Why Gold Is In A Bubble

 |  Includes: DGL, DGP, GDX, GDXJ, GLD, IAU, SLV, UBG, UGL
by: Retired Aviator

Sources used in research for this article include reports of the World Gold Council (WGC) and the U.S. Geological Survey (USGS). WGC is a consortium of large, global gold mining companies, with the explicit mission statement "to stimulate and sustain the demand for gold and to create enduring value for its stakeholders." I therefore tend to favor the USGS reports as an organization with no particular bias for gold promotion. Both WGC and USGS prepare gold reports drawing on data from GFMS, the authoritative source for worldwide gold sector data. (www.gfms.co.uk/index.htm)

As I wrote this in October 2010, gold was at a record high above $1350/oz. and silver was surging to a 30 year high of over $24/oz. Even good friends are now ribbing me that I must be wrong on the precious metals. But I'm not. First, I never predicted at what level (or when) gold or silver would peak. These are simply a function of how much foolish money pours into these metals markets and for how long. We know from the real estate bubble and the tech stock/dotcom bubbles that prices can snowball irrationally for years. Second, they are confused about the title of my book which is about inflation, not gold. Its title is "Debunking the Hyperinflation of Peter Schiff and the Gold Bugs." The book debunks the gold bugs' popular fallacy that runaway inflation must be coming. The gold bulls are dead wrong on hyperinflation (or even abnormally high inflation) and that's where they'll run into big trouble. Absent the high inflation they're expecting, sooner or later gold will fall. But regardless of how the inflation question ultimately plays out, let's take a step back from the excitement over gold's momentum and have a dispassionate look at gold's supply/demand and investment fundamentals in this two-part article. Part I addresses the gold/inflation question and gold's investment psychology, while Part II, to follow, will delve in detail into global gold supply and demand facts and trends to extrapolate the future. Shorter term, I admit that gold could go significantly higher, but five or ten years out I see gold at below $1,000 USD per ounce. I think a fair value today is actually $500-$700 an ounce.

I was actually a gold and silver bull from about 2000 to 2004. Believe it or not, silver was then just $4 to $5 an ounce, a no-brainer 'Buy', and gold was under $300. I would excitedly tell investors that they could buy scarce, century-old gold coins containing nearly an ounce of pure gold for $275 -- barely any premium over the lowball melt value at the time. They all yawned. Later when stocks had languished for several years and gold had nearly tripled to $800, some of these same people became interested in buying gold. They had it backwards. They violated the most basic maxim of investing, "buy low, sell high." They only got interested once gold was high, because gold's big move was in the news and on the tongues of so many. Gold was getting hot.

Gold and Inflation - The Great Disconnect

Some say gold and silver have risen as a direct result of the inflation being created by the massive government spending and debt. But that's not true. Gold and silver have both quintupled since 2002 with no unusual inflation so far in sight. They've continued to rise only because more and more people (especially central banks and many big money managers) have been climbing aboard the precious metals bandwagon. Some of them are convinced that paper money's proliferation must end in runaway price inflation, so for them precious metals are simply the logical exodus from the depreciating paper. Some just view metals as safe since they've performed so well in the last decade while other investment classes have floundered. Others just jump in on the price momentum. And so, since 2002 gold and silver have both quintupled in price.

Therein lies the problem. Gold and silver prices have quintupled in eight years while consumer prices in general have gone up only modestly. Sure, certain volatile commodities, energy and food are up a bit more than usual for an eight year period, but average prices generally -- from apartment rentals to clothing to dining out -- are little changed from several years ago. [CPI is up 21.3% and PPI is up 29.3% for the 8 year period; just 2.5% and 3.3% average annualized, respectively.] Of course many prices haven't risen at all and some have even gone down. Where's the big inflation accompanying the metals' run up? Where's the plummeting purchasing power of the dollar? It's a no show. That means that precious metals prices are way ahead of today's inflation reality. That makes precious metals, based on fundamentals, a lousy buy, even if inflation does in fact heat up. The metals are far less attractive and more risky at these prices than their buyers think. Here's why:

