Friday, November 26, 2010

The gold bubble meme

Leon Gettler has a simple and neat summation of global macro today:
The global financial crisis has created two worlds.

First there is the real world of increased job insecurity, growing numbers of long-term unemployed, muted consumer demand and drip-fed credit

And then there is the magical world of bubbles. They seem to be everywhere, from Australian property to Chinese internet, from gold to notes for commercial real estate in the US. A tiny Chinese stock listed on the Nasdaq, China Media Express Holdings, which places TV screens on buses in China and bombards captive passengers with advertisements, has soared since mid-September.

The price of commodities like cotton, corn and soybeans and copper is going through the roof. And the high-risk junk-bond market has returned with a vengeance in the US. Wall Street, always big on grandiloquent verbal evasion, doesn't call them junk bonds: they're "high yield securities".

Bubbles lurking out in the economy are dangerous because they deny reality and suspend laws of supply and demand. When the price goes up, potential buyers pour in, expecting further increases. The combination of greed and leverage leaves markets chronically vulnerable.

Bubbles are created by a herd mentality and all bubbles in history are the same because regression to the magical thinking of childhood does not change. It underpins the belief that markets and those assets will keep rising. The financial meltdown has encouraged this because people are prone to slip into magical thinking in times of crisis.

The only way to make money from bubbles is predicting when they will burst. Their positive feedback systems make that impossible for most of us. I know the balloon I am blowing up or the popcorn I am cooking will burst, but exactly when?

We are now seeing several bubbles that could burst any time soon.

One of the most obvious is gold, which crossed the $1400 mark in recent weeks. The gold price recently slipped with the rally of the US dollar but the Irish bailout this week and the likelihood of the eurozone crisis spreading will keep it high.

Gold is the worst bubble of all. It has no real value. For almost every other asset in the world, the value comes from the cash flow it generates like, for example, the dividend of a stock or the rent from a house, flat or office building. But gold does not generate cash flows. The only thing driving it is fear and greed, the same stuff that drove internet stocks in the late '90s, and left them overpriced. Billionaire George Soros has called gold the ultimate bubble that will burst.

Other bubbles include Chinese real estate, with developers building more apartments than there are buyers.

Another is alternative energy. Think of all the venture capital-backed companies pushing solar and wind power when the economics of alternative energy are still problematic. Few wind and solar energy installations, if any, would make money without government subsidies.

Another potential bubble lies with the emerging markets that are growing wildly even though there's no growth in the world economy. Much of their gains are backed by commodity prices that are also in a bubble.

Probably one of the most alarming bubbles is US treasuries and bond funds. US national debt is now close to $US14 trillion. Treasury bills, basically the IOUs to pay off the money the US government keeps borrowing, are rising because the debt keeps building.

This blogger agrees with the general thrust of the piece, however, it sees things a little differently, basically because its definition of a bubble is also different.

Underpinning Gettler's analysis is the idea that a bubble is any asset the value of which departs from "the cash flow it generates". Ipso facto gold and Treasuries are a bubble.

This blogger defines a bubble a little differently. It is any asset that has departed from fundamental value, not cash flow value.

Fundamental value is a calculation based on a balance between return on capital and return of capital.

In a time of flailing fiat currency, grand monetary experiment in both markets and reserve banks, inflated and unstable paper assets, and global shifts in power, the weighting for 'security' grows against 'return'.

It's the same reason that US Treasuries aren't necessarily a bubble either, though more so than gold. The jury is out because ultimately, the answer to this question depends upon geopolitics not markets.

Don't get this blogger wrong, the gold market is very volatile and could sell off dramatically any time, but the revaluation of gold is cyclical only in the sense that history itself is so. If the you think the US is about to enter a new age of fiscal and monetary discipline, stable prices and unchallenged power then you agree with Mr Gettler.

If not, then you agree with this blogger, gold is undergoing a structural revaluation.

3 comments: said...

"Fundamental value is a calculation based on a balance between return on capital and return of capital."

Thanks for this David. Beautifully simply put. I'll be borrowing this phrase to help clarify my own discussions in future.

The former ("on") infers an underlying motive of Greed (ie, how much can I gain for nothing/no labour). The latter ("of"), a motive of Prudence (how can I preserve what I already have).

Cardinal Sin vs Cardinal Virtue.

Interesting reflection of the present state of business society in particular, that the quoted author (Gettler) views bubbles exclusively through the prism of the former.

I agree with this blogger.

BTW, any thoughts on my question re the SoW challenge?

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