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Gold in a Bubble?

GOLD - 2005-2011
Chart created using Omega TradeStation 2000i. Chart data supplied by Dial Data.

It seems that every time gold makes an important high followed by a sudden collapse the comments that the gold bubble has burst dominates the commentaries. The problem with making that comment is that every time following what may be a sharp correction gold has moved on to new highs. Over the past decade no previous year's low has been broken by any correction, usually a good sign that the market remains in a bull market. And until that occurs, while the bubble people may ultimately be right, gold can go a lot higher before the final peak is seen.

The "gold is in a bubble" has great cachet for news commentators. A quick check found the following commenting about "gold is in a bubble" either in written articles about or noted by well known commentators and financial institutions over the past few months: New York Times, Business News, Forbes Magazine, Mad Money's Jim Cramer, Nouriel Roubini, Money Watch, CNBC, BNN, Financial Post, Financial Times, George Soros, MSN Money, Wells Fargo Bank, Paul Krugman and many more. Grant you, some acknowledged that while gold may be in a bubble it could still go a lot higher.

A bubble normally occurs when prices are driven well above their value in relation to some method of valuation. Unlike a stock, however, gold is difficult to value. The current shift to gold is being largely driven by a collapse in confidence of fiat currencies all around the world. Gold, with a 3,000 year history of being money is acting as a safe haven and a store of value. A bubble can be considered irrational. Owning gold, a store of value, as an alternative to fiat currencies that are falling in value, however, could be considered to be quite rational.

Fiat currencies have no barrier to supply as governments around the world can effectively print money to whatever amount is required. Gold on the other hand takes years to go from the first drill in the ground to an actual producing mine. A majority of exploration projects are never realized as producing mines. Gold is not so much rising in price as it is that fiat currencies are falling in value and purchasing power. It is estimated for example that the US$ has lost over 90% of its purchasing power since the world came off of the gold standard in August 1971.

In February 2011, Sprott Asset Management wrote an article entitled "Debunking the Gold Bubble Myth" - Markets at a Glance. Sprott knows that any comment about gold being in a bubble should not be taken lightly. When the bubble bursts the fallout can be quick and carnage wide spread. Speculative frenzies of the past such as the South Sea Company, Tulip mania in an earlier time or the late 1920's Dow Jones Industrials all ended with either being wiped out or a 90% decline.

The trouble with "the gold is in a bubble", is that far from gold being heavily owned, it is actually under owned. Sprott noted from Gold Yearbook 2010 by the CPM Group that in 1968 gold held for investment purposes represented approximately 5% of global assets. Even by the peak of the gold bubble of 1980 that had fallen to roughly 3% of global assets. Gold held as an investment fell even further that by 2000 it represented a mere 0.2% of global assets. By 2010 after 10 years of a gold bull market that had only increased to 0.7%.

Naturally, these numbers can be somewhat misleading as it does not take into account gold derivatives. The trouble with gold derivatives (futures etc.) is that it is not real and it would only become real if someone took delivery of a sizable amount. Trading in gold derivatives can quickly surpass all of the gold in the world in only a few days. An impossibility if it was real gold but in the never never land of derivatives it is normal. Trading in derivatives can give off misleading signals as to what is really going on. Changes in margin requirements seen of late are causing some of the recent volatility. In the physical gold world, demand remains good particularly as central banks are now net buyers and gold for investment remains robust; particularly for coins and bars which are usually trading at a premium to the spot price. Supply meanwhile struggles to keep up with demand.

On the note of gold as an investment in gold coins and bars, a recent study on U.S. Mint gold eagle coin sales has suggested that given the current price of gold it is not indicative of gold in a bubble. Gold coins are usually bought by people not so much for capital gain or short term speculation, but instead they are purchased by collectors and those seeking a store of value. The market for gold coins and bars is not very liquid so it is difficult to hold them for speculation. Annual demand for gold eagles has been growing even if today it is below some previous peaks seen in 1986-87, 1998-1999 and 2009. According to the study gold coins are not necessarily a good indicator of froth in a market. As the gold market goes into a bubble, demand for coins may actually fall as investors move swiftly into the most liquid instruments such as futures and ETF's. One would be better off following the Commitment of Traders (COT) report put out weekly by the CFTC. By the COT measure, sentiment for gold remains lukewarm today. (See article "If you're looking for bubbles, don't look at gold coins" Constantin Gurdgiev - Globe and Mail, September 7, 2011).

It is estimated that the world's financial assets approximates $200 trillion. Even with gold at $1800 all of the above ground supply of gold held by central banks, private investors and as jewellery only approximates $8.7 trillion in value. Private investors hold roughly $1.7 trillion worth of gold.

One way of comparing today's market is to look at the gold bubble of the late 1970's and the NASDAQ high tech/internet bubble of the late 1990's. Their charts are below. The best comparison is to compare gains from various lows seen in 1976, 1996 and 2006, important lows in 1978, 1998 and 2008.

% Gains From
Lows In Year Ending in 6 to the top Lows in Years Ending in 8 Seen Late in the Year to the top Lows 6 months prior to the top
Gold 1975-1980 741% 344% 189%
NASDAQ 1995-2000 360% 238% 85%
Gold 2005-2011 230%* 162%* 42%*

* to the current top Source: Various

GOLD 1975-1980
Chart created using Omega TradeStation 2000i. Chart data supplied by Dial Data.

NASDAQ 1995-2000
Chart created using Omega TradeStation 2000i. Chart data supplied by Dial Data.

The current gold bull market lags considerably its two bubble peers. While the gains in gold have been stellar to date, they pale in comparison with the gold bubble of the late 1970's and the NASDAQ high tech/internet bubble of the late 1990's. The Sprott paper also looked at gold equity financings in 2010 compared with high tech/internet equity financings in 2000. Gold financings in 2010 represented barely 5% of the financings seen in the high tech/internet market of 2000. They also looked at mutual fund flows in the US into precious metals funds vs. the total flow into mutual funds from 2000 to 2010. The flows into precious metals funds represented less than 0.5% of all mutual fund flows during that time period.

There is very little to support the thesis that "gold is in a bubble" about to be burst. It is under owned as an asset class and the flows into precious metals and financings do not support the premise that gold is in a bubble. Gold has had stellar gains in the past decade as have the precious metal stocks and they have considerably outperformed bonds and the general stock market as an investment. If there is a bubble, it has yet to be found except in some people's imagination.


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