Alpha, Beta, and Beyond
Nouriel Roubini
JUL 27, 2015

Alpha, Beta, and Beyond
Nouriel Roubini
JUL 27, 2015
Investment funds
Roaring ahead
Exchange-traded funds have overtaken hedge funds as an investment vehicle
Aug 1st 2015
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“Lowflation” forever in the US?
Gavyn Davies
Jul 26 15:38
So I think we need to see additional strength in the labor market and the economy moving somewhat closer to capacity—the output gap shrinking—in order to have confidence that inflation will move back up to 2 percent, but we have made some progress (June FOMC press conference).This indicates that the FOMC will be willing to announce lift off even in the presence of very low inflation prints, provided that the labour market continues to improve.
Are We Seeing a Trend Reversal with Interest Rates?
By: Frank Suess
Mon, Jul 27, 2015
In the second quarter, we saw a jump in yields across the board. The yield of 10-Year US Treasuries jumped from 1.9% to 2.4% over the course of the quarter, representing a yield increase of 50 bps. This led to a decline of almost 2% in the Bloomberg US Treasury Bond Index. In Europe the development was much more dramatic; over the quarter, the Bloomberg German Sovereign Bond Index lost around 4.5% in value. This was due to an increase in the German 10-Year yield from 0.2% to 0.8% (60 bps). It is not completely clear what sparked the massive yield increase in Europe. It might have been a technical correction due to the very high prices bonds were trading at, increased risk aversion towards Europe due to the situation in Greece (Bill Gross even called shorting German bunds "the short of a lifetime"), or possibly aggressive short positions by some investors.
With 30 years of falling interest rates, bonds are today considered to be low risk investments and government bonds are even considered to be an almost riskless asset. However, the developments in the last quarter have shown that this is not the case and losses can occur rapidly when interest rates begin to rise. We therefore need to consider a few important questions in connection with interest rates. Is the development in the last quarter to be perceived as the long awaited turnaround in interest rates? Are Treasuries, other government bonds, and bonds in general as safe as they are perceived by most market participants? How would an increase in interest rates impact a portfolio?
Yields still at historic lows
First of all, it is important to put the development of the last quarter into perspective. Both the US and German 10-Year government yields are still at very low levels (see Figure 1). Although we don't know when the interest rate environment will change, in our view it is still too early to call it the normalization of interest rates after the recent yield development. This is especially the case when we take into consideration that since 2009 we have seen four quarters where the yields increased by more than 20%, but were then followed by new lows.
When we take a long-term look at the development of 10-Year Treasury yields, as depicted in Figure 1, it becomes clear that, excluding some variations, over the past 30 years, yields have been heading in only one direction: down. And this might continue or at least interest rates could stay low for some time.
A look around the globe
As we have mentioned in the beginning of the article, the yield developments in Q2 were not identical across the board. The Eurozone saw a considerably stronger spike in yields than the US did. It is therefore important to differentiate between different countries and regions, when it comes to assumptions related to interest rate developments. In this context, let's have a closer look at the United States, Europe, Japan and China.
With the exception of the US, where the yield increase is possibly related to an anticipated rate hike by the FED, the developments of the previous quarter are not related to a rate hike by a central bank, but rather price changes on the secondary market. It is our understanding that a real turnaround in interest rates will take place when central banks start to hike rates, which is precisely why we will spend some time looking at rate hikes here.
From the countries mentioned earlier, the United States seems closest to a rate hike. However, this does not mean that we expect an imminent and substantial increase in rates any time soon.
The US was the first country to start with its QE program in November 2008, ended it in late 2014 and has in the meantime seen a visible economic recovery. Unemployment figures are currently at 5.3%, close to what the FED considers full employment. Inflation is expected to reach 2.2% next year, which is close to the target inflation rate of 2%. Although downward revisions to GDP expectations have taken place, the economy seems robust and is expected to grow 2.2% this year and 2.8% in 2016. All indications are that a rate hike would be appropriate. Yet, many other countries are still in "QE-mode" and an increase in rates would make the US Dollar more attractive in relation to other currencies, resulting in a burden on the US economy and US companies. We therefore believe that an increase, if any, is likely to come in homeopathic doses and could even be reversed should the economic condition worsen.
