The Duality of Gold

Wave-particle duality of light 

Today, quantum mechanics teaches that all quantum objects exhibit the behavior of both waves and particles. However, this duality was first noted in the attempt to understand the properties of light. The dispute over whether light’s movement could best be described by the vibrations of a wave or the action of particles dates back to the fourth century BC.

The Greek philosopher Aristotle was one of the first to publicly theorize on the nature of light, proposing that light was a disturbance in the air, like a wave. On the other hand, his contemporary Democritus argued that everything, including light, was composed of indivisible “atoms”.

Fast forward to the mid-1600s, and the scientific revolution brought new thinking to bear, although the disagreement over the fundamental nature of light continued. The great polymaths René Descartes and Sir Isaac Newton continued the debate, with Descartes showing the behavior of light could be modeled effectively with waves in a medium, while Newton demonstrated the particle nature of light through work on straight-line movement and refraction.

By the 19th century, it appeared a winner was ready to be crowned. Scottish physicist James Clerk Maxwell described a formula which successfully modeled the oscillation of electromagnetic fields. His work showed that visible light, ultraviolet light and infrared light – all previously thought to be unrelated phenomenon – were all merely electromagnetic waves of differing frequencies. The math was clear; light was a wave.

But the tables turned once again as the dawn of the 20th century witnessed the ascendance of atomic theory. Dmitri Mendeleev successfully predicted the existence of previously undiscovered elements using only the inexorable logic of his periodic table. And in experiments using partially evacuated glass tubes, for the first time electricity was shown to consist of sub-atomic particles, namely electrons. Further experiments by Max Planck and Albert Einstein conclusively demonstrated the existence of “light quanta” which ultimately came to be called photons. The science was conclusive; light was also a particle.

Today, quantum field theory actually holds that what science previously described as either “particles” or “waves” are actually excitations of quantum fields, and without getting too deep – too late, I know! – those excitations display complex behavior that is both particle-like and wave-like simultaneously. But for a long time, light was believed to singularly exhibit this wave-particle duality.

This paradox has always fascinated me, in part perhaps because I found that the competing paradigms never caused me any cognitive dissonance. Both are simultaneously true, but each model is more useful individually describing behavior under specific circumstances.

Which brings me to gold.

I’ve invested in both physical and financial gold in my personal accounts*, and overseen institutional allocations with gold exposure via commodity funds and real asset funds. And along the way, I’ve noticed a duality in how gold behaves. First, let’s discuss the particle nature of gold. 

Gold as a commodity 

The reality of gold as a commodity is pretty well accepted. In fact, gold is almost always considered a commodity by the financial community. Not, surprisingly it’s included in many commodity indices such as the energy-heavy S&P GSCI Index at the low end, where it accounts for 3.7% of the index, or the more diversified Bloomberg Commodity Index, where it has a 13.9% weighting.

Gold has many of the characteristics shared by other commodities. Unlike idiosyncratic assets such as diamonds or art, gold is fungible. This just means by using standardized quality measurements, an ounce of 24-karat gold in one place is identical to an ounce of pure gold anywhere else.

It has transparent annual supply and demand figures. For the last five years or so, the world has produced somewhere between 3,000 to 3,500 metric tons of gold annually. Industrial consumption, basically for use in making jewelry and certain electronics, has averaged 2,500 to 3,000 tonnes a year. Investment demand, from private sector investors and central banks, typically totals 1,500 to 2,000 metric tons per annum, and since gold is easy to store, much of this secondary trading comes from existing stockpiles. In the case of gold, this global stockpile is around 170,000 tonnes, which is quite large relative to annual demand.

Further, gold also has a strong correlation to inflation. It is linked to broader economic activity and experiences price cyclicality in part as a result, just not to the same degree as other commodities with broader industrial applications. The beta of spot gold prices to monthly CPI changes is around 0.9, less than other commodities which average about 3.0, but comparable to REITS which have a beta of approximately 1.0.

And like most commodities, gold has very little correlation to the stock market. Sometimes, the correlation increases in certain market environments, and in other periods it becomes highly inversely correlated, but on average, it’s just about zero making it valuable to a portfolio as an equity risk diversifier. 

One difference compared to other truly industrial commodities like nickel, aluminum or oil is that gold has a very high value density relative to its storage cost. Consider storing a million dollars’ worth of gold. That’s only two standard bars of gold, which is about 50 pounds, and it could easily fit into a small, but necessarily sturdy, briefcase. If you have ever worked out with 25 pound dumbbells, you’ve lifted the exact same weight. 

