Gold Is a Bubble

by: Daniel Brawdy, CFA

But you are missing out! You are gonna wish you had bought it when it hits $5000/oz! Gartman said so!

Well, I know, saying gold is a bubble that's like, well ... saying house prices would tank in 2005. Or AOL (NYSE:AOL) was overvalued in 1999.

But people keep bugging me so here are the top reasons gold is a bubble. Like everything stay diversified, so it should be a small fraction of your portfolio. Here's why:

1. It is (not) a good store of value.

2. There is (not) a supply deficit. Supply is tight, buy!

3. Central banks are buying, The University of Texas higher education is buying, so we should too (just like the mortgage backed securities and Greek bonds they used to own).

4. It will protect you against Armageddon.

Let's go through the list:

1. It is (not) a good store of value.

This takes many forms: It's a good inflation hedge. It will protect you against a declining ("debasing") dollar.

A good store of value has two crucial characteristics: It has low volatility (it should not matter when I need to sell it); and it should be a good inflation hedge.

1 (a). It is not a good inflation hedge.

From the end of 1973 to April 2011, adjusted for inflation, gold returned about 3%. Sure, but here is what you had to endure. There are many periods when your "investment" lost 50% or more. You might get 3%. Or, if you bought in 1980 you endured negative returns, until recently.

Click to enlarge

(Click to enlarge)

Well, you say, it's correlated with commodities, which are a good inflation hedge.

There are three problems with this:

  1. Raw commodities are only a fraction of the retail cost of goods;
  2. Even if you wanted to hedge the commodities fraction of your purchase, why would you use gold when there are some good commodities indices out there, tied actual commodities you consume; and
  3. The bulk of your cost of living is tied to housing, healthcare, taxes, education, and other services not correlated to commodities.

Let's look at the evidence.

First, there are lots of costs besides raw commodities in the retail price of goods. Let's take bread as an example. 1 bushel of wheat produces about 42, 1.5 lb. loaves of white bread. So, at $8.50/bushel, there is about 20 cents of wheat in a loaf. So if wheat doubles, a $2.50 loaf might go up 8% to $2.70.

As a result, raw commodities are far more volatile than take-your-pick food inflation index. Here is the BLS CPI-Food and CPI-Energy inflation indices against wheat, corn, oil, and gas prices (year over year % changes).

Inflation is far less volatile than the raw commodities, which ties back to the actual amount in the goods we consume, the fact that producers hedge with long term contracts, and they sell in competitive markets.

Here are some correlations between crude oil prices, natural gas, corn futures, gold.

CPI - All items

CPI - All items less food and energy

CPI - Housing

CPI - Food

CPI - Energy


Crude Oil







Natural Gas







Corn Futures













Year over year % changes, monthly. Data is from 1990 - present. Source: EIA, USDA, World Gold Council.

Click to enlarge

Oil and gas futures – decent hedge against energy inflation. Gold? Not so much! And against overall inflation? Practically no correlation! Wheat and corn futures directly are not great hedges against overall food inflation so why would gold be?

And - there are lots of items in your budget besides food and energy. Gold is a poor hedge against what is likely your biggest expense – housing.

So, some commodities, to a certain extent, can be a good hedge against the most volatile and irritating component of inflation: food and energy. Not all commodities work equally well, and commodities are not a good hedge against housing, health care, and services inflation. Not all commodities are created equal.

But ... if I really want to hedge commodities inflation, why not just pick a diversified index like the S&P GSCI Index rather than gold?

1 (b). It (will not) protect you against a declining dollar.

Oil is a big component of what the U.S. imports, so first see #1. Here is the trade weighted dollar index against gold, both in levels and as year over year % changes. Once again, gold is far more volatile. Click to enlarge
(Click to enlarge)

Whoa! Look at the chart after 2004, when a lot of hedge funds got into gold! From the peak in 2002, the dollar is down 38% while gold is up 400%. Does that mean I should think it's going back down to $407, from about 1500 today?

How about all that safe haven buying when Lehman collapsed? Gold went from $940/oz in Jul 2008 to $761/oz in Nov 08.

Conclusion: A volatile commodity with no yield and no intrinsic value is not a good store of value: it can do down as fast as it goes up. Gold has been a worse inflation hedge than a basket of real commodities like oil and agriculturals. It has been far more volatile than the dollar.

An asset that can go down 20% in any given 6 months and 50% in any year is not a safe haven!

Why do people think it's a good store of value? Because, it's going up!

Remember when the stock market, homes, tulips, we were told, were a good store of value because they never went down!?

2. There is (not) a supply deficit.

See those signs hanging over your favorite jeweler: We pay cash for gold. I can testify – people will even come to your house with a scale and buy it from you. 40% of the supply of gold is recycled gold, and there is plenty of it (about 50% of all the stock of gold is in jewelry)! Outside of jewelry, The U.S. Treasury alone has 8,133 tons, worth about $400 billion dollars. Republicans are calling to sell it as part of any budget deal. As crazy as that sounds, the closer we get to Aug. 2, the more likely it becomes to prevent a default.

So, where is all the new demand coming from? Investors! So: lots of housewives are trading in their jewelry, which gets melted down into coins and bullion. And when investors are saturated ... there is plenty of mine production for jewlery and industrial demand.

Remember: Stocks and housing were in "short supply" at the top of the craze too. When investors stop buying prices plummet.

3. Central Banks, University of Texas, they are all buying.

George Soros is selling! Really, who's your money on? With some exceptions, central banks, universities, and municipal pension funds have a remarkable aptitude for getting in at the top. And, if you buy after they buy, and after Soros sold, who's going to buy it from you?

4. It will protect you against Armageddon.

This one is easy. During Armageddon, your top priorities are food, shelter, and safety. A 12-gauge shotgun and a box of shells covers two of those and can be used to secure the third. And if you do need gold after all, offer your food and shelter and safety to some poor soul with only gold. Follow all laws in your state and take a safety class!

Here's a limited time offer to those worried about Armageddon: I will sell you armageddon insurance which will payable in gold in the event of worldwide plagues, famine, nuclear holocaust, meteor strikes (larger than 1km only), and much more. E-mail for prices, some restrictions apply.

Gold meets all the classic bubble criteria. It trades well above intrinsic value (zero in my opinion, outside of industrial demand); That "It is a store of value" is mainly premised on a ponzi scheme of people continuing to buy. When investors stop buying it will not store value!

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SLV, GLD over the next 72 hours. Please follow all laws. This is not a solicitation to buy or sell securities. I am not a legal or tax advisor and you are advised to consult one. This is not investment advice and any opinions expressed are my own for informational purposes only. All of the content is provided without assurance or warranty of any kind. No warranty of fitness for any particular use merchantability or non-infringement is made.