance but only an uncertain supposition of we know not what'. The philosophical debate has moved on in the centuries since Locke wrote. But his idea captures well the uneasy state of the world's financial markets. They are driven in the short run by perceptions, not reality. If many have the wrong impression, markets will move on that. But in the long run, markets move on matters of substance. And at present the economic substance is a 'something we know not what.'" - John Authers, Financial Times

"Many Wall Street traders are concerned about being replaced by machines in the future, but at one Goldman Sachs Group Inc. unit it’s already happened. 'Equity trading: 15-20 years ago we had 500 people making markets in stocks. Today we have three,' Goldman Sachs President David Solomon said Monday at the Milken Institute Global Conference in Beverly Hills, California. Solomon said the introduction of more technology into the trading business has made it more efficient for clients, while also introducing new risks. For Goldman Sachs, it has changed the mix of its workforce, as the bank has 9,000 engineers on staff and more employees are focused on regulation." – Sonali Basak and Christopher Palmeri, Bloomberg

Editor's note: So how has gold performed in this financial virtual reality? The short answer is surprising well. The seven charts below provide a picture of its performance over the past few years as computer-based systems have taken on an increasingly important role in the pricing of assets. They also offer an inkling how gold might perform in the future should the holodeck suddenly shut down and substance once again trump perception.

In what has become an often confusing and somewhat frightening investment market governed by silicon-based machines, gold remains the most concrete of assets. It is a real-world island in a sea of algorithms, artificial intelligence, big data and high-frequency trading. If you are like me and do not trust that world instinctively, you will likely find safe harbor in 'old reliable' – gold coins and bullion stored safely nearby. Gold, in the end, remains the most effective hedge against the excesses and unpredictability of the new financial virtual reality . . .and what could go wrong with it.

Holodeck #1: Gold and rising interest rates
Contrary to popular opinion gold is rising, not falling, as interest rates track higher

Too often gold's critics make the claim that gold reacts unfavorably to rising interest rates. That claim is not borne out by the record. To the contrary, since the Fed began raising interest rates in 2016 the price of gold has tracked higher, as the chart below amply illustrates. "While popular opinion is that interest rate hikes have a bearish effect on gold prices," says Investopedia, "the effect that an interest rate increase has on gold, if any, is unknown, since there is actually little solid correlation between interest rates and gold prices. Rising interest rates may even have a bullish effect on gold prices."

Holodeck #2: Gold and rising oil prices
Since 2000, gold and oil have been travelling companions though not in lock-step

Rising oil prices are once again in the headlines and becoming a sensitive matter among consumers. President Trump recently put the blame on OPEC for higher prices thus diverting attention away from his own hardened stance on Iran. A disruption in oil supplies from Iran would have a major impact on prices in Europe and the Far East where much of its oil is exported. The effect on prices, however, will be global. As we move into the summer travel months and the all-important mid-term elections, oil and gasoline prices could become a major issue, thus – some say – the president's tweet on oil.

Though oil production in the Permian Basin has upped global supplies, logistical problems have kept it from filling the supply gap elsewhere left by OPEC cutbacks. Black gold, in short, could become a juggernaut difficult to slow down and is likely to carry the commodity complex and yellow gold in its tow. In at least a generalized sense oil and gold have been traveling companions since 2000, as shown in the chart above, though not in lock-step. Gold has held up better than oil in the down times – oil being the more volatile of the two. We should not forget, too, that oil prices are important in the context of overall inflation. Almost everything produced or manufactured in the United States and elsewhere has an oil component in the pricing equation, including gold.

Holodeck #3: Sentiment is swinging toward gold and away from stocks
Despite constant media attacks, investor sentiment in gold remains strong, but not too strong

In January I made an out-on-the-limb prediction that gold would trade at $1550 sometime in 2018 and the upside would come the result of a shift in market sentiment. In keeping with that prediction, I thought a closer look at gold sentiment at this juncture would be in order. Gold market sentiment switched gears dramatically at the beginning of 2016 and has remained strong to the present despite the price ups and downs of recent months. Sentiment, as shown above, has renewed its upswing after a couple months of weakness.

I asked Sentiment Trader's Jason Goepfert, the developer of this chart, if he agreed with my assessment that gold sentiment signalled strength building in the gold market – something also reflected in a technical analysis of the gold chart (see below). Here is his reply:

"I would agree. Typically when the Optimism Index stays above 50, and rarely goes below 40 during bottoming processes, it's a sign of a solid up trend. Vice-versa for bear markets (stays below 50, with readings above 60 preceding peaks). So the past year or so has been constructive in that regard and I'd rate it as a positive for gold. I'd get nervous if it becomes too optimistic, above 70, or drops below 40 and gold can't rally. So far, no signs of either."

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