Is Gold In A Bubble?

Includes: GLD
by: Thomas Noon

Last week, Wells Fargo (NYSE:WFC) issued a "Gold Bubble" warning and this week, the WSJ headlines screamed "Gold Rally Hits a Wall".

The Wells article gave no reason for gold prices to be mispriced -- other than the concern that people will sell in panic if prices go flat or decline. So, a decline will lead to further declines? And, this rise is only being caused by the rise itself? “Investors in gold are hoping that other investors will come along to bid up their holdings in the future,” Wells Fargo says.

Wells knows what the worldwide "hopes" of gold buyers are -- and sellers? So, the majority of gold holders are only holding it for a higher price? Once again, the basis of a call for a decline is "it has risen this far, therefore that is too far". I cannot accept this as real analysis; it just doesn't dig deeply enough into the "why" and "who" of the question.

"With very little warning, the bottom can drop out on gold prices very quickly. For example, during six short months in 2008, gold lost more than 30 percent of its value," Wells Fargo says. But, Wells fails to explain that, while gold fell from $1000 to under $700 in 2008, it was due to a temporary market panic on all stocks, commodities, bonds of unprecedented historic proportions (other than the 1929 stock market crash).

Here is another well-written retort to the Wells article that appears to refer to my earlier article, The Gold Suit Index. The WSJ article just reported the facts of the recent fall, offering no real analysis or reasoning for it.

As I've written many times before, gold's "price" is really gold's exchange rate with the U.S. dollar -- i.e. how many USD does it take to buy an ounce of gold? In the time that gold has risen 90% in USD.... (April 1, 2009 to August 15, 2011), the exchange rate from Swiss francs to USD has fallen by 35% (1.25 CHF per USD to 0.80 CHF per USD). So, using the Swiss franc as one baseline, gold has risen in Swiss francs 48% since April, 2009 and the USD has fallen 35% in Swiss Francs and so gold in USD has risen 90% ($900 vs $1820 as of Aug 26 at 1PM PT).

But, then, we must be aware of the assumptions. For instance, it cannot be said with absolute certainty that gold was correctly priced (relative to all paper currencies) in April, 2009 at $900 USD or at 1,035 CHF. Could it have been underpriced at that point because it was oversold? After all, it had been up to $1,000 shortly before that and it possibly still hadn't recovered fully from the beating that all things financial took in the fall of 2008 when gold fell from $1000 USD to $690 or so. Certainly, this tends to happen with all other currencies (including gold and the Swiss franc), i.e. the apparent mispricing of exchange rates for both short and long periods.

So, why the rise to $1908, why the recent fall to $1740 and why is it recovering again back up over $1820 at this writing -- or is that another dead cat bounce? Herein lies the point of this writing: The "price" of gold is truly only the exchange rate between gold and other currencies. I purport that, since around 2004-2006, the true exchange rate has been slowly becoming more clear and that, before that, there were too many obstacles to all of the potential buyers and sellers finding one another and being capable of doing a market-clearing transaction....and that now for the first time in history, they are being given that ability through new technologies.

What is the real exchange rate when the transaction cost is material to the price at which things are being traded? What is the market-clearing price when the ability for world traders to make a market is clearly hampered by time, distance, regulations, or lack of information? When 90-99% of all possible trades and 50-60-85-95% of all possible traders are effectively barricaded from the marketplace, what does it do to the exchange rate/price of anything?

Prior to the most recent past, the difficulty with which world currency traders could trade gold with other currencies has been very, very material to the trade itself. Take the extreme example of pre-1900s in gold trading: Only kings and governments could hold it and protect it with their army, the cost to transport it from country to country was a very meaningful part of the total sales price (like half or more), refining quality varied making it very costly to discern between samples of 90% or 95% or 99% pure gold, any purchase probably meant you would own it for a lifetime or more, and perhaps only 0.1% of the world's population had accumulated enough wealth to be able to put 10-15% of their wealth into it.

In short, it was an illiquid market to the extreme. This environment meant that the actual "price" was highly negotiable only between a microscopic section of humanity and the trade was fraught with risk and uncertainty. Whole cargoes of gold were lost at sea with no insurance coverage. Very often, if you wanted to sell, the number of possible buyers could be counted on one finger. This transaction cost, lack of communication, and risk would be similar to putting an effective 55-75% tax on the sale of an asset or to a government outright ban of ownership by private parties. How can the actual "price" be ascertainable in such circumstances? The willing-buyer and willing-seller cannot find one another and they can very seldom converse, let alone transact.

There have always been many things effecting gold's exchange rates, including wars, currency printing, and even the expectation of changes in exchange rates themselves, etc. Hyperinflation has occurred many times throughout history and hundreds of paper currencies have become worthless for various reasons. And, in every case, when the purchasing power of any paper currency is brought into question, the holders of the paper trade all of it in for gold or other hard assets. Bad currency drives good currency from the market.

But, one significant shift in world circumstances has just only established itself. That is the ease with which people can get into - and out of - PMs.

Prior to November 1, 2004, only the few richest people - or the most feverish gold bugs - owned more than a few thousand dollars of coins or bullion because it cost 10%-15% to buy it and another 10-15% to sell again (for smaller sales). Even today, Swiss America charges 10% over spot to buy physical gold. Just these fees alone can put a chilling damper on any trade -- thereby stifling the market and making the true free-trade price impossible to read. Imagine if these costs were present in the trading of paper currencies.

