The Not-So-Efficient Market

There is a theory in stock circles called the “Efficient Market Hypothesis.” It was first proposed by a student of famed mathematician Benoit Mandlebroit (who proposed Chaos Theory) named Eugene Fama. The theory is easy to understand; markets such as the stock market have so many players that it reacts instantaneously to process all known information about a given security. A corollary of this theory is that because all information about the market has already been “priced in”, that it’s impossible to beat the market because any actionable information about a given security is already reflected in its price. This theory was popularized in books such as A Random Walk Down Wall Street. It has been attacked in a number of books including Benoit Madlebroit’s The Misbehavior of Markets as well as my book, What Do You Mean My Money’s Worthless.

I’ve found that some of my biggest investing mistakes are caused by giving any credence to the notion that the market has priced in any information at all. Case in point, for much of this year I was an investor in the Prudent Bear Fund (ticker=BEARX) which is a mutual fund that is short the market, yet, despite many of my predictions of doom and gloom coming true, the stock market continued to hold its value in the face of more and more bad news. Then came October. Paulson and Bush announced that they were going to do a massive bailout of all troubled assets on bank balance sheets after allowing Lehman Brother to fail, and the stock market rallied strongly. 

At that point I lost faith that the stock market was going to decline. It seemed that the Federal Reserve and the US Treasury were simply going to inflate the problem away, and the market was responding in just such a direction. So the logical move to me seemed to be to invest in gold in order to protect from inflation and away from shorting. I figured that, with all the bad news that has come out, if the stock market was going to crash it would have already done so. I closed my short positions just before one of the most violent stock market collapses ever based on the belief that knowledge of the credit freeze and oncoming recession were already “priced into” the market. I’m still up on the year (which few people can say) but I missed out on a great opportunity to profit due to my putting ANY credence in the notion that the market was efficient. 

Now I’m realizing that the key to investing is not to predict the tomorrow’s headlines, but rather to figure out which of yesterday’s headlines will the have staying power to shape market movements in the future. That’s what I’m trying to do today. Call it the “Slow Market Hypothesis”- which significant piece of news will the market take the longest to get through its thick head? A question that is very much on my mind today. 

The headline that’s dominated the last couple of months has been that “Deflation is Coming. Run to Cash!” Call me crazy, but I think that headline’s played out now. The headline of today was that “Dollar slides as Obama vows stimulus.” Gold moved strongly up and Barrick Gold, my personal investment vehicle of choice, closed the day up 8.39%. I think that the headlines going forward are going to become more focused on inflation rather than deflation as markets react to the new ending stream of new dollars being cranked out by the Treasury and the Federal Reserve. Just today, it seems that Congress and Bush are dipping into the bailout goody bag for $15 Billion to loan the auto industry. The hard figures on M2 straight from the Federal Reserve says that our money supply has expanded by 7% over the course of year, which is not nearly as alarming as the “Adjusted Monetary Basis” (a measure which accounts for changes in the reserve requirements as well as changes in foreign exchange market intervention) which the St. Louis Federal Reserve Bank publishes. Here, take a look at it yourself:

That’s a rather astounding rise in the monetary base (1400% annualized), and it’s only going to get worse. The next stimulus package that’s being proposed by Barack Obama is roughly $1 trillion

The rise in the value of the dollar was caused because liquidation was forcing people to sell their assets in order to meet margin calls that were written in terms of US dollars, but that’s going to be a short lived phenomenon. As the full impact of these monetary shenanigans start to sink in, the market will seek a safe haven that isn’t being grossly tampered with, and that’s going to lead them back to gold. That’s my prediction anyway, we’ll see how it turns out.

Why Gold?

Nat posted this question:

Really, as an investment right now, any commodity is a good buy. I would say gold, guns and bullets are pretty valuable. So your second question is really the one i am asking about. Why should we peg the dollar to gold and not some other natural resource? Gold has no true value. Its pretty, is used in some manufacturing, has a history, but other than that, useless.