Europe just started its asset-purchasing program in March, 2015, and the balance sheet is still around 800 billion below their target of 3.3 trillion Euros. The official aim of the European QE program is to provide liquidity to the banking sector to jump start lending and thus increase economic activity. The inofficial aim, in our view, is to depreciate the Euro in order to increase European competitiveness.
An increase in rates now would be a counterproductive measure for both the official and inofficial aim because rate hikes throttle lending and increase the relative attractiveness of a currency. It is therefore very unlikely that a serious rate hike would be implemented by the ECB anytime before the current program runs out in September, 2016.
The QE program in Japan, dubbed "Abenomics", is starting to show first positive results.
Japan has left the brief recession of last year behind and grew by 3.9% in annualized terms in Q1 of 2015 and is expected to grow well into 2017 (more on Japan in the next article). After having seen decades of deflation and having one of the largest debt-to-GDP ratios, we highly doubt that the Bank of Japan will increase rates at the first sign of a slight economic recovery.
China's economic indicators are being revised downward. GDP growth is expected to decrease from 7.4% in 2014 to 6.5% in 2017 and export numbers are showing weakness. Additionally, we believe that the property downturn is likely to continue. Taking the above-mentioned into consideration, it is understandable why China has started to loosen its monetary policy. Since Q4, 2014, the People's Bank of China (PBoC) has reduced lending rates from 6% to 4.85%.
Furthermore, since the beginning of 2015, reserve requirements for banks have been reduced
twice. Both of these steps are monetary instruments used for loosening monetary policy. Due to the weak economic data, coupled with the fact that bank-lending rates in China are currently between 7-8% in real terms, we believe that the PBoC is likely to further reduce rates and not increase them for the time being.
Where do we think interest rates are headed?
As we have outlined above and summed up in Figure 2, we believe that different countries and regions are at different stages in their monetary policy and a one-size-fits-all answer to the question where interest rates are headed cannot be provided. Nonetheless, we do not believe that an increase on a wide scale would be economically feasible for the time being and there are substantial risks involved due to high debt levels. The German 10 Year yield development (from 0.2% to 0.8%) in the last quarter illustrates that coming from a low base, a triple digit increase in the financing cost can happen very rapidly. Imagine if a government or company that took on debt at a very low cost would suddenly be faced with triple the cost when refinancing or issuing new debt.
How does a rate hike impact my portfolio?
As we are uncertain if and when a rate hike will take place, we will turn to the most burning question for investors: How does a rate hike impact my portfolio? Even if the turnaround doesn't come anytime soon, it will occur eventually. So it is important to understand the impact it can have on one's portfolio.
When interest rates rise, newly issued bonds are issued with a higher coupon than prior to the hike. This means that older bonds issued with a lower yield become relatively less attractive; investors are willing to buy them only at a lower price and thus the price of the bond decreases.
Bond yields are therefore negatively correlated to the bond price.
Figure 3 depicts the value zero-coupon bonds with different maturities would lose if interest rates would rise by 1,2,3 or 4 percentage points. The calculation is based on simplified assumptions (change from a zero interest rate environment and a parallel shift in the yield curve), but is meant to illustrate the impact of a rate hike on bonds. There are two main aspects we would like to concentrate on. Firstly, the higher the rate hike, the more bonds lose. This is intuitive, as the higher the hike, the less attractive a bond, that was issued with a lower yield, becomes. Secondly, the time to maturity is also a critical factor. When interest rates rise, future cash flows from bonds are discounted at the new higher rate. The longer it takes until the capital is repaid, the higher the negative impact on the bond price. There are several other aspects in connection with bond pricing, but going into all the details would go beyond the scope of what we want to cover today.
As a general rule, we can say that an interest rate hike would also be negative for equities.
Future earnings, cash flows, etc. are discounted using a higher rate and this should technically lead to a decrease in prices. Furthermore, when yields rise, bonds become relatively more attractive in comparison to equities and investors tend to increase their allocation to bonds.
However, equities are much less sensitive and react less "mechanically" to interest rate changes than bonds. UBS recently came out with a study where they analyzed the 12 previous cycles of interest rate hikes by the FED. Their conclusion: on average, the S&P 500 increased roughly 10% in value in the 12 months after an initial rate hike. This also holds true when we look at the rate hike prior to the financial crisis, depicted in Figure 4. Although the FED started to hike rates in 2004, stocks continued to perform well, i.e. generating returns of nearly 40% since the start of the hike until the highs in 2007. The substantial increase in the FED fund rate did not negatively impact stocks for several years. This is not to say the general rule of interest rates hurting equities is not true. Our point is rather that even if an imminent rate hike would be at hand, there would be no immediate reason to reduce equity exposure.