Less to Gain and More to Lose

Two possibilities exist: I am right that high inflation will simply not materialize, or I am wrong and we'll have skyrocketing prices of everything. In either scenario, buying gold or silver today is a bad move compared to other choices. Since gold and silver have already had a huge run up while consumer prices in general have not, gold and silver buyers today stand less to gain and more to lose than they would by plowing their dollars into other durable hard assets that have not yet had any run up. In other words, if you want to get out of paper money and into physical assets as an inflation hedge, buy stuff that hasn't yet inflated rather than gold or silver, which already have. Perhaps buy a fine musical instrument or maybe that antique car you always wanted. Home prices are down 25-50% compared to 3 years ago and mortgage interest rates are at all-time lows. It makes little sense for a potential homeowner with a down payment saved to instead invest it in gold at an inflated $1350 an ounce. As always in investing, get bang for your buck and buy things that are underpriced so the math works in your favor.

Consider two investors: one bought gold early at $300/oz. and the other one is buying today at $1350. The buyer at $300 earns an additional fat 33.3% return for every $100 that gold rises. With spot at $1350, he's already got a quadruple-plus on his investment. If it goes to $1500 it's a quintuple; at just $1800 a sextuple. But the investor buying at $1350 only earns a measly 7.4% return for every $100 gold rises beyond the $1350. For him to just duplicate the four-bagger that the early investor already has, gold will have to soar wildly to over $5400. The math is simply lousy when you join the party late, even if gold's price does move your way.

But what if inflation never heats up and so eventually gold settles back down well below $1000, as I am sure it will? The early investor will still be sitting on a hefty profit while the late one will have a permanent loss. So the risk/reward picture gets worse and worse the higher the buy-in price. The more you pay, the greater the likelihood of losing money and the less return you gain from any upside price moves. A gold buyer at $2000 would need for gold to reach $3000 just to make a 50% gain. An additional thousand dollar move would be a vast territory to cross for just 50% upside. It took eight years for gold's first thousand dollar move. And wouldn't you be nervous waiting and hoping for $3000, sitting on a single, little one ounce gold bullion coin for which you paid a whopping $2000? This increasingly lousy risk/reward picture at ever higher buy prices is one reason why the latecomer buyers become skittish and bubbles always crash. Many set 'stop loss' sell orders that when triggered can cause an avalanche of selling and the price to cascade further. The real question is, "What price per ounce for gold constitutes a "bubble", and at what price does gold ultimately stabilize once the fear of dollar-collapse Armageddon has faded?"

My thesis: Gold at $1350 is already much too high based on:

(a) the runaway inflation/currency crisis theory being incorrect;
(b) gold's lack of income or growth and
(c) the immense gold supply overhang that will increasingly be available to the gold market the further the price of gold may rise.

Point (a) is too lengthy to discuss here, though I address it in depth in my book, so I'll move on to point (b) and Part II of this article will delve into point (c).

Zero Growth or Income -- Guaranteed (b)

How would you like to own a stock where the underlying business is guaranteed to never have any revenue, earn a profit, or grow any larger? Such is the case with owning hard assets such as precious metals. This is a fundamental reason why investment metals' prices should remain relatively earth-bound. Some other investments such as growth stocks can justify geometrically climbing prices due to their great upside potential in the form of business growth and growing income. But a 1 ounce gold or silver coin generates no income and it can never grow any bigger than an ounce. Your only hope is to sell it to someone for more than you paid. This should give you some pause when you shell out $1400 for a little one-ounce coin. Are you really sure someone will one day pay you $2000 or more for it and make it worth your while? Really? Who? With zero growth or income, gold is only a safe investment when it is clearly underpriced. Otherwise it is just a trade. They tell you gold is a "safe haven" to store your wealth, but if you buy near the peak and then the gold price falls, that's no safe haven.

Disclosure: No positions. If gold continues to rise, at some point above $1500/oz. I will short GLD.