I am a great believer in divergence when it comes to the talking about the economy and her markets because it allows you to take a slightly more nuanced perspective than the risk off/risk on debate that has dominated the discourse for the past two years now.

The Global Economy

Still, there is much to suggest that when it comes to global economic discourse whatever your take on things is it follows an easily identifiable framework (click for better viewing).

It is my bet that whatever your position is on global growth, markets, the future of the Eurozone, the prospects of a bubble in China, inflation in India, the price of base commodities (etc etc) you will find yourself comfortably positioned somewhere in the matrix above. In fact, it is hard to form an opinion today on the global economy and its sub-components without taking a decisive stands along the spectrums above. Naturally though, there is more than meets the eye.

Note in particular that I take “excessively” loose monetary policy as given since here we find another case of divergence. Essentially, the debate is currently raging between those who advocate fiscal austerity as a precondition to securing future growth and those see it as a repetition of the same mistakes that were made in in 1937 as policy makers in the US assumed that the recovery was already a reality. Yet, when it comes to monetary policy it is taken as given that rates will stay near zero in the G3 for at least the next 8-12 months. Again, we have divergence here; divergence between policy positions and debates, but also divergence between global monetary policy regimes since you can just ask Reserve Bank of India Governor Duvvuri Subbarao what he thinks of loose monetary policy as he recently headed a 0.5% upward move in the base rate which widens the spread to the G3 even further.

Divergence here of course plays to the disadvantage of both monsieurs Trichet/Bernanke and Subbarao since the money created by the former won’t stay to help their ailing economies but, in stead, race off to India (and elsewhere) fuelling an already raging inflation bonfire. Recently, the IMF downgraded its forecast for global growth (relative to pre-crisis levels) and thus in some sense lowered the bar for the natural speed limit of the global economy. It would however be too pessimistic to interpret this as secularly bad news since divergence will be the key word going forward on the macro level. Especially, the divergence between those economies with sufficient domestic demand capacity to reach “escape velocity” and those whose domestic economic momentum is essentially deflationary is a key theme.

To Pick or not to Pick

Another case of divergence which I recently picked up on is the growing discomfort among value investors that the gains from stock picking is being traded away. This is a long running theme on FT Alphaville and this week it is running two stories which push this point of view. The first is the coverage by Izabella of this piece in which Toronto-based money manager Friedberg Mercantile describes the pain of seeing its long time old and faithful market neutral strategy collapsing due to the correlation of everything. Of course this is not a cry-baby defence piece and it tracks its issues to a lack of dispersion between stocks due, in part, to the rise of exchange traded funds (ETFs) designed to mimic an index or specific asset class.

But this is not all and Ms Kaminska continues her coverage on this by pointing to a piece from Barclays Capital equity research people which lays out the same story. I especially like the point that while equity correlation remains a function of volatility the increasing run to index traded products increases the base level of correlation.

To summarize, in our opinion, while equity correlation continues to be highly dependent on volatility, the rise in indexation has led to a permanent increase in its “base” level.  Thus while we do believe that the current high levels of realized and implied correlations are unsustainable, the eventual drop is not likely to be as high as some market participants might expect.

I think this is a very interesting point.

I do also find it almost ironic since one could arguably point to the fact that an increasing focus on buying the market (or a specific asset exposure/class) would mean that value investors got better prospects of carving out niches for them to excel in.

As for the divergence in all of this, you should by no means think that the value investor narrative is dead and buried. Today, Greg Donaldson (the director of Portfolio Strategy of Donaldson Capital Management) has penned a story over at Seeking Alpha in which he specifically suggests that retail investors go for single stocks and not “the economy”.

What retail investors may be missing is that they are not investing in the economy. They are investing in companies. And, some – even many – companies can do quite well even during weak economies.

This point was recently given a run in the always excellent research from BCA (no link available) where they made a classic analysis of the SP500 sectors adjusting weightings based on valuation metrics and thus that positive returns were to be found in a market which traded sideways or even corrected downwards. Of course, they did talk about sectors but still the message was very much one of divergence based on fundamentals despite overall head winds to the economy. Similarly and despite the almost non-event of the recent Eurozone stress test one theme which emerged was indeed that investors could now discriminate between banks based on on their disclosure of sovereign debt holdings. Intuitively, this makes sense too I think, but if everything is correlated should you willingly allocate funds to such a strategy?

Where do you belong?