On November 1, 2004, SPDR Gold Trust ETF (NYSEARCA:GLD) became the first bullion ETF and everything began to change. Today, GLD is the biggest ETF by total assets at $66-70 Billion. Now, through gold bullion ETFs, you can buy at a 2.3% premium to spot and also sell at a 2.3% premium to spot and they only charge a 0.4% annual expense fee to own it. Options on GLD and other bullion ETFs have emerged and become commonplace.

Today, you can short gold if you'd like....something that could be done only by the most sophisticated traders in the physical-gold bullion markets prior to only 8-10 years ago. In short, the bullion market in gold and silver and platinum and many other PMs is now much more liquid than ever before in history....much to the dismay of paper currency issuers.

Typically, whenever an asset class has been freed from high transaction costs, then and only then can the price (the exchange rate in the case of currencies) become truly known. An example of this in the beef business would be the cost to a rancher of driving his cattle 100-200 miles to the rail head and selling his beef-on-the-hoof only to the one buyer who was there when he got there; he had very high transaction costs and risks of losses and no real exposure to the buyers. The rancher's share of the total cost of beef on the plate in San Francisco in 1880 was very small. Today, the rancher's price is the largest part of that cost...because the transaction costs have been largely removed and because he can find and sell to the highest buyer quickly and efficiently. He can sell locally near his ranch and the cost of trucking and rail has been reduced to pennies per pound. He is exposed to every buyer in every market instantly through the exchanges; the beef rancher version of an Exchange Traded Fund. Every willing buyer and every willing seller can transact business instantly, including future deliveries.

The Internet has changed the world of commerce and finance; today, you can buy a teak carving of a hawk directly from a hand carver in Bangladesh and FedEx will have it to you in 2 days for $20-30. I have one in my TV room. I paid a price that was half what I thought it was worth considering the excellent workmanship and talent that it took to produce; the carver sold it for 5 times what he would have accepted gladly considering his standard of living and what he could buy in his village for that currency. Both he and I are better off by a wide margin because the Internet and FedEx have put us in direct business with one another and virtually removed ALL transaction costs of the trade.

Gold is no exception to this transaction cost issue. For the first time in history, the true offering price, asking prices, and available supply are known to all buyers and sellers and the market price changes every few seconds for 23-1/2 hours per day worldwide. For the first time in history, the true worldwide demand can be known and brought into the valuation equation and the suppliers can make a deal -- including prices for future delivery if requested -- and they can rely upon the trade.

So, slowly over the last 5 years or so, it is becoming fully known the degree to which the world marketplace desires to own some portion of their holdings in gold and slowly, more and more people are realizing that it is perhaps safer to hold their gold in a vault 15 floors under the streets in London, so as to reduce the transaction costs and risk of losses to the point of irrelevancy to the buying and selling decision.

But, this paradigm shift in world exchanges has not completed itself yet. Many things have slowed this down. There has been a struggle being waged between the old-school sellers and holders of physical gold who poo-poo ETFs and "remote ownership" -- they have screamed bloody murder that GLD is a fraud and that they don't even hold the gold that they claim to own. And, still today, 95%+ of the world's possible buyers do not have a Internet access to involve themselves in the market. This struggle for credibility and accessibility has slowed this market from quickly establishing itself fully. But, with time and experience, the buyers are adjusting and evaluating the risks of "remote ownership" and the markets will grow evermore fluid and liquid.

So, am I arguing that gold's price is correct just because the price is the price? Perhaps, but the old adage goes: "Don't fight the tape." The tape is usually trying to tell us something and that could be that the incessant use of debt and money printing worldwide has caused - or will soon cause - great degradation in the buying power of paper currencies.

People the world over are, for the first time, able to trade gold for a diminimous transaction cost. We can for the first time, collect the ballots and count the votes. They are voting with their cash which asset they would rather own: gold, paper cash, corn, real estate, or more inventory for their business.

And, for years now, they have been saying that gold and other PMs are underpriced as well as many other commodities like corn, coffee, wheat, rubber, tin, and oil. Even on top of a 100% rise in 30 months, the buyers of gold are still buying all that the sellers have to sell. The debate continues with the recent drop, assuming that this recent drop was not driven by some big shortseller or a reserve bank trying to throw water on the fire of gold's rise, but let's not get into that.

Does this constitute a worldwide speculative bubble? It is possible. But, bubbles usually have one factor in common -- they are local events within countries or markets or states where there exists temporary local illiquidities in supply. It is no accident that the worst states in America to be hit by the real estate bubble were places where land was artificially held off the market, like California where it takes decades to bring a property to market, or Las Vegas where the city is surrounded by BLM land that the federal government sells only in dribs and drabs.

Gold and many other commodities are no longer local and is now traded freely around the world and will flow to whomever offers the highest price from whomever charges the least. This new liquidity of the gold marketplace argues that the current price is merely a measure of the worldwide willingness of people to sell their current holdings or future deliveries against the demand of buyers to grow their current holdings as a store of wealth and as a hedge against a possible further deterioration in the exchange rates with paper currencies.

It is also possible that world paper currencies will regain their perceived values and that the major world governments will balance their budgets every year and re-establish fiscal discipline and decrease their debt/GDP ratios to 10-15%. It is possible that the exchange rates between gold and all world currencies will become more stable and the major world currencies will once again be backed by gold by the governments that issue them.

Yes, this also could happen. But, I would not expect this latter outcome to occur, not to the point of holding my breath in anticipation.

Disclosure: I am long GLD.

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