On the other hand, $1 million worth of oil is an enormous quantity. West Texas intermediate (WTI) oil is trading at about $60.88 a barrel today, so $1 million equals about 16,425 barrels. With 42 gallons to a barrel, this means you would need to store 690,000 gallons of oil in order to warehouse a million dollars. That’s nearly 50% more volume than the entire Houston aquarium. That’s a lot of oil.

Partly because it is so economical to store, gold also tends to trade differently on the futures market than many other commodities. Other commodities that are more explicitly connected to the production cycle may trade at a premium in the futures market because they are expensive to store, a scenario known as contango. Or if supply is limited and they are in demand for immediate consumption, the futures can trade at a discount, which is called backwardation.

Consider aluminum, which trades around 22 cents per pound today. To store a million dollars of aluminum, you’d need 4.5 million pounds of it! And that storage cost is priced into the futures curve, where one-year futures trade about 4.6% higher than the spot market. On the other hand oil, which in its refined form is consumed on a daily basis by millions of rush hour commuters around the world, can be 7.0% cheaper with the December 2020 futures contract. Unfortunately, that won’t help you get to work tomorrow.

The gold futures curve is like neither of those; it’s very flat. In fact, the one-year future for gold on the Chicago Mercantile Exchange trades a mere 1.5% above the spot rate. That’s less than we’d expect just for a financing cost proxied by one-year Treasury rates of 1.6% today. In fact, that looks more like a currency transaction. 

And in a world of negative rates, where people pay borrowers for the use of their capital, money has a cost of storage. Banks charge you to deposit it, not unlike gold. Which leads to the wave nature of gold, or how it also has some of the aspects of currency. 

Gold as a currency

Currency is generally defined as a system of money in circulation as a medium of exchange, typically one issued by a central government or bank. Gold is certainly no longer widely used as a medium of exchange for commercial or personal transactions. No one slams down a gold coin for a night at the inn anymore. However, it was not too long ago that there were gold coins in widespread circulation in all major economies, and even in the US the gold standard was not fully abandoned until 1971.

Over a longer term view, gold has the distinction of being the most widely used medium of exchange in all of human history, and frankly, nothing else even comes close. Its history dates all the way back to 600 BC, when King Alyattes of Lydia and his son Croesus (who later came to be known as the wealthiest man of antiquity, hence the idiom “richer than Croesus”) became the first monarchs to mint gold coins, known as Trites. For nearly 2,500 years since, governments have issued gold backed or gold denominated currency; the last forty years have been the exception rather than the rule.

To be clear, I’m not calling for a return to the gold standard, but the history of gold as a valuable asset goes back much further than even central government issued money. Egyptian hieroglyphs from as early as 2600 BC describe gold as the metal of the gods, and it was used extensively to decorate monuments to both their deities and pharaohs. Even older golden objects such as the Golden Hats and the Nebra disk discovered in Germany dating back to the 2nd millennium BC show that gold already had developed powerful religious and royal connotations to early Europeans. And still 2,000 years prior to this, pre-dating even the Bronze Age, we find the earliest recognized gold artifacts ever discovered at a burial site in Bulgaria known as the Varna Necropolis. The 3,000 objects found here include various beads, necklaces, and rings, and demonstrate sophisticated religious beliefs about the afterlife and hierarchical status differences that challenged previous knowledge. 

Yuval Noah Harari, the author of Sapiens: A Brief History of Humankind, believes that the singular most unifying trait of humans is our ability to create and share fiction. Religion is a perfect example, whereby people share a belief system about reality based on little else than our collective agreement. Harari argues money is another example of a shared collective fiction. Dollar bills have absolutely no intrinsic value except in our collective imagination, but everybody believes in the dollar bill. Economists argue this fiction is due to the “full faith and credit” of the U.S. government support for it, but the willingness of counterparties to a transaction to support the fiction behind it is what truly provides that credibility. Once the credibility is lost – once most no longer believe the fiction – currency loses its value. This is when hyperinflation sets in, like recent examples in Venezuela or Zimbabwe. The shared fiction of any one country’s individual currency is far more likely to collapse sooner than the global belief in gold.

Gold has held unique importance for virtually every civilization that has ever encountered it, for at least four thousand years. It has been used as a formal currency for two-and-a-half thousand years, the last half century notwithstanding. Any market is nothing more than the shared fiction of its participants, and regardless if a few brilliant investors no longer believe in the “barbarous relic,” the vast majority of the inhabitants of planet earth still do and that’s unlikely to change anytime soon. It’s a global quasi-reserve currency because of the time-tested strength of this shared fiction.

Despite this, gold cannot be used as the medium of exchange in typical commercial transactions, unlike other currencies. But consider the following thought exercise. Imagine taking a few ounces of gold bullion, a two-year-old smartphone, a television, a bundle of copper wire and a canister of gasoline to a pawn shop.

