Wary of the New Gold Rush

No doubt about it: gold is the flavor of the day.

Everybody is buying gold, from macro hedge funds to retail investors. Gold prices seem poised for an endless increase. What is the limit? $1500 an ounce? $2000 an ounce? The market sentiment is as bullish as can be.

Well, does it remind you of something? Have you heard the word bubble before?

Personally, when I see everybody buying something, I would refrain from doing so. Once there is a shift in market sentiment, this could unleash considerable bearish forces.

Let us review the reasons that may drive gold price higher.

1. Gold is a good hedge against inflation

This not entirely true. It is true for periods of hyperinflation or stagflation as in the 1970s. But historically, gold has performed poorly as a hedge against inflation in periods of mild inflation (1945- 1969 and 1982-2009) as the chart below shows.

Source : inflationdata.com

Hence, if you really believe in hyperinflation then you SHOULD buy gold. But if you think, like me, that this fear is largely overdone, then you would do better to think twice before rushing into gold.

With sluggish growth ahead in the US and elsewhere in the developed world, I don't see the prospect for "core inflation" (purged from volatile commodity prices) to rise higher than the 2% - 2.5% range implicitly targeted by the Fed. This is a great deal short from hyperinflation!

If private demand does not pick up with all this massive deleveraging going on, I am more worried about the potential for a protracted deflation and a Japanese "lost decade" scenario.

2. Gold is a hedge against dollar weakness

True. Gold may be seen as the ultimate store of value. But if you believe, like me, that the dollar will eventually rebound in the next 3 to 6 months (this would be the case if the Fed, despite its current wait-and-see approach, raises its policy rate before the ECB, somewhere between March and June 2010), then you should not be so bullish about gold.

3. Gold is a hedge against uncertainty

Half true. Gold could be a hedge against policy uncertainty but this will eventually recede for the reason indicated above: monetary policy normalization.

4. Gold is a pure monetary asset

Less true than before. Gold is affected by supply-demand dynamics. After all, gold is nothing more than a commodity as "precious" as it is. From the supply side, the investments made in the pre-crisis years by the major gold mining companies could increase capacity by a substantial amount in the coming years. From the demand side, rising demand from India and other developing countries is likely to be a temporary phenomenon. Women in rural India buy gold because the financial system is still underdeveloped over there (only 20% of the people have a banking account in India).

5. Technical factors support gold

This may be true in the short run. Technical analysis is indeed a powerful tool for predicting market movements at short horizons (10 to 20 days). However, technical analysis is no guide for the long term. Fundamentals will eventually prevail.

All that said, I still agree with gold bulls that the upward price trend could probably go on for some time (maybe for 2 or 3 months), until the Fed finally decides to "get out of the woods" and states clearly its exit strategy, which I believe will not be very different from previous recessions.

But I don't buy "the gold rush" story. Eventually all bubbles crash. The current gold bubble is no exception.

Disclosure: No positions

Comments

[Raybee:]

A gold bubble ? I don't understand the near hysteria regarding a move of 15% -20% in the gold price from the $900 level to the $1050 level in the past year ! This is particularly confusing considering the known structural weakness in the monetary systems throughout the world. A bubble ? Yes, some short term profit taking could occur but the " bursting of a bubble " no way . I just think that those who are missing this move are in panic mode. On an inflation adjusted basis gold is way undervalued . The critics even cite gold as underperforming inflation ! Can you have it both ways ?

Oct 08 08:41 AM

[User 497469:]

This is one of the dumbest finance articles I ever read.

Oct 08 09:08 AM

[coolrider:]

Again, this so called "expert" misdefines inflation. Inflation is a monetary phenomenon, not a pricing phenomenon. Just because prices are not rising does not mean that inflation is not occurring. Simply put, inflation is an increase in the money supply over and above the GDP increase, and that is certainly happening and will continue to happen for many years to come with the deficits that are being projected. That means we are already in an inflationary spiral and that prices (which are just a symptom) will follow and the value of the dollar will continue to decline. I do not see hyperinflation but do see 15-20% inflation similar to the 1970's. In that scenario, it appears that Asia will be the next economic growth region with solid currencies and plenty of latent demand, not to mention the trends in Asia toward freer economic policies (human rights notwithstanding). I am one of those economist that does not see a deflationary future, but does see the U.S. economy being severely damaged by current spending trends.

Oct 08 09:44 AM

[Kristjan Ve...:]

I don't know why you even bothered writing this article. You clearly don't know what a bubble looks like. Right now, we're in the point where everyone is talking and writing about gold, but how many are actually buying? And many actually hold physical gold? It's the big players that are doing most of the buying, not your average cab driver. They will be the last ones to the party and buy gold once it hits several thousand (will it be 5000 or 150000 is up to Banana Ben). If, that is, they still have the money to buy gold after they have lost everything.

