Gold and its Valuation: Lessons from the Vatican

We’ve all heard the sales pitch: Gold functions as a hedge against averse geopolitical events, so buy it at any price to deal with any manner of catastrophic events. The truth is that hedges only work when purchased at the right price and income producing assets are the core objective in any portfolio.

The logic for buying it seems sound enough. Putting it in my terms, the story goes like this…

Our planetary civilization functions like a massive brain… interconnected neurons driving flows of capital, goods, and labor pretty much to where they are used most productively. There may be some frictions, but this is the aim and objective.

This brain, since the fall of the Iron Curtain, functioned pretty free of psychoses, at least compared to most of the 20th century. During the Cold War this brain was bi-polar, split between the Communist bloc and the NATO/CENTO/ASEAN alliances, with the rest of the world playing one against the other for short-term bribes.

After a couple of decades, psychosis is back with a vengeance. But the diagnosis isn’t bi-polar disorder. The world is careening toward multiple personality disorder.

Constantly shifting alliances, ambiguous aims, and deeply imbalanced trade flows mark the growing strength of China, India, and Asian export oriented economies. Even the EU often pursues policies at cross purposes to itself and to the US. All the old alliances are corroded.

The US still stands at the top of the food chain, but it is unable to impose its wishes as it used to. The world has grown too much for it, relative to the past. Multiple loose confederations of smaller peers acting in concert for short-term gain only to reassembled in different ways is the rule.

Even so, the US treasury market remains the liquidity reserve for the world. There is literally no other place on the planet where a country or person can invest billions of dollars and withdraw billions of dollars seconds later all with minimal transactions cost.

Over time, a multi-polar world means that there will be alternatives to treasuries. Investors will be looking for substitutes—not perfect substitutes, but alternatives based on geopolitical circumstances. Most of the possible alternatives will be paper issued by countries that have no property and capital protections in place. Possibly they will be denominated in crypto-currency that has no legal standing and potentially no contract enforcement standing in jurisdictions. Except for gold. It is costly to store and transport. There is market and liquidity risk, but the need for an alternative to treasuries will make the economics more palatable.

The global need for treasuries will remain. But there will be diversifying hedges at the margin and liquidity will be sourced at a greater scale in the market than it is now. Geopolitical frenemies will see higher counterparty risk in treasuries and just won’t store reserves there, at least as much. So in a multi-polar world where people think about a return of their money instead of a return on their money, that is where you buy gold.

It seems sound, but it is not. The problem isn’t the logic. The issue lies in the execution. It is almost always the right move to sell insurance (and insurance is the basic function of a hedge) rather than buy insurance. More precisely, implied volatility overshoots realized volatility in a crisis, so the short premium trumps the long position. Especially when risk premia are high. High risk premia is where to extract money.

That is to say: Crises don’t last. People get used to new circumstances and get back to business. So when Kim Jong Un shoots nuke after nuke after nuke, he can’t up the ante anymore. The market gets used to it and the risk premia decays. Hedging becomes a lower-percentage shot. You always have to look at valuation, hedge or not.

Valuation is where it is easy to get lost in the lingo. To find value ultimately you have to look for cashflows, otherwise you are buying lottery tickets. Cashflows often define carry, but not always. Gold isn’t a bond and you have to get carry somewhere else. But you still can’t separate carry from cashflows entirely. Ever. To realize carry on gold—to realize a return on gold—you have to monetize it.

Think about the wealth of the Vatican. Priceless books, priceless artifacts, priceless treasures, lots of gold and precious things baked into them; all in storage and display. To get a valuation on these items, you have to distinguish between the book value and the ability of assets to produce income.

How much is St. Peter’s Basilica worth? Aside from charging tickets to visitors, it does not have a lot of income-producing potential. And it must be very costly to maintain. These are factors that hurt resale value. $10 billion? $100 billion? Could be either. Could be neither. The book value may be priceless. The book value may be nearly worthless.

How much is the contents of the Vatican museum worth? A lot of the paintings and art in it would go bidless in the marketplace if the starting ask is too high. You could sell them at a steep discount to booked value and invest the proceeds into… that’s right… assets that generate cashflow. Income is the name of the game.

Ultimately, you can put whatever book value you want on the Vatican, but it is close to worthless when it comes to paying yesterday’s bills and expenses associated with it. One would be better served financially by, ahem, bulldozing the Papal palace and putting up high-rises on the land.

Same with gold. You must at some point convert the gold investment into income-producing assets. Otherwise it is only worth what you can get on the market. It is worth is determined only by how much a buyer thinks he can exchange it for income-producing assets.


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