Gold Bubble: Final Warning?

by: ChartProphet
It has led to murder, war, trade, technological advances, and a way to quantify value. We’ve melted it for coins, worn it as jewelry, and invaded countries for it. And it has been one of, if not THE, most sought-after resource throughout human history. But with Gold prices surging almost 500 percent in ten years, can we really say that Gold is 5 times more valuable and important today than it was in 2000 or 13 times more than it was in the 1970s?

The reasons behind the Gold surge are understandable:
1) Gold has historically been a store of value. Since people will always want more Gold, it can be used as a means of exchange. The more Gold you own, the richer you are.
2) Gold is a tangible asset. At a time when the stability of stocks, derivatives, and other financial instruments are in question, Gold offers a tangible and supposedly “stable” alternative. Gold is a hard asset you can actually hold in your hands.
3) Gold has limited supply. In order to increase the amount of Gold in circulation we have to mine it. And mines are obviously not limitless; there is a specific amount of Gold in the Earth’s crust, and when we deplete all the earth’s Gold reserves supply will cease to grow. And if demand is continuous while supply is limited, Gold prices are expected to keep rising.
4) Gold acts as a currency hedge. As the US Dollar has plummeted and as fears over the Euro escalated due to the uncertain future of the Eurozone’s economy, Gold has been a way to avoid the potential disaster that unfolds if “paper” money becomes worthless. By buying Gold, it is assumed that if world economies fail, Gold would still be accepted as currency.
5) Gold as an alternative to equities. The stock market devastation we have lived through with the 2000-2002 Technology Bubble bursting and the 2007-2009 Housing Bubble collapse, many investors have almost completely lost faith in stocks. But with a desperate need to increase their wealth in order to support their own needs, pay for their children’s education, or fund their retirement, investors still continue searching for some form of investment to do so. Out go stocks, in comes Gold – if stocks haven’t worked, maybe a historically-valuable, tangible, limited, and protective asset such as Gold could.
But while these reasons are understandable, they don’t necessarily support the extent of Gold’s surge. Yes, they do support Gold prices going up. But who says they support a 500 percent move?
Rapid price run-ups tend to diverge from the underlying fundamental reasons for their move. In other words, as people start getting overly excited about a certain investment theme they actually run the price up too far, too fast. Their reasons for excitement may be accurate, but their excitement and the extent to which prices run up are actually getting ahead of themselves. Prices can’t go up forever, and they eventually start to drop. And as more and more people start to realize this, prices plummet faster than before. This marks the bursting of the Bubble that will eventually see prices crash and many people worse off than before. And if Gold is the current bubble, this fate awaits many people now investing in Gold.
So why could Gold be a Bubble?
1) Rapid price run-up. Prices never run up forever; they always come back to stable levels. Gold prices are up almost 500 percent since 2000 and almost 1300 percent since the mid-70s. At some point they have to come back down. When that will happen is still in question, but they will stabilize at some point. And stabilization may involve a quick plunge in prices.
2) “We Buy Gold” everywhere! In the past two years, there have been more “sell your gold” commercials and “we buy gold” stores than ever before. It seems as if everywhere I go or look I see some kind of reference to gold. The prevalence of these stores and commercials not only points to market saturation, but also points to the massive spotlight that has been shining on Gold.
3) EXTREME speculation. A bubble requires investors to be so absolutely certain that prices will continue to rise that they actually neglect to protect themselves from the risks involved. By asking “How high is Gold heading?” instead of “Why is Gold going up?” or “Can Gold go higher?” we’re actually ignoring the downside involved, which can lead to severe panic if Gold actually does start to drop. Here is why extreme speculation is here and very dangerous:

