The Gold Bubble: Why It Just Won't Burst

Includes: GLD, SLV
by: Edward Moseley

There has been a lot of focus on the price of gold recently. Some say it is expensive, or that it is time to sell. Charts have been constructed that pit gold against the Consumer Price Index in an attempt to disprove the market's perception of gold as the greatest hedge against inflation. For several years there has even been talk of a gold bubble. This leaves one to wonder why market leaders like Morgan Stanley claim gold to be the best commodity going into 2013.

While comparing the CPI to certain commodities it is important to note that inflation does not affect all prices uniformly; and by the time the price structure has adjusted to inflation, prices have all been affected in different magnitudes. It is fruitless to ask how a commodity such as gold or silver will trade against the CPI, which is simply an aggregate of various commodities that are themselves affected by inflation in their own unique way. Indeed, at the end of an inflationary period some commodities may even trade below their initial price.

There are sources other than the CPI which may provide a more accurate view of the value of the two commodities considered money over the course of human history: gold and silver. One source would be the monetary base - the sum of cash, coins, and demand deposits in the economy. The monetary base provides a correlation of importance from which information may be extrapolated.

Click to enlarge

This chart of the monetary base shows a trend that more closely tracks the price of gold and silver as seen over the same period. GLD and SLV were clearly stimulated in 2011, after which their value ceased to increase or decrease much further, and they traded sideways to the present day. The peak in the monetary base that occurs in July of 2011, after QE2 had run its course, is interesting as it may correspond to peaks in the value of GLD and SLV around the same time period.

The right side of the text boxes are approximately aligned with the dates they refer to.Click to enlarge

Click to enlarge

(Note: For both charts the right side of the text boxes are approximately aligned on the horizontal axis with the date they refer to)

Currently, GLD is trading above its 200 day moving average and below its 50 day moving average. SLV is trading above both its 200, and 50 day, moving average. It is the opinion of the author that both are fairly priced, and initiation of a position at any point in the near future may be advisable for reasons outlined below.

The Myth of The Gold Bubble

Those who claim that gold is simply an asset bubble lack the necessary economic theory to substantiate that claim. If you ask, "Why is it a bubble?" one may reply indignantly about just how much its value per ounce has risen since 2000, or even 2010.

It is here that we must ask, not "Why?" but, "How has this bubble risen?" In the opinion of the author of this article an asset bubble is marked by credit expansion, and forms when credit is allocated for the purchase of goods. The credit expansion creates an increase in demand for an asset. If credit expansion continues, the asset price may be bid up to very high levels. It is only once the asset begins to become illiquid by slackening demand, be it credit contraction or otherwise, that the collateral is no longer worth the loan. Here, instead of an individual owning an asset and simply losing a portion of the value of that asset, we see both the debtor and the creditor assuming a losing as the collateral no longer covers the loan. In an asset bubble, like in the housing bubble, "collateral damage" occurs.

Keeping these factors in mind, it is unlikely that anyone is taking out loans to speculate in the gold market. There we lose the facet unique to asset bubbles. If, indeed, people were to take out a mortgage on the equity of their homes and use it to invest in precious metals, there would be an indeterminate chance that the investor would hold any combination of shares of GLD, QQQ, SPY, or DIA. The effect is the same, and would simply take the form of a small stock market bubble, as opposed to a particular asset bubble.

One must also inquire as to why a commodity is being purchased. One does not purchase breakfast cereals as a store of wealth. It is precisely the perception of gold or silver as stores of value that set their price (giving allowance for other industrial applications); and as such it should not be anticipated that the price of gold should correlate to inflation as measured by the CPI. The price of gold is set as result of great demand for a commodity that is perceived as having the characteristics of an inflation hedge, and as being one of the most liquid assets available. With this in mind it is clear why, when running a regression of gold returns against the CPI, no correlation may be found. There is a much closer correlation between the expansion of the monetary base and the raise in the prices of both gold and silver. Changes in the CPI are simply the results of inflation; the expansion of the monetary supply is its cause.

So who does hold gold reserves? Central banks. The Bank of Korea recently increased its reserves by 20 percent. This year, as the dollar loses its grip as the reserve currency of the world, central banks worldwide increased their gold purchases from 457 metric tons in 2011 to 493 metric tons. It is the view of the author that central bank gold demand will need to increase if they are to continue to expand their balance sheets. It was recently announced that Latin American central banks have been purchasing more gold.

Now we must consider what would have to occur to burst the gold bubble. Gold would need to become illiquid. However, since gold is one of the most popular assets backing all central banks' balance sheets, it is among the most liquid assets available. Demand for gold would need to decrease. There is no sign of flagging demand, as both India and China's demand are projected to increase in 2013 despite a slightly lackluster year prior. Central banks would need to end their loose monetary policy. It would appear that cheap money is in fashion these days, as The Bank of England decided to hold its interest rate firm at its record low of 0.5%, China added additional capital to its economy, Japan may initiate more monetary stimulus this month, and The Federal Reserve, as part of QE4, is injecting $85 billion into the economy monthly until unemployment is under 6.5%. Investors can expect the loose monetary policy to continue for several years to come.

It is in the opinion of the author that there is no gold bubble. The monetary base will continue to expand across the globe as economies slow and central banks act by using countercyclical monetary policy. Gold will maintain its luster as a commodity money aside from the depreciating Euro, Yen, and USD. In light of the topics discussed above, the initiation of a position in gold or silver could prove profitable over the long term if central bank monetary trends continue.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own physical gold and silver and may further my position in either over the next 72 hours.