I would again recommend that anyone who has this question read Murray Rothbard’s essay Case for the 100% Gold Dollar. It succinctly answers this very question. So as to not just rehash what Rothbard argues, I’d like to make this a hypothetical exercise. 

Pretend for a moment that the government had no power to issue money or to declare legal tender. A lot of people have a hard time with this because they feel that money inherently comes from the government, but they are wrong. As I say in my book, money is a self-organizing principle of a community. So at the beginning we would see various communities using different commodities as money. Perhaps the East Coast would settle on using gold as their money, but let’s say Nevada preferred Silver, except for this one town in Nevada which has decided to use cigarettes. 

So we had those three commodities being used as money in three different places. That may seem crazy, but it’s not in any way different that the situation we have today with different countries standardizing on different fiat monies with no backing whatsoever. When I go to Canada in a couple of weeks I an going to exchange some of my American Dollars for some Canadian Dollars; returning to our hypothetical example, if you were visiting the East Coast, you would exchange your silver currency for gold. In this way, the free market would determine both the exchange rates of all of the commodities used as money. In addition, each person in a given community would be allowed to chose what form they wanted to store their wealth in. 

So you can think of this hypothetical exercise as a grand social experiment regarding money. As the communities began to trade more and more with each other, there would be a tendency to standardize on one particular money so that trade could be normalized across more communities. Whatever this grand money would have to be would have to meet certain criteria:

1. People would need to value it. 
2. It would need to be scare. (So oxygen is out until the air is so polluted we can’t breathe it anymore).
3. It would need to be easily transported.
4. It would need to be rendered into standardized units.  
5. It would need to be a store of value across time. So it would need to not be easily perishable. 

Ok, let’s come back from the hypothetical experiment for now. In this thought experiment we learned that money is a self-organizing principle and that as communities traded with each other there would be a tendency towards adopting the same money as your trading partners.

Now here’s the kicker. This experiment has been run already- more than once. Precious metals always seem to become the desired money upon which communities settle. I can’t tell you why it is that humans value precious metals, but we do. So the reason I’m saying we should return to gold now is because it the money that societies have always gravitated towards for at least the last 4000 years or so.

Now I’m not saying that gold will be the money of the human race for the next 4000 years.  Perhaps in the future we will develop a Star Trek fabricator that, in addition to piping hot Earl Gray tea, will render as much gold as you could possibly ask for. The commodity of choice in the Star Trek Universe might be Dilithium crystals or antimatter, because that’s what makes society go. But that world won’t evolve over night, and if and when it does evolve, gold will be tradable as a commodity for these dilithium crystals right up until we technology got to the point where we had complete control over all matter. 

In the meantime, if you are still not convinced that gold should serve as our money, and Article I, Section 10 of the US Constitution which reads that “No state shall… emit bills of credit; make anything but gold and silver coin a tender in payment of debts” still hasn’t convinced you, then know that I as a free market person respect your right to call for any form of money you wish. We can it is conceivable that we could always start the experiment over and allow all communities to start trading in their own money, but I’d be prepared to put a heavy wager on precious metals coming out on top. 

In terms of the world we live in today, you are correct in saying that any natural resource can conceivably be used as a money to back a currency, but bankers are still partial to things they can put in their vault. Even in today’s world, where every effort has been made to demonetize gold, every central banker in the world will still show and accept it to be shown on a balance sheet as asset. That’s saying something. So if gold is still used as a money amongst central bankers today, despite all of the efforts to the world’s governments to deny it’s use as money, then that’s really saying something.

The one final thing I want to point to is that virtually all commodities in the world are lower today than they were a year ago, except gold. It is the commodity that people have fled to as they have lost faith in the system. So much so that many bullion dealers haven’t been able to keep gold coins in stock. What do you think the odds are that people are going to suddenly stop valuing it?

So, my question to you is, “Why not gold?”