Hu Jie: The fundamentals of gold are the market sentiment | Insights

[Introduction] .

Recently, the sharp fluctuations in the gold market have sparked widespread discussion. What exactly is driving the ups and downs of gold prices? Is it inflation data, geopolitical conflicts, or central bank gold purchases?

In response, Professor Hu Jie from Shanghai Advanced Institute of Finance (SAIF) at Shanghai Jiao Tong University pointed out during a related interview: None of these are fundamental; the fundamentals of gold are actually market sentiment, which is driven by various “stories.” Understanding this is key to analyzing gold prices.

The following text is organized based on Professor Hu Jie’s remarks.

*This content only represents the personal views of the professor and does not constitute any investment advice

#

Two Asset Types, Two Pricing Logic

I believe gold belongs to a special type of asset. To understand gold’s pricing, first, we need to divide the world’s assets into two major categories:

One is assets that (future) generate cash flows, and the other is assets that (future) do not generate cash flows. For example, bonds and stocks belong to the former, while gold, Bitcoin, and artworks belong to the latter. The pricing principles for these two types are completely different.

For assets that (future) generate cash flows, we assume there exists an abstract “super investor” in the market—extremely wealthy and with an extremely long lifespan—thus, with an extremely long investment horizon. This investor can hedge and arbitrage between future cash flows and current prices. This is the familiar pricing logic everyone knows.

But for assets that do not generate cash flows, that set of pricing logic doesn’t apply. How do you price assets that don’t produce cash flows? When an investor holds such an asset, like gold, the only way to realize its value is to sell it to the next person, completing the investment cycle. When does the next investor appear? At what price are they willing to buy? This constitutes the fundamental of these non-cash-flow assets. So analyzing when the next investor will come is essentially the fundamental of gold, which we also call market sentiment.

#

Gold’s Fundamental Is Market Sentiment

Gold’s fundamental is market sentiment. Market sentiment is the driving force behind gold prices; analyzing gold is essentially a form of sentiment dynamics analysis.

Market sentiment is subjective and elusive. As the saying goes, “Know the person but not their heart,” different people—ordinary investors, professionals, central banks, politicians—have different emotions and thoughts. The collective emotions of all these participants form the market’s driving force.

What drives market sentiment are often various “stories.” For example, many people have heard of the “Gold as an inflation hedge” story. After hearing it repeatedly, they believe it, and when inflation occurs, they think, “Now is the time to buy gold.”

However, historical data shows that, in fact, gold prices have little to do with inflation. After the Bretton Woods system was abandoned in 1971, gold prices rose from $35 per ounce to $800, but then from the 1980s onward, they fell back to around $300, oscillating until the early 21st century. The problem is, the early 1980s was when U.S. inflation was at its worst, and subsequent inflation fluctuations occurred, yet gold prices kept falling. So, the story of “gold as an inflation hedge” has no solid data backing it.

But whether the story is true or not doesn’t matter; what matters is how many people believe it. As long as enough people believe, it will drive market sentiment and influence gold prices.

Another example is the “Gold can replace fiat currency” story. When people think fiat money is unreliable, they think of gold. There are also stories about “geopolitical risk hedging”—when geopolitical issues arise, people think of buying gold. This is meaningful for those in war-torn regions, but for observers, it’s more psychological. The “central bank gold purchases” story also fits here; central bank buying has some logical basis, but as soon as central banks take such actions, some people use this story to drive sentiment.

When these stories and emotions accumulate and are triggered by events like the Russia-Ukraine war, with various factors intertwined, the “gold story” becomes coherent, completely igniting market sentiment and sparking a bullish market for gold. Meanwhile, a bull market tends to generate herd mentality, pushing gold prices higher and higher.

#

Vulnerability and Reversal of Sentiment

Sentiment is dynamic and changes over time. Today’s bullish sentiment for gold is “unsustainable,” as some investors start taking profits, and others see price fluctuations and become nervous. This causes sentiment to waver, and if a decline occurs, negative sentiment may overwhelm positive sentiment.

My observation is that negative sentiment is gradually rising while positive sentiment is declining. When negative sentiment surpasses positive, the subsequent self-reinforcing cycle could lead to an increase in negative sentiment.

We observe two “negative” factors. First is Kevin Waugh’s nomination as the new Federal Reserve Chair candidate. His support for the Fed’s “balance sheet reduction” impacts market sentiment, causing gold prices to plummet. Whether people understand what “balance sheet reduction” means or not, as long as this mysterious term can influence sentiment, such a reaction is natural. Second is the escalation of the Iran conflict. There’s a circulating story that “rising oil prices will lead to inflation, inflation will cause the Fed to raise or slow down rate hikes, reducing dollar liquidity, and suppressing gold prices.” Although this story contradicts the fact that gold prices rose during the 2022 rate hike cycle, it still successfully drives negative sentiment.

In summary, for assets like gold that do not produce cash flows, their prices are fundamentally determined by market sentiment, and behind that sentiment are stories. As long as people believe in these stories, sentiment is ignited, markets fluctuate, and these fluctuations in turn generate new emotions.