And the impact of interest rates on gold? In general there is a negative correlation between gold and real interest rates. When real interest rates rise, gold becomes less sought after, as investors search for investments with higher yields. However, according to the World Gold Council, the negative effect of real interest rates on gold is only triggered when real interest rates rise above 4%.
Conclusion for investors
We don't know where and when an interest rate hike will take place. Nevertheless, monitoring the development of yields should be part of any risk management approach, because as we have shown in this article, yield normalization can have a substantial impact on the portfolio.
Low Gold Prices Seeing Chinese Pile In Again; SGE Withdrawals Exceeding New Mined Supply
by: Lawrence Williams
Jul. 26, 2015 1:23 PM ET
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Oil and gas crunch pushes Russia closer to fiscal crisis
'Russia is going to be in a very difficult fiscal situation by 2017. By the end of next year there won’t be any money left in the oil reserve fund,' says Unicredit
By Ambrose Evans-Pritchard
7:42PM BST 23 Jul 2015
Requiem for the Macrosaurus
The beginning of the end of the Jurassic Period of economics.
By David Rothkopf
July 27, 2015
This summer’s biggest movie is Jurassic World. Apparently, people have an endless appetite for dinosaurs, which could also explain much about the popularity of Flintstones vitamins or, for that matter, Vladimir Putin. Fortunately for these people, there remain dinosaurs among us who are producing mayhem on a scale unimagined by even Hollywood’s CGI wizards.
We call them economists.
The term may initially evoke visions of kindly bespectacled wonks droning on about arcane theories or perhaps government big shots mumbling unintelligibly before Congress. But we know better: These are powerful women and men. They have made giant policy decisions that have affected the lives of billions, often while working behind closed doors with data and on strategies that few understand and fewer still believe in.
Economics has long been known as the dismal science. Thomas Malthus, a cleric who also wrote about economics, has become the poster child used by many to illustrate the rationale behind this label. (Thomas Carlyle actually first coined the term in reference to the study of the business of slavery.) In the very last years of the 18th century, Malthus posited the argument that population growth would ultimately derail human society’s efforts to perfect itself. “[T]he power of population is,” he wrote, “indefinitely greater than the power in the earth to produce subsistence for man.” It is indeed a grim prognosis. But it highlights another reason economics might be seen as dismal: that is, just how off the mark its predictions can be.
Being wrong has long been a special curse of economists.
Being wrong has long been a special curse of economists. You might not think this would be the case in a so-called “science.” But, of course, all sciences struggle in those early years before scientists have enough data to support theories that can reflect and predict what actually happens in nature. Scientists from Galileo to Einstein have offered great discoveries but, due to the limits of their age, have labored under gross misconceptions. And in economics we are hardly in the era of Galileo quite yet. It is more like we are somewhere in the Middle Ages, where, based on some careful observation of the universe and a really inadequate view of the scope and nature of that universe, we have produced proto-science—also known today as crackpottery. (See long-standing views that the Earth was the center of the solar system or the belief that bleeding patients would cure them by ridding them of their “bad humors.”)
Modern economic approaches, theories, and techniques, the ones that policymakers fret over and to which newspapers devote barrels of ink, will someday be seen as similarly primitive. For example, economic policymakers regularly use gross estimates of national and international economic performances—largely aggregated measures based on data and models that are somewhere between profoundly flawed and crazy wrong—to assess society’s economic health, before determining whether to bleed the economic body politic by reducing the money supply or to warm it up by pumping new money into its system. Between these steps and regulating just how much the government spends and takes in taxes, we have just run through most of the commonly utilized and discussed economic policy tools—the big blunt instruments of macroeconomics.
I remember that when I was in government, those of us who dealt with trade policy or commercial issues were seen as pipsqueaks in the economic scheme of things by all the macrosauruses beneath whose feet the earth trembled, whose pronouncements echoed within the canyons of financial capitals, and who felt everything we and anyone else did was playing at the margins.
