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What If the Market Is Just A Quarry of Pet Rocks?


When confidence falls, every investment offers the same analogy.

Last week, Wall Street Journal columnist Jason Zweig stirred things up by comparing gold to the pet rock.

Maybe he didn't go far enough. Every investment offers the same potential outcome.

Now, before you shake your head in disgust, let me explain why.

Mr. Zweig observes:

"Gold is supposed to be a haven amid hard times and soft money. So why, even as Greece has defaulted, the euro has sunk against the dollar, and the Chinese stock market has stumbled, has gold been sitting there like a pet rock?"

In offering explanations for gold's recent lackluster performance, Mr. Zweig goes on to say:

"Because gold, unlike stocks, bonds, real estate and other financial assets, generates no income, valuing it is all but impossible. "It's intrinsically worthless or intrinsically priceless," says Paul Brodsky, a former hedge-fund manager who now is a strategist at Macro Allocation, an investment-research and consulting firm in New York. 'You can build a financial model to value it, but every input is going to be your imagination.'"

Both suggest that an investment without income is impossible to value.

"Every input is going to be your imagination."

As a researcher in confidence-driven decision making, I would frame the challenges that Mr. Zweig and Mr. Brodsky have with gold slightly differently: valuing gold requires extraordinary abstract thinking. We have to construct a story that offers future certainty without any current certainty upon which to base it.

We have to rely on our imaginations.

For gold, as Mr. Zweig points out at the top of his essay, that imaginative story was that the precious metal "would be a haven amid hard times and soft money."

At gold's 2011 peak, not only did the gold bugs believe that to be true, but everyone else did too. The story was a given to investors. The thinking saturated the market.

And as I can personally attest, those who didn't agree were mercilessly mocked:

Mr. Zweig and Mr. Brodsky suggest that the construction of a story that offers future certainty without any current certainty to base it on is unique to gold.

I don't believe that at all.

Every investment has the potential to be a pet rock. What differentiates "stocks, bonds, real estate and other financial assets" from gold is merely the ease at which we can come up with a story that we believe to be true about the investment's future.

Without income, or some other quantitative input that we perceive adds to a greater certainty of value, gold's story is simply harder for us to fabricate.

History is full of examples in which stocks, bonds, real estate and every other financial asset have been valued using nothing but our imaginations. It's a daily occurrence. That's what markets do.

What analyst stock reports and financial television segments do is to add perceived credibility to the story. If others believe it, it must be true, or at least truer. It is not just imagination if supposed experts share the same view, right?

As the bubble showed so well, investors' willingness and ability to undertake abstract thinking goes hand in hand with high confidence. As our confidence rises, it becomes easier for us to think creatively. Even more, we scrutinize things less, as well, especially when others, particularly supposed experts, agree with us. We trust a story without verifying its underlying inputs.  As we saw with hindsight after the bubble burst, our inputs, not to mention those of the experts, were at best imaginative.

But note that in 2000, our vivid imagination applied to not just non-income producing stocks. At the peak, "Dividend Titan" stocks like GE (GE) traded at record valuation multiples. Investors were imagining record profits and growth far out into the future for the world's biggest and most stable corporations. The abstract thinking was extreme.

This happened before, too. The markets undertook similar abstract thinking in the late 1960's/early 1970's when investors poured cash into a small group of the nation's biggest companies because their stories were too compelling to ignore. And for most of the 1970's, these "Nifty Fifty" companies performed like pet rocks.

With gold down 40% from its highs, it is very easy to critique, if not laugh at, the abstract thinking accepted by investors at the top. The same was true for internet stocks in 2003 and home builder shares in 2009. The stories from the peak no longer made any sense.
The banking crisis  showed that even supposedly safe investment (like the ones on the far left of the chart above) can be subject to imaginative stories at extremes in confidence. The stories of extraordinary safety and soundness around AAA mortgage-backed securities and AAA-rated AIG (AIG) evaporated as confidence fell in 2008.

As we saw then, as our level of confidence falls, not only do we scrutinize things more, but we demand more and more irrefutable facts to support our decisions. We jettison our intuition and imagination and insist on quantifiable data. We replace our blind enthusiasm for the future with intense doubt in the present.

When there is panic investors move to the investments options at the far left of the chart above. Cash offers the "me/here/now simplicity" that we crave when confidence is at an extreme low. People stuff their mattresses at the bottom - not at the top.

Money flows to where confidence is highest, no matter whether that is into stocks, bonds, real estate, commodities, or cash in a mattress. Our investment choices prices reflect how we feel.

But it is important to appreciate that the better we feel, the more abstract thinking takes hold of our investment stories. At the top, whether you realize it or not, "Every input is going to be your imagination."

Needless to say, as Mr. Zweig points out, gold's story today is far less imaginative. The precious metal is a pet rock.
As a researcher, I like the metaphor.  It's very "me/here/now/simple."

Even more, I like the timing of Mr. Zweig's latest essay. It comes after a 40% drop in price. Once again the media follows mood -- even the extraordinary Mr. Zweig.

So are we at THE bottom for gold?

Personally, I would like to see more stories about gold as a utility good. That kind of thinking would help to show that investors' imagination has gone full circle -- From delusional about gold's extreme high value to delusional about gold's extreme low value.

That "pet rock" is readily accepted by investors as the story today for gold.

That suggests we are getting close.

Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.
"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the 'me, here, and now' behavioral tendencies of the post-crash world."  -Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation

Twitter: @Peter_Atwater
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Position in SH; Creditor of JP Morgan
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