The gold bubble

Ten years ago, when the NASDAQ bubble came a-cropper, this blogger was a day trader. And yes, like many others it took a bath.

It was an invaluable lesson. It offered an inside glimpse of bubble psychology. How a market can dislocate and seize the collective imagination. And how, afterwards, the whole thing appears so outlandish, populated with fallen heros like Chris Tyler of star tech rocket Solution6, which was bought by Telstra in a play to merge it with Sausage Software at the peak of the madness.

Within a few short months, Tyler was on the streets carrying the moniker "Two bags". As the market fell, a previous conviction for pot smuggling in the US had been exposed. He had been caught with two garbage bags of weed.

Such is the lunacy that takes hold in a market mania.

We should juxtapose this, today, with a piece in the FT by Mark Williams, who apparently "teaches finance at Boston University School of Management". In it, he labels the gold bull market a gigantic bubble because:

Historically, two-thirds of gold demand comes from the jewellery industry and from countries like India and China. The remaining demand is generated by investors, manufacturing and the dental industry. But over the last four years, gold has staged a spectacular price rise and won many new investors. Everyone from hedge funds to individuals has jumped in, seeing gold as a way to improve portfolio diversification. Today portfolios often allocate 5 per cent or more to gold. A decade ago such an allocation in sound investment circles would have been heresy.

Market dynamics have changed too, with investors playing a larger part in what is driving prices higher. Now private investors hold over 30,000 tons of gold, more than the entire holdings of all the central banks on the planet. In short, gold fever has arrived on both Wall Street and Main Street. But all fevers eventually break.

The 2010 gold bubble is fuelled by a combination of five main factors: historically cheap cost of borrowing, a prolonged bull market, early profiteers, marketing hype and the risk being ignored. Investors claim that the current market high of $1,380 an ounce is not overpriced, but a reflection of global economic uncertainty, high unemployment and a decline in currency values. Gold is acting, as it should, as a hedge.

Investors also point to the 1980 bubble, when gold peaked at $850 an ounce and plummeted by 60 per cent in one year, as an aberration. Inflation was then over 13 per cent and short-term interest rates were above 16 per cent. Today none of this exists. Gold enthusiasts note the 1980 pre-bust price in today’s dollars and say gold must climb to $2,100 before hitting such dangerous levels. But such logic is flawed in that it assumes that 1980 is a good benchmark for the future. Ignored is the 20-year period from 1980 to 2000 when money invested in gold was dead money.

Today price is increasingly being determined by investors’ insatiable appetite for gold. But what happens when the shine wears off?

After this blogger's misadventures with tech stocks, it spent a lot of time researching what had gone wrong. It concluded that the NASDAQ bubble was nothing more than the latest expression of a deeper problem; that Keynesian US monetary and fiscal policy was being destabilised by a doomsday cycle of increased debt. That meant asset bubbles were now everyday events. It recommended to everyone it knew to buy gold. Generally, it was laughed at.

Since then, the doomsday cycle has only gotten worse, to the point now where it is threatening to engulf the entire world in a trade war. The underpinnings are as clear as day with the US stuck in debt-deflation and having to reverse course on its policies of de-industrialisation (just as we will have to).

The moral of this story is that these are fundamental drivers for the gold price. So far as this blogger can see, gold is the only asset that has such long-term, strategic fundamentals. Look at the alternatives: Housing is laughable, equities and bonds are in a Fed bubble; emerging markets are caught in a trade war, industrial metals are fine but hostage to Chinese GDP growth. Gold is all there is. This is why countries, like the ROK, are revisiting gold as a reserve asset. Back to the article:

Despite their human origins, most bubbles are not easily spotted until it is too late. The dotcom bubble took four years to burst; the real estate bubble six. The last speculative gold bubble, in 1980, took four years to implode, while this latest reincarnation is seven years in the making. This bubble will likely be pricked only when economic outlooks improve and unemployment figures in countries like the US drop below 8 per cent. This might come in 2011, but it could take much longer.

The learned gentleman is right about one thing. Gold will sell off, probably dramatically at some point. It is a very volatile market. But the bull market won't end until US monetary and fiscal policy are cured with discipline somewhere far into the future. Either that, or the $US is replaced by a global reserve currency backed by discipline. A point implicitly acknowledged by Williams:

Unlike previous asset bubbles gold is a tiny fraction of total global investment capital. When the bubble pops, it will represent less than 2 per cent of the world’s total. Those most hurt will be the investors who are the last ones out. These tend to be the smaller investors – just as in the real estate bubble, those who can least afford to lose. However, in the aftermath of the credit crunch we have entered into an era in which global systemic risk is high and unpredictable. Even small events, seemingly unrelated, can trigger larger financial events.

If there is a silver lining to this bubble, when it does go bust, and gold prices plummet, it will be a sign that the global economy has snapped back from economic chaos to prosperity. This will signal job growth, stable currencies, a stop to US Federal Reserve quantitative easing. Then there will be little reason to own gold. In the end, speculators will relearn an age-old lesson: gold in times of financial stability is hazardous to investor health. Like tulips, it is pretty to the eye but does not provide lasting sustenance.

In short, when the great struggle of our time ends, so will the gold bull market. This blog is not holding its breath.

This is not investment advice and this blogger does not hold any investments outside his home and cash.