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Gold: A potential bubble

By Daniel M. Ryan
web posted November 23, 2009

During the generally horrific year 2008, there were only two asset classes that were up. The first is T-bonds, which benefited as a safe haven during the financial crisis. As the Federal Reserve lowered interest rates, a further benefit accrued to Treasury securities. The only other asset class was gold.

These two appearing on the same winner's list is paradoxical for an old-fashioned market watcher. Gold is traditionally an inflation hedge. A gold bull market has been indicative of more inflation coming down the pipe. Inflation lowers the real rate of return; to compensate, nominal interest rates rise. Typically, a bond's interest rate is fixed. If the associated interest rate go up, the income stream from a bond becomes less valuable. Thus, when nominal rates rise across the board, the prices of bonds fall. This relationship is somewhat blurred in the corporate-bond sector, as changes in creditworthiness also impact, but it's not for Treasury bonds. Given gold's traditional role as an inflation hedge, seeing both gold and bonds in the winners' circle is as paradoxical as seeing bull and bear ETFs both up on the year.

How Bubbles Are Formed

Experienced investors tend to acquire a basic sense of how markets move. Since the art of investment consists of buying assets that are out of whack on the downside, and selling ones that are out of joint on the upside, there's an incentive to seek and spot those anomalies.

An asset is ripe for a bubble when it gets out of whack on the upside, for a considerable amount of time, and keeps rolling upwards. One reliable indicator of a bubble in the making is normally bullish advisors sending out warning flags - "It shouldn't be this high" "A major correction is likely to come soon" "Irrational" "Historically unsustainable" - and, afterwards, the investment in question making all of those grizzled old pros look like fools. The widely-anticipated correction fails to show up. This confoundment took place in the U.S. real-estate market as of 2003.

A full-fledged bubble, however, needs a "New Era" story to make those historical relationships look misleading. It has to explain why those old pros were fooled. The New-Era story for the 1920s U.S. stock market fell into place in 1924. At that time, it was generally believed that the only investment class was high-quality bonds. Stocks, no matter how solid the underlying companies, were believed to be speculations. That's because a company's earnings fluctuated, and the dividends were only paid if the company had enough (sometimes retained) earnings to justify a payout. Bonds lacked those risks.

Then came Edgar Lawrence Smith with the short book Common Stocks as Long-Term Investments. His data showed that a carefully-selected basket of common stocks not only held up over the long term, but also tended to outperform a similar basket of corporate bonds. The subsequent "New Era" pronouncements, right up to 1929 and even beyond, were elaborations, extensions, and exaggerations of Smith's point. What characterizes a New Era story is its rationale for treating a historically overvalued investment as undervalued; the disjoint is ascribed to an essentially permanent sea-change, or previous veil of ignorance being lifted.

New Era stories tend to emerge when an asset seems permanently overvalued. It makes sense out of the refusal of said asset to fall back to historical norms.

Why Gold May Be In A Bubble

As mentioned above, gold shared the distinction of being one of only two asset classes that were up for the '08 calendar year. Since then, T-bonds haven't done all that well but gold has. As of last Friday, gold closed at US$1150.90 per ounce; as of the end of December in '08, gold was about $900. That's made for an increase of about 27% over the last ten and two-thirds months. In the same timeframe, the 30-year T-bond has fallen in price. In the early part of the decade, one of the push factors behind residential real estate was, in general, that it didn't go down in the 2000-2 recession and did take off in the recovery. This observation was the base for the New-Era financial products that blew up last year and the year before.

Gold's also forged ahead despite a revered gold bull of long standing sending up the warning flag. Two weeks ago, Marc Faber – "Dr. Doom" – warned that gold was at risk for a major correction; this warning, he later rescinded because of gold's continuing rise. There's already signs of complacency from at least one lesser-known gold bull.  And, as the gold price continues to climb, a New-Era rationale is taking form.

This rationale starts off with two solid observations: gold also serves as a crisis hedge, and it tends to move in opposition to the U.S. dollar. Recent central-bank gold purchases, particularly India's, and recent Chinese complaints about the dollar are factored in. All of these put together gives a real New-Era story, which we'll hear more frequently if gold keeps rising: The U.S dollar is losing its reserve currency status, and gold will be (at least part of) its replacement.

Like any good New-Era story, it plausibly explains why an asset class is out of whack. In this case, it explains why gold is ratcheting up despite little to no inflation on the immediate horizon. It also ties in gold's rise with the U.S. dollar's drop, and recent international dissatisfaction with the U.S. government's debt and deficit levels. It's also subject to extension, should inflation reappear, and exaggeration. If gold enters into a full-blown bubble, the above New-Era story will be warped into excited proclamations of the "imminent" demise of the greenback.

Cautions and Warnings

The above prediction is contingent upon gold not being hammered down in the near future. A sharp rise in the U.S. dollar, due to the greenback carry trade being unwound, would knock gold right off its perch. There are still lots of gold buyers pushing gold up because of expected future U.S. inflation. If those expectations don't materialize, then gold could well plummet and return to those historical norms. In that case, it won't sustainably rise until or unless inflation comes back. The conditions being ripe for a bubble does not imply that there will be one: many incipient bubbles never turn into full ones. A major gold-price decline or even serious correction, will render the above nugatory. I can only tell you what colors a gold bubble will be flying under if it stays up and/or keeps climbing.

I should also add that I have a financial interest in gold going up, so the above analysis may well be tainted by my own hopes and dreams. ESR

Daniel M. Ryan is currently watching The Gold Bubble.

 

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