As ever, picking the right strategy or formulating your own and informed opinion on global economic and financial matters is just as much a question of where you don’t fit in as where you fit in. Be it a question of the main fault lines of the global economy, the right between loose/tight monetary and fiscal policy or the right investment strategy divergence is the name of the game and choosing the right side of the fence is not only important for your own intellectual satisfaction, but also may be important for your portfolio.

I think an accurate definition of “paper” and “physical” is important to the accuracy of your statement: “I am reasonably confident that paper and physical are bound together.”

“Physical” to me means real physical gold that has been delivered in settlement. Anything else I deem “paper”. Note that my definition of physical includes Allocated or GoldMoney for example, as they purchase real physical gold and store it, ie it comes off the market and is unable to be lent/fractionalised.

“Physical” does not include the near month futures contract. There is a place for buying 3 month and selling 6 month in which case you are arbitraging paper “gaps”, but what we are interested in is the effect on the real physical cash price.

But what if you could play the arbitrage (closing the gap) game without actually putting any physical at risk of delivery? Would this change the accuracy and credibility of the basis signal?

I assume you are talking here about using unallocated. OK so lets scenario it. Assume a stable supply/demand for both cash and futures so without the actions of an arbitrageur the cash price would remain at $1200 and Dec futures at $1195 for a period of 6 months. Hedge fund notices this and wishes to profit from it but it does not want to (or have) physical gold it wants to risk.

Hedge fund contacts their friendly bullion banker and asks to lend gold. Bullion bank conjures out of thin air some fake unallocated gold, merely recording an asset in its books (loan to hedge fund) and a liability (unallocated owed to hedge fund). Let us assume the amount of ounces is enough to move the price in our otherwise stable market by $3.

Hedge fund’s first step is to buy the Dec futures at $1195 but in doing so its price increases to $1198 (lets say that is the next offer price). Secondly they have to sell spot. Say they find a trusting investor who is willing to accept a transfer of the fake unallocated gold for $1200. Again, this action decreases the spot price to $1997 (next marginal bid price) and the market is now in contango. So far so good.

But what happens in six months? The hedge fund only has two choices – cash settle or physical settle.

If they cash settle then they have to sell back their Dec futures contract, but doing so will cause the price to decrease from its new equilibrium price of $1198 to $1195. Likewise, they have to buy unallocated to repay the loan to the bullion banker, but that will increase the spot price from $1997 to $1200. All that cash settling has done is delay the appearance of backwardation but not eliminated it.

If they physical settle then they get their gold from COMEX and deliver it to the bullion bank to repay their loan. Now this would have no effect on prices. However, the bullion bank now has physical 1:1 backing its unallocated liability to the trusting investor. If that investor asks for delivery, it will have no effect on price because the bullion bank has the physical. In a roundabout way the hedge fund eventually did sell real physical gold to the trusting investor.

Now your retort may be that the fact that the trusting investor was willing to accept fake unallocated allowed the manipulation of the basis to turn backwardation into contango. You would be correct, and that is the point of my scenario. The basis is therefore reflecting reality, the reality that there are idiots prepared to accept paper gold.

The basis IS telling the truth. It is not the hedge fund or the bullion bank who have “manipulated” the basis, it is the trusting investor. But in a sense the basis has not be manipulated, arbitrage is ensuring it reflects reality, that there are idiots who are prepared to bid dollars for paper gold.

If that trusting investor was not so trusting, then the hedge fund would not have been able to execute their arbitrage because there would be no one willing to accept their paper gold. The cash price would have remained at $1200 and the market in backwardation, and the basis would reflect reality, the reality that people were only willing to bid dollars for real gold.

You said “If gold stops bidding for dollars (low gold velocity), the price (in gold) of a dollar falls to zero. This is backwardation!” My reply would be that even if all (real) gold stops bidding for dollars, but there is plenty of paper gold bidding for dollars which are being accepted, then there is no backwardation.

My logic therefore leads me to the conclusion that the basis does not lie, that it cannot be manipulated. Professor Fekete was right all along, long live the basis. However, I don’t feel totally confident in this statement, as I said I’m not an expert in futures so there is probably a flaw in my scenario and logic. If so what is it?

Over time, group 1 will swell and end up holding most of the above-ground physical gold in the world. Group 2 will shrink and end up holding mostly paper gold. Group 3 will be financially sucked dry by the vampires in group 4. And group 4 will ultimately find it has no more markets to churn.

