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Is the gold sector a Black Swan?

Posted by Austin Petersen • 20 May 2013

Name That Black Swan

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By Jeff Clark, Editor of BIG GOLD

A lot has happened in the past few months. First, the Cyprus banking crisis roiled the markets and exposed, yet again, the risks posed by Western banks and their investments in sovereign debt. Two weeks later, we saw the precious-metals market drop significantly. The exact cause of the price drop is debatable, but one thing is certain: “paper gold” is playing a big part in the market’s instability.

Is there a potential event that could negatively impact your world so much that it’s imperative you insure against it?

Of course. That’s why you carry fire insurance on your home, for example. The odds of your house burning to the ground are very low – but the outcome would be so financially devastating that you need to have insurance to protect against the loss. The same could be said of life insurance, auto insurance, etc.

What about an economic or monetary event that, in spite of you being prudent with your money, could damage your financial status?

Those exist too, and they’re called “black swans.” It’s this type of event that is the basis of our third installment in the core reasons we must continue to own gold. In spite of gold’s recent waterfall decline, we’ll show that the need to own gold has actually grown.

img_black_swanFirst, what exactly is a black swan?

Like a black swan bird – something that occurs rarely in nature – a black swan event is a high-profile but rare occurrence that is beyond the realm of normal expectations. The term was introduced by Nassim Taleb in his 2004 book, Fooled by Randomness. It’s a metaphor that, according to Taleb, has three characteristics:

  • The event is a surprise
  • It has a major effect
  • After the event, it is rationalized by hindsight, as if it could have been expected. In other words, the data were available to foresee it, but risk mitigation programs didn’t account for it.

What I found interesting in reviewing Taleb’s thesis is that he stated in 2004, “Banks and trading firms are especially vulnerable to hazardous black swan events and are exposed to losses beyond those predicted by their defective models.” In other words, his black swan theory essentially predicted the financial crisis that hit four years later.

You might argue that a black swan event could occur at any time. That’s true. But our current fiscal, monetary, and economic circumstances are so tenuous that the possibility of a black swan event hitting our economy is greater than usual. Indeed, the number of anomalous events that could take place is large enough that collectively they represent a high probability. And since we all live and work within an economic system and use money every day, the impact to us as individuals could be severe.

So the question is this: what data are available now that show where we are most vulnerable to experiencing a black swan event?

Social breakdown: Many European countries still have 50% unemployment in the under-24-year-old crowd, with little prospect of improvement. The triggers are in place for a breakdown of public order in the EU. Particularly concerning would be if the disorder spread to other countries and continents.

War: While Kim Jong-un of North Korea captures all the current headlines, US General James Mattis reports that sanctions and diplomatic efforts to stop Iran from gaining nuclear capabilities are not working. He said Iran is at the point of “enriching uranium beyond any plausible peaceful purpose” and called 2013 the “year of reckoning.”

Financial system collapse: The world economy is worth about $80 trillion. Banks hold derivative positions worth about $1.6 quadrillion (1,600 trillion). If a portion of those bets came crashing down, the financial system may not have the capability to cover the losses. Even if they did, the markets would be roiled.

Screen Shot 2013-05-20 at 3.06.44 PMA major bank raid: TheOttawa federal budget last month revealed that politicians are contemplating the possibility of a Canadian bank failure. One potential solution is similar to the one just imposed in Cyprus: for the first time ever, officials did not include a guarantee in the budget language that expressly prohibits the possibility of a raid on the bank accounts of ordinary Canadians.

China dumps Treasuries: As of January, China holds over $1.2 trillion in US Treasury securities, more than any other country. They’ve expressed concern for years about the diluting value of those securities due to money printing. If China were to sell Treasuries in any significant quantity, interest rates would jump and the dollar would crater.

Sudden, runaway inflation: This would be particularly devastating for the simple reason that hardly anyone is expecting it. We outlined in our February issue that history shows inflation can occur suddenly and rise sharply. Since it hasn’t occurred, many think it won’t… a dangerous assumption, given the ongoing massive dilution of many G7 currencies.

What about a black swan within the gold sector?

Comex delivery failure: In the first three months of the year, stocks of gold held at Comex warehousesplunged by the largest figure ever on record during a single quarter. While the reason behind the move is unclear, nearly two million ounces of gold being withdrawn from the Comex and moved to undisclosed locations does not paint a picture of confidence in the exchange. And it wouldn’t take an outright failure; an announcement of a delivery delay would send a very unsettling message.

There are undoubtedly numerous possible black swans, and I’m sure you can think of others. The point is, given our current set of circumstances – runaway debt levels, ongoing global easing programs, and little political will to do what is necessary to steer away from the crisis instead of deeper into it – how do we protect ourselves against some of these possible outcomes?

According to Wikipedia, “the main idea in Taleb’s book is not to attempt to predict black swan events, but to build robustness against negative ones and be able to exploit positive ones.

Gold won’t solve all our problems, but when it comes to building robustness against possible monetary fallout, its 3,000-year track record says there is no substitute. Since many black swans swimming in our waters relate to our monetary or fiscal standing, the risk for gold is more to the upside than the downside. So in spite of gold’s recent waterfall decline, the need to protect against a black-swan event has actually grown. Only those who have purchased gold before a black swan event will be protected and benefit from rising prices.

Here are three concrete ways we think investors should consider “building robustness” with their gold holdings…

Favor physical metal over paper forms. In today’s environment, the pinnacle of risk is solely holding paper assets. Be sure that your gold holdings are denominated more in Eagles and Maple Leafs than in ETFs and certificates. This includes fractional programs where they don’t offer delivery, even if the metal you own a portion of is fully allocated.

Use non-bank storage. Private vaulting facilities are not subject to bankers’ hours, the sudden declaration of a bank “holiday,” or systemic risks within the financial sector.

Store a meaningful portion internationally. By storing some physical holdings outside your political jurisdiction, you reduce four primary risks: confiscation, capital controls, asset seizure by a government agency, and increased lack of personal control. We can never eliminate risk; the goal is to diversify so that any one event doesn’t impact our entire portfolio.

While it’s healthy to have an optimistic outlook, it’s dangerous to not be prepared financially in light of the current fiscal and monetary predicament that has trapped many countries. The data available now should compel us to make those preparations.

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