Gold: The Only Remaining Bubble?

 |  Includes: DGP, DZZ, GLD, IAU
by: Alan Brochstein, CFA

I have had a premature or possibly wrong call on gold. While I generate much criticism from and disagreement with the cult of gold regarding my conclusions, I believe that many of them overlook the fact that we share a lot in common with regard to the underlying basis of our views. I know that I tend to be early, and I maintain, for now, that is the case here as well.

I first wrote about gold in October. It generated so much negative attention that I thought I must have been on to something, as I have noticed that the most vociferous opposition to my ideas has often served as a great contrarian signal. In any event, the price plunged afterwards, and I probably got a little overly encouraged. When it rallied back partially, I followed up in early December. Obviously, since then, the price has not only risen, but it has in fact exceeded the price by 10% or so since I first wrote about it. Gold still remains in a consolidation, with lower lows and lower highs over the past year (click on chart to enlarge):


Today, I want to reiterate my views that gold isn't likely a refuge from this deflationary spiral we are entering. I guess it was easier for me to "pound the table" when my arguments looked like they were correct, but the case remains the exact same if not more so given what has transpired globally.

There are two reasons that one might consider owning gold, and I focused primarily on one, the inflationary hedge potential. I believe that the other rationale is what has been supporting its high valuation: Safety. I read today about a gentleman who stored his gold at Stanford Financial, so be careful if you are pursuing this strategy!

Here are my current observations:

  • Gold is in a bubble
  • Inflation isn't happening
  • Gold longs need to be cautious of poor technicals

It is ironic how many financial commentators refer to the "Treasury bubble". It is very unclear that the safety response in Treasuries is any different from that which has sustained the high price of gold (note sustained, not skyrocketed). I have seen no references to the "bubble" supported by evidence of investors margining to buy Treasuries or futures. Gold, on the other hand, appears to be purchased on margin broadly, at least according to the dealers with whom I have spoken. When I have looked at the trading volumes in the double-long and double-short ETFs, it is pretty clear where the speculators are (similarly for the doubles on bonds). I think the crowd is wrong.

The inflation argument is one in which the inflationists are premature if not just wrong. The fallacy in the argument is in just looking at one action without observing the bigger picture. The analogy I like to use is a bathtub. The water is flowing, and the inflationists are fearing that it will overflow. What they fail to realize is that the drain is running even faster.

In real terms, wealth destruction is deflationary. For folks who seem to (rightly in my opinion) not believe that the government can do much to "fix" the problems, I wonder why they think that their efforts will be more than sufficient to do so. Banks aren't lending because the universe of qualifed borrowers is rapidly diminishing. The multiplier effect of the high-powered money that gold bugs fear is falling faster than its creation. Look to Japan as an example in this regard. I believe that rather than inflation, we will see higher savings and higher taxes for quite some time, both of which will retard our economic growth. Down the road, there is also a possibility for higher interest rates too, another growth impediment.

Finally, as I mentioned above, the technicals are risky. The price of gold bounced hard off of support, but it continues to be unable to take out either the highs from the summer or early 2008.

Given the general correlation to other commodities, which are now at rather extreme relationships (oil/gold, silver/gold) at least in recent history, gold could see some mean reversion. There aren't many gains in the world these days, so just as oil surprised us last year plunging from almost $150 to $100 and now $35, we know that the pendulum can swing. It clearly hasn't started to do so yet, but watch out if it does. The fact that there are so many looking to it as a savior, many on margin, suggests caution when (or if) it does turn. As the chart below indicates (click to enlarge), gold is as expensive today as it has ever been relative to a basket of commodities:

Gold v CRB

As I said, I share a great deal of my fundamental views of the economy with the cult of gold, I just conclude differently. There aren't many assets that will stand up to this crisis, and I don't believe that gold, absent its momentum appeal and its (ancient) historical tendencies is an exception.

Disclosure: None