But think of the data on which those decisions were based. GDP, as it is calculated today, has roughly the same relationship to the size of the economy as estimates of the number of angels that can dance on the head of a pin do to the size of heaven. It misses vast amounts of economic activity and counts some things as value creation that aren’t at all. Even the guy who pioneered the idea in the 1930s, Simon Kuznets, warned against using it as the prime measure of national economic well-being. Trade data, such as that used in measuring national surpluses and deficits, misses a big chunk of trade in services and much Internet activity, among many other swaths of trade—and is widely reported inaccurately. Labor statistics, such as unemployment rates, are cooked and deceptive. The list goes on. The reality is that only two things are known about most of the data that policymakers use to make decisions: It is late and it is wrong.
But today the world stands at the dawn of a new era thanks to the advent of big data and enhanced computing power. Already there exist data flows that will show economic fluctuations in real time and down to an incredible level of detail: by community, by block, by family, by business, by however you want to slice it. The world will also be able to find correlations never before imagined. Old ideas, like tracking national economic performance based on geography, will give way to new ones, like tracking customizable groups that share much closer correlations than borders. There is a “you-istan” out there full of millions of people who act more like you, who respond to stimuli more like you, and who rise and fall more like you than do your neighbors. Next-generation economists will be able to target their actions more surgically.
Whereas today’s economic models rely on a relative handful of variables, future models will be able to utilize a limitless number, creating opportunities for policymakers to develop new tools.
Many of these new models and tools will require not the insights of microeconomists, but those of nano-economists, superspecialists in the relationship between much smaller economic units and the larger economy as a whole. Economic policymaking will therefore devolve from central governments to state and local governments, which are not only closer to the issues and the solutions that workers, companies, investors, and citizens require, but are better equipped to work with the local private sector in real time to solve those issues.
New economic theories will also emerge based on growing sources of real-time data about every aspect of markets and the factors affecting them—and new, ever more powerful tools will be created for analyzing that data. Some will relate to the fact that soon money as we know it will be replaced by alternative bit-based and mobile-payment systems, knocking old-school monetary policies for a loop. Others will have to do with the new ways we not only create jobs, but define work. There may ultimately be a need to revisit the issue of the redistribution of wealth as big companies harness capital, technology, and data to grow rich—but in so doing, benefit comparatively few investors and employees, while displacing many. Just as the 20th century saw the advent of the weekend, the hyperproductivity of the intelligent-technology-empowered 21st century might see labor demand fall and four- or three-day weeks become the norm. Taxation will transform as methods by which we track activity and levy fees within the economy change; such processes will easily cover more kinds of activity in real time, while algorithms will constantly adjust for the economic circumstances of those being taxed.
Gradually, there will be a recognition that most of the economic value in the global economy is created and exchanged in virtual rather than real space, with important consequences for the metrics and ideas we use for measuring that value.
Indeed, tomorrow’s economics will be so unlike that of today’s that it might just take a Hollywood device—like a mosquito preserved in amber, carrying, for example, the blood of Alan Greenspan, from which viable DNA can re-create this macrosaurus—for future generations to fully grasp the Jurassic Period economic thinking and approaches that have governed and guided our daily lives.
Why the Fed Needs to Get Off the Dime
Waiting until the unemployment rate reaches the natural level before beginning to raise interest rates risks inflation.
By Richard W. Nelson
July 24, 2015 6:52 p.m. ET
Federal Reserve chair Janet Yellen at a news conference following the Federal Open Market Committee meeting in June. Photo: Bloomberg News
There is a lot of discussion about what level of unemployment the Federal Reserve should seek to fulfill its mandate to promote maximum employment and stable prices. This key unemployment rate is called either the “natural” rate, or “Nairu”—the non-accelerating inflation rate of unemployment.
Yet there seems to be an assumption among many policy makers, analysts and market participants that the Fed should wait until the natural rate of unemployment is reached before it begins to raise interest rates. That would be a huge mistake, greatly increasing the chances of significant inflation beginning sometime next year.
The problem is that the Fed has to finish normalizing monetary policy by the time unemployment falls to its natural rate—and that may take more than a year once it begins. If the Fed waits until the natural rate of unemployment is reached, there will be many months when interest rates are too low. These low rates can cause the economy to overheat, putting pressure on prices.
