I recently read an article that tried to claim that by Niall Ferguson’s definition, Gold is not a bubble – and that if it is a bubble, one should keep buying because we are most likely in the early stages. I was unfamiliar with Niall Ferguson’s definition, but upon closer review, I think that by his definition one could conclude that gold most likely is a bubble.
In his book, The Ascent of Money, Niall Ferguson distills the formation of bubbles into five stages:
- Some change in economic circumstances creates new and profitable opportunities.
- Euphoria sets in, whereby rising expected profits lead to rapid growth in share prices.
- The prospect of easy capital gains attracts first-time investors.
- The insiders realize that the now-exorbitant price is unsustainable and begin to take profits by selling.
- As share prices fall, the outsiders stampede for the exits at once, causing the bubble to burst.
So, let’s go through the events of the last several years and see how they fit in to the framework.
STAGE 1: The US and Global economies enter a recession after a Real Estate Crisis in the US. Investors flee "risky" assets and seek the safety of Treasuries and Gold.
STAGE 2: The price of Gold nearly doubles from the Fall of 2008 to December of 2010.
STAGE 3: Over 1 million NEW investors enter the Gold market through ETFs. The ETFs grow to become the largest private buyers of gold in the world, and hold more gold than all holders save 4 central banks: The US, Italy, Germany and France.
STAGE 4: Since Gold peaked on 12/7/10, the assets of the GLD ETF (NYSEARCA:GLD) have been declining. Around 550,000 ounces of Gold (~$800 million dollars worth) has left the trust from 12/6/10 through 12/31/10.
STAGE 5: ?????????
There are many other ways to define a bubble, and the five stage criteria are not a divine edict that must be religiously adhered to. But I will argue that if one does follow Niall Ferguson’s definition, the real question does not seem to be whether or not Gold is a bubble, but when Stage 5 begins. With the US economy continuing to improve and China taking steps to reign in inflation, my bet is it could be sooner than we think.
Disclosure: I am short GLD.