When one of my readers at Plan B Economics asks me if gold is in a bubble, they usually refer to gold's appreciation in terms of U.S. currency. What many don't realize is that the value of gold priced in U.S. dollars is based on two things: 1) the movement in the fundamental value of gold caused by supply/demand, and 2) the movement in the value of the U.S. dollar. (I specifically use the term 'value' because gold's price in U.S. dollars is the ratio of these two 'values'.)
In theory, the value of gold could remain constant while the value of the U.S. dollar diminishes, thus increasing the price of gold. In fact, the value of gold could even fall, but the U.S. dollar price could still rise if the value of the U.S. dollar fell further.
As most are aware, the U.S. dollar has lost significant value over the past decade. The following chart illustrates the decline of the dollar on a trade-weighted basis:
Many people forget this, but currency devaluation is a big component of gold’s performance – just look at the chart below that compares the hyper-depreciating German mark against gold during the 1920s. Gold’s value at that time, in German marks, was almost entirely driven by the depreciation of the mark (caused by hyperinflation). Was gold in a bubble during Germany's hyperinflationary episode? Or was the gold price in marks simply a reflection of the mark's destruction?
[Click images to enlarge]
Fast-forward to today. Since 1999, gold has appreciated by 539% in U.S. dollar terms. This sounds like a lot, so it's reasonable for my readers to wonder if gold is in a bubble.
But looking at the trade-weighted value of the U.S. dollar in the first chart, it is clear that a large portion of gold's appreciation has been influenced by dollar-depreciation.
Isolating Gold's Returns From the Effects of the U.S. Dollar
What if, over the past decade, gold were priced in something other than U.S. dollars, such as foreign currencies, units of medical care or barrels of oil? The chart below shows gold priced using various assets, and it is clear that gold's gains over the past decade are highly dependent on the denominator used in the pricing equation. To illustrate the denominator's effect, here are some samples from the chart:
Gold appreciation relative to the US dollar: 539%
Gold appreciation relative to the Canadian dollar: 309%
Gold appreciation relative to units of education: 233%
Gold appreciation relative to barrels of oil (West Texas Intermediate): 40%
This variability illustrates that gold's U.S. dollar price appreciation is in fact highly influenced by the value of the U.S. dollar.
Bottom line: For American investors to be bullish on gold is to be bearish on the dollar, and vice versa. A bubble in gold is theoretically possible if enough investment flows into the asset, however retail ownership remains very low. On the other hand, if gold's price appreciation is primarily caused by the depreciation of the asset by which it is priced - in gold's case, the U.S. dollar - a bubble doesn't exist leaving gold's price further room to rise.
Disclosure: Author is long gold bullion.