According to economic projections by the Federal Open Market Committee (FOMC) at its June 16-17 meeting, 3.5% to 3.75% is the likely level of the federal-funds rate after monetary-policy normalization is completed. Currently the Fed’s target range for this key interest rate is 0% to 0.25%.
The Fed historically has increased the federal-funds rate by 25 basis points (0.25 percentage points) at each of its monthly meetings. All indications are that the Fed would like to move even more slowly this time around, so it can gauge the impact of its actions on economic activity. That implies it could take 14-15 months or more to complete monetary policy normalization.
The Fed has no time to spare. In the FOMC’s March 2015 economic projections, committee members estimated that over the longer run the unemployment rate would settle in the range of 5% to 5.2%.
However, a recent study by Federal Reserve staff suggests that Nairu may have fallen much lower, perhaps to 4.3%, and the FOMC may well modify its views in this direction. But over the past 15 months, employment growth has been strong and unemployment has fallen by 1.3 percentage points, to 5.3% from 6.6%.
If unemployment continues to fall at this pace, the unemployment rate will fall to around 4%—below the Fed staff’s 4.3% estimate of full employment, and well below the current estimate of the FOMC members, before monetary normalization is complete. This analysis suggests that the Fed is risking inflation beyond its 2% target by waiting to begin raising rates, and will face an increasing risk the longer it waits.
It is true that longer-term interest rates are likely to rise quickly as financial markets anticipate the Fed’s next moves. And so higher short-term and longer-term interest rates could impede employment growth and the achievement of full employment. Still, the FOMC could monitor the movements of interest rates and employment monthly, making appropriate adjustments as needed.
On the other hand, the risks of delay—higher and perhaps rising inflation—are not likely to emerge until we are closer to full employment. By then adjustments would likely be too late.
The best course for the Fed is to begin raising rates very soon, if cautiously.
Mr. Nelson, a former chief economist at the Federal Home Loan Bank of San Francisco and manager of banking research at the New York Federal Reserve, is the founder of RWNelson Economics, a consultancy in Orinda, Calif.
The Disappearing Retirement Fund
by Jeff Thomas
July 27, 2015
As a general principle, I’ve always tended to avoid entrusting others with my money. I’ve avoided funds, as they are often based upon investments that are peaking or close to peaking. I’ve avoided pension funds, as they’re often structured in a similar manner.
And whenever by law I’ve been required to be invested in such funds, they’ve rarely been successful over the long term. In the end, I would invariably have made more money by pursuing those investments that had great promise but at the time were unpopular (and therefore underpriced).
As dubious as I tend to be of conventional investment schemes (and those who broker them), I am doubly dubious of any government-run scheme. Governments, historically, have proved to be poor money managers, and politicians tend to place more value on big promises that garner votes than on delivering on those promises.
And so, I’m predictably biased as to the likelihood of any form of fund that any government may be involved in. Even if it’s structured well, which it may well not be, governments, if they have the power to do so, will tap into the fund, draining it of the intended recipient’s contributions, leaving the fund exposed, should a crisis occur.
And, periodically, crises do occur. Presently, the First World is facing an economic crisis of unprecedented proportions.
As someone who advises on internationalisation (the practice of spreading one’s self both physically and economically over several jurisdictions in order to avoid being victimised by any one jurisdiction), I’m regularly asked what the optimum level of diversification might be for an individual in a given situation.
Whilst many of these individuals can unquestionably benefit from such diversification, there are quite a large number of people who are in the age sixty-and-over category who state that they’re hoping to get by solely on their Social Security and their pension. (If the investor is an American citizen, this often means a 401(k) or similar fund.)
For these individuals, I’m afraid it’s difficult to provide encouraging advice, as their retirement is rooted in what I consider to be dead-end investments that will diminish drastically, or disappear, long before the individual reaches his own demise.
Social Security
The Social Security fund of virtually every country that has one is woefully underfunded. Typically, these funds have relied on the next generation’s contributions to pay for the benefits to those presently retired or retiring.
Unfortunately, the original premise, back when Social Security was introduced, was that the population would always increase. During the baby-boomer years, benefits were ramped up dramatically, as there were so many younger workers per retiree.
But now, that relationship has reversed. The baby-boom generation lasted for 18 years, so each year, for 18 years, the ratio of working people will diminish against those who have retired.
