An optical illusion in the form of a focus on flows – rather than stocks – is a well-known flaw in the analysis of asset markets. Two examples this year demonstrate the phenomenon: one from the market for gold and the other from the market in stock options. Analysis of the illusion in gold helps provide a clue to how present high speculative temperatures in corporate bond markets – intimately related to the options market – will collapse.
Taking gold first, the World Gold Council (WGC) pronounces in its latest quarterly report (August 2018) that demand for gold has fallen by around 2 per cent to just below 1000 metric tons. By implication, this ties in with the decline in the dollar price of the yellow metal. The message is also consistent with the market narrative which spells out how new demand is concentrated in emerging market economies, especially China and India, and the sharp slowdowns there together with currency depreciation justifies a serious price fall (in US dollars).
This narrative is economic nonsense. With the stock of above-ground gold at near 190,000 metric tons, it is evident that the price depends on the heterogeneous expectations and preferences of worldwide holders of the yellow metal in all its forms (jewelry, bars, and coins) not on the additional trickle of demand identified in each quarter by the WGC or anyone else. Even so, malfunctioning markets for some time – especially under conditions of monetary inflation – can award flow narratives undue weight and this is maybe what has been occurring recently.
We turn second to the market for options on equities. We know from finance 101 that a holding in corporate bonds of company X is equivalent to an investment in riskless government bonds plus a kicker in the form of writing a put option at a low striking price (relative to present price) on the (hypothetically unleveraged) equity of X, collecting meanwhile the premium income. The risk (from the viewpoint of the investor in this combination) is that the equity falls sharply in price, meaning that the buyer of the put has a growing claim against the writer – equivalent to the corporate bond price falling far below par.