a. Common investors can now buy gold. With the introduction of the Gold ETF (NYSEARCA:GLD), any person who wants to buy gold can easily do so by simply buying the GLD. Before 2004 the only way to buy gold was to buy the actual thing. If gold is available to everyone, and becomes the hot new commodity, a bubble is definitely possible.
b. No hedging by the mining companies. In order to protect their businesses from a sudden decline in Gold prices, mining companies have generally hedged themselves by owning some put options or other forms of derivatives that would limit their losses in case of such declines. And the higher the price of gold, the more dangerous the price decline is for the miners. But because most of the miners think that gold prices are going to continue rising, they have recently stopped hedging themselves. At a time when protection is actually the most important in the history of their businesses, they’ve joined the gold craze and ceased to hedge. This has to be one of the most counter-intuitive moves I’ve ever seen. Hedges are protections “just in case” prices go down; miners seem to have forgetten that “just in case” is a small bet compared to the potential devastation they may be setting themselves up for.
4) Gold isn’t enough! With Gold prices soaring, investors have looked for new ways to take advantage of the run-up. Not only have investors run the price of gold (GLD) to high levels, but they have found ways to leverage their positions and even increase speculation in related metals. First, Gold itself was enough (GLD). Then, when investors wanted increased returns if gold went up, they bet on the gold miners through the Gold Miners' GDX ETF; the GDX moves in correlation to GLD, but with a higher beta (in essence, if GLD goes up GDX should move proportionally higher). Now it seems even the regular miners aren’t enough! Investors are now going even further downstream, betting on the junior miners (NYSEARCA:GDXJ). The junior miners are not only a third derivative bet (Gold-Gold miners-junior miners), but they also signal the extreme belief investors have that prices will continue higher.
And if a third-derivative play in Gold wasn’t enough, investors have speculated in the entire precious metals sector. Since Gold is going higher, they say, so should the prices of related metals. And to satisfy investors’ insatiable demand for these metals, the “Glitter” ETF (NYSEARCA:GLTR), composed of gold, silver, platinum, and palladium investments, was introduced on October 22nd.
And if metals weren’t enough, investors have also chased “Rare-Earth” resources through companies such as Rare-Earth-Elements (NYSEMKT:REE) and Molycorp (MCP). Not only did Molycorp CEO, Mark Smiths, recently “mistakenly” call the Rare-Earth craze a “BUBBLE” (“I don’t think short-term prices in rare earth (minerals) are prices people ought to be counting on…they are really spiked right now and there may be a bubble occurring because of all of the news and the frenzy.”), but the fact that REE and MCP are up about 500 percent and 300 percent respectively since the summer should be enough of a warning.
5) Gold Vending Machines. It wasn’t enough for Gold to be bought at jewelry stores or through distributors directly. They have now built vending machines from which to buy Gold! A German company, Gold-To-Go, has began setting up vending machines around the world in order to attract the average investor. Buying Gold coins and bars from a vending machine? I hear “BUBBLE”!
6) Inflation or Deflation? Gold prices have increased due to fears over currency and economic growth. But buyers of Gold have bought Gold both due to fears of deflation and due to the potential for inflation. In other words, some bought Gold because they expect deflation and some bought it because they expect inflation – but one of the two is wrong! We can’t have both deflation and inflation; therefore, a considerable number of investors are wrong and have pushed the price of Gold up farther than is warranted.
7) Front Page of the Wall Street Journal. When a story makes the front page of a widely-circulated newspaper or magazine, it signals widespread recognition of that story or theme. Since heavily-distributed newspapers and magazines tend to reflect the widespread sentiment of its readers and the general population, a front-page headline signals the acceptance of that idea as consensus.
It’s been a fairly long-standing negative omen for the market when major cover stories marvel at the wondrous bull-market run-ups and, inversely, a positive omen for the market when cover stories mourn the death of markets. That said, positive cover stories regarding investment themes are bad omens, signaling an upcoming pause or correction, if not an end to that theme.
Gold made just such an appearance on September 29, 2010 on the front page of the Wall Street Journal, in an article titled “Gold Vaults to New High.” If a front page spot is a signal of widespread acceptance and a warning of an upcoming correction, the Gold Bubble is alive, but probably not so well.
In conclusion, Gold prices have run up tremendously based on fears over the economy, protection against currency troubles, and as a diversification strategy in investors’ portfolios, but may have formed a bubble that may be peaking due to excess speculation, the lack of protective hedging by both investors and miners, insatiable investor appetite, and the realization that Gold may no longer be as good of a bet as it was until now.
If Gold prices fail to close at new highs within the next few days, expect this to be a short-term peak if not the long-term top.

Disclosure: Short GLD, Long UUP

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