Saturday, August 18, 2007

Gold's Value is a Derivative of Human Psychological Functioning

18 August 2007

Why is the price of gold so volatile - and gold mining shares even moreso?

The obvious answer has just now occurred to me, which is that the price of gold is a derivative value based on underlying fundamental factors driven primarily by human psychology.

John Doody, the
Gold Stock Analyst, recently commented on the derivative status of gold mining shares, as follows:

"A derivative is a financial asset that takes, or derives, its value from the value of another asset. Unlike most stocks, that solely derive their value from the underlying company and its operations, gold and silver miner shares get their value from: 1) the underlying mines and properties they own, and 2) the inherent option on price of the metal… higher prices mean higher current profits and a greater value for the unmined ounces in the ground.”

Therefore, if the price of gold itself is a derivative product, you have a recipe for a very volatile market in gold mining company shares as derivatives of a derivative.

In fact, in my early learning, the term “derivative” referred to a value in calculus, as follows: “The result of mathematical differentiation; the instantaneous change of one quantity relative to another.”

In the real world of calculus, derivatives tend to be multiplying factors, and exponential or sinusoidal behaviour is not uncommon in mathematical derivatives.

For example, in calculus, acceleration is a derivative of speed or velocity. So the instantaneous rate of change in velocity is acceleration, and acceleration creates dramatic physical phenomena and psychological responses, unlike velocity, to which we rapidly become psychologically habituated.

In physics, gravity is not measured in terms of velocity, but in terms of acceleration. Thus gravity is mathematically a derivative function. This explains why things fall faster and faster towards the earth the longer they fall, and thus, the greater the height from which they fall.

To make my point briefly, then, the behaviour of gold mining shares is more akin to the behaviour of a race car driver, accelerating into straightaways and braking at curves, or, if you will, to Newton’s mythical apple, which gains speed as it accelerates in its fall towards the earth. As you know, the apple reaches zero acceleration and velocity when it comes into contact with the earth (at which point the analogy is perhaps more descriptive of the behaviour of the market value of subprime mortgage lending companies than of gold mining shares in the present environment).

To take a step back however, let us ask, “In what sense is the price of gold a derivative of human psychological functioning?”

I wish to answer this question briefly, though I am sure a very involved study could be made of this topic.

In short, the price of gold depends primarily upon people’s general perceptions as to the stability and trustworthiness of their currency.

When people are confident in their currency – and this can occur even when inflation proceeds at a constant pace, akin to a constant rate of velocity if you will – there is generally little anxiety as to the fundamental soundness of the currency.

However, when the value of the currency adjusts rapidly, the experience is more akin to acceleration (or deceleration), and this is much more noticeable, as there is a perceptible change in the rate of inflation of the currency (this could occur in the case of either inflation or deflation of the currency).

The human brain is designed to ignore factors which are constant, whether due to the absence of change, or to a constant rate of change, but to attend to – and perhaps even be startled, disturbed or traumatized by – dramatic changes in a factor which has heretofore been stable or constant.

Thus, when people begin to notice that the value of their currency is eroding more rapidly than previously, and in recent history, that has most often been due to inflation, or loss of value of the currency, this provokes a psychological response, specifically, in most cases, feelings of insecurity. (Associated with this is an increased need to compete with others to attain protection from the ravages of inflation, for example, in annual pay-increase agreements, etc., and this factor adds further to sensations of insecurity.)

When ongoing events tend to maintain the perception of instability in the value of the currency, insecurity can grow to fear or panic – and it is in such psychological environments that the price of gold begins to adjust, and this itself appears to be a derivative function.

That is, as concern about the security of the currency grows, the human tendency is to assign an “accelerating” value to gold as an alternative or ultimate currency. In contrariwise manner, when feelings of fear and/or panic subside, there is a tendency for the price of gold to decelerate, and move again to lower levels.

Thus, changes in the price of gold tend to amplify the underlying human psychological factors related to confidence in the stability and value of their nation’s currency. When confidence begins to unwind, the price of gold begins to accelerate upwards. When confidence is not quickly restored, a longer-term rising trend in the price of gold ensues, as it did for the first time in 21 years in February 2001. That rising trend remains in effect today, and is likely to persist for years or decades to come.

When complacency returns (and all human emotions tend to ebb and flow), as it did between 2003-2007, the rate of change in the price of gold may abate or temporarily turn negative, and this was seen in May 2006, when the price of gold reached a peak, and then turned dramatically down – though this downward shift was not initiated until there had been two years of market stability.

Since early in 2007, there have been rising indications of market and currency instability, and these have been reflected in the renewed decline of the US dollar and in adjustments in liquidity due to rising defaults on US-originated mortgages, 20% of which are now in the extremely unstable subprime arena (twice their typical historical level). More recently, contamination from the subprime sector (and from exhaustion of the US real estate bubble) has begun spreading to a wider class of financial assets, and confidence in the stability of the economy and the currency is again eroding.

Mr. Bernanke's landmark August 17, 2007 decision to lower the bank credit rate in the face of rising inflation sends far-reaching signals about risks to economic growth and a willingness to sacrifice the value of the US dollar in order to attempt to preserve burgeoning economic activity within and beyond the borders of the United States.

In such circumstances, the atmosphere becomes more favourable for increases in the price of gold – and if the price of gold is a derivative, this will tend to be an accelerating function. Further, rising gold prices tend to drive the market value of gold mining and exploration companies higher, and if these too are derivative products, then there is the potential that the market value of these securities will further amplify the accelerating value of gold itself.

Thus, you have a recipe for a market with dramatic variance (defined mathematically as “the second moment around the mean; the expected value of the square of the deviations of a random variable from its mean value”).

To put the above discussion in layman’s terms – when conditions become favourable for acceleration in the price of gold, there are indicators that an even more potent acceleration in the market value of gold mining and exploration companies is at hand (though this may vary dramatically from company to company, depending upon perceived fundamental factors in each company’s sources of longer-term value).

And because gold mining and exploration shares are thus derivatives of a derivative (the mathematical term is “second derivative”), then the potential for dramatic movements in the market value of gold shares is very likely at hand.

Now – aren't you glad you did your mathematics homework, so that you understood all of this?

I will caution that much of my discussion has been general or even analogical. I cannot provide a specific set of mathematical equations to back up my work.

However, at its root, I think that derivative and second derivative functions are in fact what we are probably dealing with in the market for gold and for gold mining and exploration companies.

In experiential terms, the behaviour of second derivatives feels like a roller coaster ride. If this is true, then gold mining and exploration shares will continue to be volatile, subject to variance (which is itself a second derivative).

So, if you are an investor in this volatile but fundamentally growing and strengthening sector – buckle up, and be prepared for the ride of your life! My guess is that the price of the ticket will be worth it, so long as you have a cast-iron stomach!

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