If anyone has ever tried to procure the services of a pawn broker, you’ll know they are a market-maker masquerading as a secured lender. They issue term loans against collateral fully realizing the borrower often does not return, and the item must be then sold at a profit. The effective interest rate on the loan, or discount to their expected sale price, represents basically how liquid the underlying collateral is. The wider the spread, the riskier the asset.

In our above scenario, the haircut on gold will almost assuredly be lower than just about any other asset precisely because that pawn broker knows it can be sold quickly and easily. Gold is fungible, valuable and highly liquid. 

And because of this, gold also has another characteristic often associated with money; it is a reliable store of value. Indeed, of the estimated 170,000 tonnes of global supply of gold, about 34,000 tonnes of this – or 20% – is currently owned by central banks around the world. In fact, central banks, usually managed by highly trained economists, have been among the biggest buyers of gold over the past several years precisely because they believe in this facet of the metal.

But, like a physicist, let’s see if there’s any empirical research to support this theoretical duality. 

Currency-commodity duality of gold 

Empirically, we’ve already seen that gold has an oscillating relationship with equities. On average, the correlation between gold and the S&P 500 is right around zero, but in some market conditions, it is modestly negatively correlated, and in other environments it’s slightly positive. So, it clearly has regime shifting characteristics, but that’s not terribly different than other commodities.

However, where we do find unique conditional correlation is in gold’s relationship with inflation. As we mentioned earlier, the beta of gold to inflation, like other commodities, is fairly high. However, beta, a linear regression, doesn’t capture regime shifting dynamics, which are by definition non-linear. A polynomial regression does.  

Looking at monthly price changes in the Bloomberg Commodity Index versus the CPI, we can observe that a diversified basket of commodities captures more of inflation on the downside than it does on the upside. The function is modestly concave, or negatively convex, where the slope flattens going to the right but drops more precipitously to the left. Theoretically, it makes sense that commodities will increase in price as inflation rises modestly, since they are a major input into the production function. However, at ever increasing rates, this relationship breaks down, possibly because too-high inflation causes demand destruction and producers can’t continue to pass price increases on to their consumers. In a deflationary environment, collapsing commodity prices tend to lead CPI declines, as demand for inputs drops abruptly while businesses work through existing inventories. 

Gold, however, looks decidedly different. Unlike diversified commodities, gold is the only asset that I’ve encountered with a strong convex relationship to CPI. (And this regression has a higher adjusted R-squared than the linear equation, not just a higher R-squared). Gold increases in price when inflation goes up, rising even more sharply in hyper-inflationary environments, but it can also increase in price when inflation falls. In technical terms, gold exhibits positive convexity with regard to CPI. While most commodities have a higher down-side correlation to inflation, dropping precipitously in deflationary environments, it is precisely in such conditions that gold outperforms, behaving more like a store of value, or a reserve currency, than an industrial linked commodity. 

Of course, unlike physical science, there’s no guarantee that this relationship will hold in the future. It’s not an immutable mathematical equation. Although it’s impossible to predict ahead of time exactly how gold will respond in any given environment, it can be shown to alternately exhibit both inflation and deflation hedging characteristics at various points. And at times gold can be either a risk-on or a risk-off trade, having positive or negative correlations with US equities depending upon macroeconomic conditions.

In an environment where the Fed is once again turning accommodative in the face of continued mixed economic signals despite an already substantial debt overhang and fiscal deficit, with rising nationalism politically and protectionism economically around the world creating significant instability and uncertainty that doesn’t appear to be fully priced into many (any?) risk assets, with global central bank demand continuing to grow as they purchased a record 225 tonnes in Q2 2019 alone to add their reserves, and a multi-year dollar rally that is finally showing some signs of weakening, it doesn’t seem so irrational to add some optionality to your portfolio from the convexity which gold offers. 

And strong momentum from a 15% rally year-to-date doesn’t hurt either; trend is often a powerful signal in both currency and commodity markets. But even if the three-month, or the three-year, behavior of gold doesn’t meet expectations, the long term performance of the asset has been relatively consistent. Over the last century the Dow Jones has appreciated at about 5.4% per annum; gold has made 4.6% with nearly identical volatility.

Perhaps ultimately gold is a financial singularity where no one model perfectly describes its behavior, existing as both a currency and a commodity simultaneously. And for those investors with a thirty-year outlook, those who don’t see an imminent catalyst to end the shared collective fiction, a small allocation to the convexity provided by this duality is likely to be rewarded.

* I currently own physical gold and financial gold in my personal accounts.