This is the theoretical process that gold backwardation should represent. A healthy and REAL gold contango SHOULD send this process into reverse, perhaps slowly at first, but reverse nonetheless.

So the question I am asking is which direction are we heading right now in this process? How close are we to the end of this process? And why aren’t the market signals matching the rest of the picture?

If group 1 already has most of the physical gold and is now a one-way flow, is that not the state-of-the-market that backwardation should signal? And if the state is present but not the signal, what does that say about the signal?

Following from my conclusion that the basis does not lie, then the “signal” must be correct, which means “the state” of group 1 strong hands having most of the physical gold is not correct and we not close to the end of the process you describe. This is consistent with the defence by goldbugs to claims we are in a gold bubble that investment in gold is still a fraction of portfolio allocations and the mass market is not buying gold. Dollars are not being bid for gold, real or paper.

If you don’t like the conclusion, then you must find a flaw in my logic about the basis. I am more than happy to be proven wrong. Well, maybe not just yet, I’d like to pick up some more cheap gold

I would not be surprised that for many this backwardation thing makes their head hurt and perceive it as all very theoretical and of no practical use. But this is not true and backwardation is a potential profit opportunity for those holding gold. However, it is also being overplayed.

Backwardation is when the future price is less than the cash (spot) price. Consider you are a long term holder of gold expecting to sell it in a couple of years when the price peaks. One day you wake up and note that the price of gold six months into the future is being quoted on COMEX at $1150. You check with your local coin dealer and he is quoting to buy your gold at $1200. What does this “backwardation” mean to you? See below (numbers for purposes of calculation simplicity, not real costs).

You work out that it will cost you $100 to ship your 100oz to the dealer. He will pay you $120,000. You deposit $20,000 of that with your broker as margin (plus extra to cover fluctuations) and buy the $1150 futures contract, plus brokerage fee of $50. You deposit the remaining $100,000 cash in the bank for 6 months at 0.5%. On maturity of the futures contract you stand for delivery and incur $50 brokerage and $100 shipment cost. Your profit on this is $4950, composed of

* Sale of gold: +$120,000
* Purchase of gold: -$115,000
* Interest on cash: +$250
* Brokerage and shipment costs: -$300

Now this is a great deal. At the end of the 6 months you still have physical gold but you have earned additional money while you wait for your eventual sale in a couple of years. Why would you not take up this opportunity?

Well, the deal is saying “Sell us your gold now and (trust us) … we will have it to sell back to you in the future for less!” You are exchanging your current physical gold for a future claim to gold. You have “counterparty risk”, to COMEX, to the short on the other end of your 6 month futures contract.

Of course, such a wide difference between cash and futures prices does not normally occur, because faster and bigger players see the profit opportunity and get in first. Their action of selling lowers the $1200 cash price and their buying of the 6 month futures increases the $1150 price and thus eventually the gap (and profit) disappears. That is arbitrage.

But if you did see such a big difference in prices, it means the big players aren’t taking up the deal. The cash-futures gap is telling you that people don’t trust COMEX, they don’t think they’ll get their gold back in the future. What backwardation is telling you is that people don’t want to give up their gold, even for a little while. As FOFOA says: “gold stops bidding for dollars”.

This leads to my closing point, which is best summed up by Tom Szabo’s December 2008 comment: “Let’s talk if and when the backwardation is large enough that the arbitrage was there and yet still nobody chose to go after it. That would be truly something!”

For example, if the cash price was $1200 and 6 months futures $1199.25, in my simplistic (and unrealistic from a cost point of view) example, that would mean a profit of $25. That is technically backwardation and technically a profitable one. But could you (or the big players) be bothered with all the work involved in selling gold, buying futures and then taking delivery, all for $0.25 per ounce profit?

Therefore, the only backwardation that matters to me is backwardation that:

a) means reasonable profit and
b) no one is willing to take that profit (that is, it is persistent).

Any other backwardation is just noise and has no “information value” by itself.

If this topic interests you, the following two services specialise in tracking the gap between cash and futures (known as the “basis”):

The Metal Augmentor (Tom Szabo)
Gold Basis Service London (Sandeep Jaitly)

These services look at the bigger picture and don’t get distracted by instances of technical backwardation. They look at the trend in the basis, trying to identify in advance when significant and persistent backwardation will occur.