Because gold has risen rather spectacularly over the last ten years, many claim that it has become a bubble. This claim is usually made solely on the basis that the price has risen, rather than any economic argument.
Few, if any, of those making the claim correctly identified any other bubbles of the past ten years. Now they are “bubble experts,” at least with respect to gold. Even though other commodities have risen faster recently, gold is the one that is called a bubble.
The argument over gold seems to have two distinct sides. One group is distinguished by the “gold bug” who suffered for almost 20 years believing in gold. Members of this group know that gold is not in a bubble. It is merely making up for lost time. Many in this group believe that gold is still undervalued and nowhere near a bubble.
The second group is less descriptive but seems to have a lot of people who missed the run-up. Their claim that gold is in a bubble sometimes seems motivated by a need to validate missing this market. It is if they will generate psychic income when and if gold collapses.
Both groups tend to be emotional. Their arguments are less economic and more religious. Which group is correct is for you to decide, but here are a few comments that seem relevant.
The first group represents a small proportion of investors, a fact that casts doubt on the bubble hypothesis. A bubble usually occurs when most investors have boarded the train, collapsing when maximum pain can be inflicted on maximum people. Krassimir Petrov expresses the non-bubble symptoms and his opinion on gold:
Gold still has outstanding fundamentals. I believe that over the course of 2010, the fundamentals have strengthened significantly: (1) “No Exit [Strategy] for Ben” as he unleashed QE2, and will likely unleash QE3, QE4, etc., (2) no more central bank selling of gold, (3) more central banks become buyers of gold, and (4) trial balloons for a global gold-backed currency.
I have no idea how people could even claim that gold is in a bubble – barely 1 out of 100 people have any idea about investing in gold. During the real estate bubble, every second person was involved in it. Maria “Money Honey” Bartiromo has yet to report from the COMEX gold pits; gold fund managers and analysts have yet to obtain rock-star status; and glamorous models are not yet dating the gold guys. Who is the Henry Blodget [co-host of Tech Ticker] of the gold sector, do we have one yet?
Yes, gold will eventually become a bubble, but that feels 5-8 years away.
Whether gold is in a bubble is difficult to determine.
Valuation of assets is tricky business. What something is worth is ultimately what someone else will pay. Theoretical models calculate worth but if no one is willing to buy at that price, then perhaps the valuation model is incorrect. If the model is correct and real prices deviate materially from the model price, then the market is distorted, which can be a sign of a bubble (prices too high) or a depressed market (prices too low). Lots of money can be made by buying or selling in either type of market, so long as you are not on the wrong side of a trade when prices return to normal.
Is it possible to model the proper price for gold? Theoretically yes, practically no. Gold can be looked at as money or a money substitute. If one accepts that as a basis of valuation, then the price of gold is relatively constant because its supply is relatively constant. Its constancy is reflected in comments like the following:
In 1900 you could buy a fine suit for an ounce of gold. Today it still costs an ounce of gold to buy a fine suit.
The implication is that gold does not change value (at least not very much) over time. It appears to change because the numeraire, the dollar or other fiat currencies in which we price gold, are depreciating. That makes the price of gold appear to rise (or fall). To illustrate, the chart to the right shows crude oil priced in dollars and priced in gold grams. Oil has risen considerably in dollar terms, but hardly at all in terms of gold. It appears that much of what we see as price increases is little more than dollar destruction.
It is this argument that prompts comments like “Using this as a model, it would seem that one could determine whether gold is in a bubble by comparing its price change with a change in the rate of inflation.” Unfortunately, there are insurmountable flaws when this otherwise theoretically correct approach is applied to real world data:
- We don’t have a proper measure of inflation. We have various indices, of which the CPI is best known, which purport to measure inflation in some sense. Unfortunately, it is impossible to construct an index that does so properly, even if that were one’s intent. The CPI index is highly politicized as Shadowstats.com demonstrates. Thus, we do not and cannot have a true measure of inflation using any price index.
- If the impossible could be overcome (it cannot) and a proper index were available, this approach would still not enable an adequate test. Collected data for an index is always historical. Markets always price assets based on expectations. Thus, even if you knew with certainty that inflation was 10% last year, that would not mean you would expect gold to be 10% higher today than it was a year ago. The price of gold today reflects unknown and unmeasurable inflationary expectations rather than history.
- The above point is why it is so difficult to create valuation models for anything. Price is based on future expectations. These expectations are subjective and not measurable. As an example, if you expect Bernanke to announce a halt to QE2, presumably you might value gold less than if you expected him to announce QE3.
The point about QE is particularly relevant for gold. If you believe that QE is not going to end, then you are probably bullish on gold. If you believe that QE will cease, then presumably you are not bullish on gold. From a personal standpoint, I see only one way for the government to remain liquid and pay its bills without more QE. That way is a return to a balanced budget within the next few years. Because that requires spending cuts of about $1.7 TRILLION, I would guess that QE goes on for as far as the eye can see or the economic collapse, whichever comes first.
An interesting approach, from an entirely different perspective, was offered by Chris Blasi. He investigated whether capable investors had increased their investment in gold over time. His premise was that a bubble can only occur with widespread participation. According to his empirical work there has been no increase in participation by capable investors. Thus he concludes:
Coming from a professional background that included time with a Wall Street broker dealer, merchant banker, and M&A firm, I have seen several investment manias first hand. If this great gold bull market were to wither away now, without the traditional blow-off top characterized by a flood of new participants feverishly bidding up the spot price, it would be a historic anomaly. More likely, analysis seems to indicate that only a minimal number of investors have benefited from the rise in gold and silver so far. Further, this strongly suggests that the bullish trend for precious metals remains in place, and there is still room for substantial appreciation over the long term.
Nothing can be definitive in forecasting. While it may be conforting that Mr. Blasi finds no bubble evidence, that does not mean that gold must go up from here. Long term I believe it will, but, even if it does, it will resemble a volatile, roller coaster ride with major short-term swings both up and down.
Finally, we can look at the price pattern of gold versus known bubbles. The chart to the right shows previous bubbles, including gold itself. Current price behavior looks nothing like a bubble, at least not yet.
Gold is not for the faint of heart except as a small part of your portfolio as a hedge against inflation. One possible reason for its volatility is the composition and nature of ETF investors.
As an aggressive investor, I am overweighted inflation hedges like precious metals and (sometimes) other commodities. If I have any positions in stocks, they are generally shorts. Until about five years ago, I was a normal “buy and hold” type investor. Recognizing what was coming, it became obvious that buy and hold was a risky strategy and one that would not protect against either an economic collapse or high inflation. I am not comfortable with this “gunslinger” mentality, but do it out of necessity.
The nonsense from our Federal Reserve and Federal Government has forced even retirees out to points on the risk curve where they should not be and into investments/speculations they never before engaged in.