Oct 08 10:22 AM

[tedfoo:]

I know we're not in a gold bubble now. I see 5 articles this morning telling me we are in a gold bubble. I'm told by many investors that gold is going to crash. This is certainly good news. Keep it coming guys, drag some retail short top pickers in with your bedlam.

I'm an amateur technical analysis guy, but I see nothing but a healthy chart. Gold is screaming north because of a year of consolidation and now a breakout has occurred. Sure a down move may occur, but it won't be because of a popping bubble, it will be a healthy correction. That's something stock market hasn't had since March. And you're telling me it's gold, not stocks, I need to be wary of?

Oct 08 11:36 AM

[JeffDB:]

But everything is predicated on your prediction that:

"But if you believe, like me, that the dollar will eventually rebound in the next 3 to 6 months..." seekingalpha.com/artic...

and

"monetary policy normalization."

and

"the Fed finally decides to "get out of the woods" and states clearly its exit strategy, which I believe will not be very different from previous recessions."
---

Maybe those things will happen, but they are far from certain in my opinion.

The U.S. is still running a trade deficit, massive fiscal deficits - 3 times last year's, and an enormous debt, and we're still in the throes of "The Great Recession".

Are they really likely to raise interest rates soon while unemployment approaches double digits and is still climbing? Under our prior definitions of unemployment, we'd already be in double digit territory.

Higher interest rates would also hammer the banks even as they struggle to stand as it is, and record numbers of which have already gone bankrupt and many hundreds of others are "zombie banks" which just haven't been declared dead yet. and the FDIC is essentially out of money. and commercial loans are already in crisis mode, raising rates as their interest rate resets come due could be disastrous there as well. and the government is holding at least hundreds of billions of mortgage backed securities so another round of defaults there would pile even more IOUs onto the deficit heap.

Your prediction on the Sept. 20th article you linked to, e Dollar: A Strong Buy, about the U.S. economy being the most resilient, the first to recover, and the first to raise interest rates doesn't seem likely to pan out, given Australia's recent interest rate hike, and I'm skeptical of these predictions as well.

Oct 08 12:43 PM

[liber:]

"Women in rural India buy gold because the financial system is still underdeveloped over there"

lucky for them

I buy gold because the financial system is overdeveloped over here!

Oct 08 04:18 PM

[frdm45:]

Even though his points make somewhat sense, and they are based on flawed assumptions and faulty reasoning, I have one sentence for the author: "China is pushing its citizens to buy gold and silver". This one FACT alone will dramatically change any supply/demand/intrinsic value assumptions we have about gold and silver. I won't even bring up US dollar reserve currency issues.

Oct 08 07:59 PM

[wdhalgren:]

I see from your disclosure that you have no position in gold. So why are you wary? Worried that the gold rise will endanger the real bubble, paper asset prices that have been selectively targetted by trillions upon trillions of new issuance from the federal reserve?

Well, it's been clear from the outset that Bernanke could not control the consequences of his malfeasance. The move in gold isn't a bubble, it's a perfectly rational response to the destruction of global fiat currencies, particularly the US dollar. You should brace yourself for a lot more "wariness" by the time this all plays out.

Oct 08 08:20 PM

[Mr. Ed, Jr.:]

We are nowhere close to being in a gold bubble.

When you start to tire of every nitwit local reporter interviewing everybody in your town about gold, when every conversation seems to include the terms "spot price" or "take delivery", and when the coffee shop waitress is giving advice on the best way to buy and store gold, which vault offers such and such advantages, blah, blah, blah.... then we will be in a bubble.

Oct 08 08:30 PM

[KBowen7736:]

" After all, gold is nothing more than a commodity as "precious" as it is. "

Did it ever occur to you that if gold was not a monetary asset then why do Central Banks around the world bother with it? You should study a bit of history about how our country transitioned into paper currency from the days of gold minted coins and bags of gold dust being used as an exchange medium. You will quickly see that gold was always held at the bank in reserve to redeem any paper that was exchanged.

Oct 09 09:24 AM

[ducat:]

The comments on this article make an otherwise "bunch of hunches" an extremely worthwhile read. I wish the author luck in his next attempt to diss the gold market. As some here have already recommended, a good study of the history of money and gold would really help.

Oct 09 05:02 PM

[Tony Daltorio:]

Another in a string on nonsensical article from this so-called investment expert........

Oct 10 01:14 PM

[Rizzle:]

It's so funny... a bunch of gold bugs going apeshit because this guy wrote a piece calling gold a bubble. Gold has quadrupled in value in roughly 10 years. But it's only doubled in value in 20 years.

I'm not going to debate the "logic" of what will happen. We will all wait and see won't we. The same gold bugs probably can't consider that the increase in government money is dwarfed by the decrease in the monetary value of the private sector. Economics is just like religion in most respects. Religion with a front of scientific precision.

Nov 02 11:35 PM