Gold's Flash Crash: Bubbleomix Analysis

Includes: GLD, IAU, OIL, USO
by: Andrew Butter

Last week gold was down 27% from its peak. That's called a bust.

If there was a bust, that means there must have been a bubble. Three questions:

1: Is the bust over or is there more to come?

2: What is what Warren Buffet calls the "intrinsic value" of gold today, in dollars?

3: When will gold get back to that value?

According to the 7-Immutable Laws of Bubbles or Bubbleomix, the bottom of a bust is always equal to:

(Intrinsic Value)2 / Price At Top of Bubble

Of course no one agrees what is the intrinsic value of gold expressed in dollars, if they did you wouldn't get 25% swings in less than a year, unless that changed a lot over a year, which is unlikely.

Put that another way, if $1,325 was the bottom of the bust and $1,800 was the top of the bubble, then the intrinsic value, or what International Valuation Standards calls "Other Than Market Value," is the square-root of those two numbers multiplied together, i.e. about $1,550.

That's the number the gold price, in dollars, ought to be heading back to over the next six months to a year (if) $1,800 was a bubble (and) $1,350 was the bottom of the bust.

But how can you tell $1,350 was the bottom? Some experts are saying gold is headed down permanently.

That's the thing, bottoms happen when the sellers dig their heels in and stick. It doesn't matter if there are no buyers or hardly any, and if no one wants to sell then the price sticks. A bottom is not when the buyers flood in, it's when the sellers stick.

So did the sellers start to stick? If they did then that's a sign of a bottom, as in when the numbers of transactions falls below the trendline.

This is the story on the ETF GLD, which may not properly reflect the market, but at least there is data on volumes:

Click to enlarge

My take on that chart is that from September 2007 to September 2011 the market for gold was logical. Buying interest went up, big falls in price by up to 5% in a week were typically preceded by a previous (recent) jump. In September 2011 transactions started to fall, what that means is the price is sustained by sellers holding, rather than buyers coming to the table, which suggests the action early 2011 might have been the start of a bubble, as in when price departs markedly from the "fundamental," whatever that is.

Support for that idea is because about that time the price of gold was expressed in oil, and went ballistic. Personally, I'm coming back to the idea that the best marker for the price of gold is indeed the fundamental value of oil. Of course one can debate endlessly what that is. Personally I reckon it's about $90 Brent these days.

The recent drop was not preceded by previous recent jump; that has the hallmark of a bust down from a bubble. One piece of bad news however for anyone with gold is that the volumes still didn't settle down to below 10 million a week (on the GLD ETF), until they do what's happening is a bust-in-progress.

So (if) early 2011 was the start of a bubble, (then) the right price is now about $1,550 which means that at $1,800 gold was 15% too expensive, which means that the bottom of this bust is going to have to come in at about $1,350, according to Farrell's Second Law.

In other words it looks like my elegant theory linking gold price to U.S. Treasuries outstanding was probably wrong and the best benchmark for the fundamental value of gold is the fundamental value of oil. And sometime in the next year or so gold is going to edge back up to about $1,550.

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. I have no business relationship with any company whose stock is mentioned in this article.