Ergo, each year, those working will need to be taxed more heavily if the system is to continue.
Unfortunately, at some point, we reach the tipping point and the concept itself is no longer viable.
After that point, benefits will be reduced and, possibly, eliminated altogether.
When retirees first hear this, their reaction is usually, “But that’s not fair. I paid in, all my life. They can’t do this to me.” Unfortunately, it is not a question of “fair”. It’s a question of arithmetic. The promised benefits will decline. As a result, those who are counting on Social Security to sustain them in their retirement will find themselves short.
Pension
Similarly, pensions are at risk. Most pensions are invested, to a greater or lesser degree, in the stock market. Most funds pride themselves on being “diversified”, by which they mean that they are invested in a variety of stocks.
Unfortunately, when a stock market crashes, good stocks often head south along with failing stocks, as brokers seek to save their skin by unloading portfolios. (This does not mean that some potentially solid stocks will not experience a recovery in time, but few will ride out a crash unaffected.)
At present, the stock market is being propped up artificially and is overdue for a crash. Although it would be impossible to predict a date, a crash, if it occurs, would have a major and permanent effect on a pension scheme.
But, wait… there’s more.
As if these threats to planned retirement were not enough, there’s a further threat. As previously stated, many governments are financially on the ropes, and historically, when governments find themselves on the verge of insolvency, they invariably react the same way: go back to the cash cow for a final milking. Each of the jurisdictions that is in trouble at present, has, in its playbook, the same collection of milking techniques.
One of those will have a major impact on pensions: the requirement that pension plans must contain a percentage of government Treasuries.
Political leaders have already announced that there’s uncertainty in the economic system and pensioners may be at risk. Therefore, whatever else happens to their plans, it’s essential that a portion of them be guaranteed against failure. Therefore, legislation will be created to ensure that a percentage be in Treasuries, which are “guaranteed”.
Sounds good. And people will be grateful. Unfortunately, the body that is providing the guarantee is the same body that has created the economic crisis. And if the government is insolvent, the “guarantee” will become just one more empty promise.
Recently, the US Supreme Court ruled that employers have a duty to protect workers invested in their 401(k) plans from mutual funds that perform poorly or are too expensive. By passing this ruling, the US government has the power to seize private pension funds “to protect pensioners”. It also has the authority to dictate how funds may be invested.
The way is now paved for the requirement that 401(k)s be invested heavily in US Treasuries. (Some are already voluntarily invested, as much as 80%.)
Game Over
And so, those who hope to fund their retirements primarily with Social Security and 401(k)s, may well find themselves virtually without retirement income.
The question is whether this means “Game Over” for millions of Americans (and since similar developments are taking place in many other countries in the world, millions more in the EU, Canada, etc.)
And, yes, it does mean “Game Over” for many, unless they choose to exit a system that is set to collapse like an old mine shaft, trapping its occupants.
Still, there remains a brief window of opportunity, and that opportunity is to pay the penalty for exiting the system and internationalising whatever level of wealth can be salvaged.
Ideally, this means physically moving to a jurisdiction where such conditions do not exist, but a more limited escape may be created by removing as much money as possible from the retirement fund, moving it to a less risky jurisdiction and converting it to those forms of wealth storage that are least likely to be targeted by rapacious governments and corrupt banks.
Accepting the realization that the piggy bank will be less full is a painful one but is far less painful than to face the day when the piggy bank is all but empty.
Editor’s Note: If you don’t want to move abroad, you can still benefit from offshoring your retirement savings. It can live abroad instead of you - and outside the immediate reach of bankrupt politicians.
Retirement savings are always a juicy target for governments in need of cash.
In just the past six years, retirement savings have been plundered in some form in Argentina, Poland, Portugal, Hungary, and numerous other countries.
It’s incorrect to assume that it couldn’t happen in the US or your home country. History shows us that it’s standard operating procedure for a government in dire financial straits.
Fortunately by taking your investments offshore, you can make yourself a hard target and make it impossible for your retirement savings to vanish at the drop of a hat.
But it’s not just a defensive measure. Offshoring your retirement savings will unlock a whole world of new international investment opportunities that would otherwise be unavailable.
What Is The Intrinsic Value Of Gold?
by: Andrew Hecht