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Austin J. Wentzlaff joined OnApproach in 2013 as a Business Development Analyst and is now currently Director of Business Development. He is responsible for developing marketing strategies, driving prospects to contract award, building and maintaining high-level relationships with current and... More
  • Gold: The Greater Fool Theory 0 comments
    Feb 11, 2014 2:14 PM | about stocks: GLD

    Introduction

    Gold (NYSEARCA:GLD) has been marveled at since it was first discovered in the Middle East around 6000 BC. This fascination with gold helped aid in the discovery of the Americas. Westward expansion in the United States with the California Gold Rush. Wars have been fought over and people have lost their lives for gold. People have even declared their love for each other over it. It's undeniable that gold has had an enormous impact on history. The same cannot be said about gold as smart investment choice. Before digging into the historical prices of gold and its potential as asset bubble, a few quotes from the Oracle of Omaha, Warren Buffet will help get keep the brain thinking:

    "Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

    "The problem with commodities is that you are betting on what someone else would pay for them in six months. The commodity itself isn't going to do anything for you….it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something that you expect to produce income for you over time."

    "Gold is a way of going long on fear, and it has been a pretty good way of going long on fear from time to time. But you really have to hope people become more afraid in a year or two years than they are now. And if they become more afraid you make money, if they become less afraid you lose money, but the gold itself doesn't produce anything."

    "The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end."

    There are three important points that Buffet makes about gold that may indicate gold is a bubble that's going to burst (even more than it already has). Those three points are that gold has little utility, increasing gold prices are based on the speculation that prices will continue to rise, and fear is a catalyst for gold prices. To say gold has no utility is a stretch, gold is used in jewelry, medicine and electronics, among other things. That being said the utility for gold is very low. Of all the gold consumed in the world about 50% is used in jewelry, 40% in investments, and 10% in industry. Almost half of all the produced gold is used just to satisfy investments. Investments that are subject to irrational investors decisions.

    These investment are fueled by the thought that gold will always go up. Just as people believed the prices of houses could never go down. Given the small amount of utility gold has (just 10% of gold production), prices of gold should follow percent changes in inflation as all assets with little to no utility do. Just as Nobel Prize winner Robert J. Shiller has indicated with his research on housing prices. Historical gold prices and inflation statistics suggest that increases in gold prices and the rate of inflation have started diverging. Gold is increasing at a much fast rate than inflation just as houses did before the bubble burst in 2008. Every time this has happened the price of gold has reversed itself.

    Historical Price of Gold and Inflation (Decade)

    Decade

    Average Inflation

    Decade

    Average Price ($/oz.)

    Gold Price - % Change

    1920s

    0.08%

    1920s

    20.38

    -0.24%

    1930s

    -1.94%

    1930s

    20.38

    40.01%

    1940s

    5.63%

    1940s

    33.98

    -6.82%

    1950s

    2.05%

    1950s

    34.91

    1.08%

    1960s

    2.36%

    1960s

    36.17

    14.56%

    1970s

    7.08%

    1970s

    131.93

    88.23%

    1980s

    5.55%

    1980s

    418.60

    -61.42%

    1990s

    3.01%

    1990s

    350.91

    -37.47%

    2000s

    2.56%

    2000s

    522.09

    71.30%

    2010s

    2.10%

    2010s**

    1469.07

    13.23%

    Average

    2.85%

     

    Average

    12%

    Source: National Mining Association, USA Gold & US Inflation Calculator

    For the sake of simplicity, gold prices and inflation have been broken down into decade averages. Doing this allows one to analyze the price trend of gold versus the trend of inflation more easily. It is expected that price of gold and inflation should be almost directly correlated since gold has little to no utility and is thought of as a hedge against inflation. This isn't the case however, gold and inflation have a correlation of only .133413 from 1914-present (99 years). Gold has had a tendency to diverge away from the average rate of inflation during two scenarios, high interest rates and times of economic crisis. The reason for this is people fear their money will become worthless by hyperinflation or an "end-of-the-world" scenario. Scenarios such as the most recent economic crisis in 2008. People believe that their money will be safe in gold because it can be used as currency when their economy's currency becomes worthless. People continue to buy gold during economic crisis for that reason and for the reason that the price continues to climb when the stock market is not. As shown in the preceding table and following chart, theses spikes in gold prices are often followed by a sharp decline. This sharp decline is usually accompanied by a time of economic prosperity because people's fear and pessimism have turned to optimism.

    Source: National Mining Association

    The last time gold prices surged like they have in the recent decade and a half was in the 1970s. Gold gained 88.23% throughout the decade following double digit gains it made in the 1960s. The 1980s and 1990s both experienced tremendous gains in the stock market both with triple digit growth. Those two decades also experienced a huge slide in gold prices. The last decade to present (2000-2013) has an eerie resemblance to the 1970s. The stock market experience subpar growth and gold price rose at an absurd rate. The economy has started to recovery in that last couple of years resulting in a decline in gold prices. As long as the economy continues to recover and people's fears continue to ease, gold prices will continue to fall even more than they already have. Gold prices could see declines just as bad as the 1980s and 1990s if the economy has similar growth. One aspect that makes the high prices in gold seem strange is the low level of inflation. Typically, increasing inflation results in an increase in gold price. That hasn't been the case however, inflation has continued to decrease as gold has continued to increase.

    The Greater Fool Theory

    The greater fool theory that states one can make money buying almost any asset regardless of the valuation because someone will buy the asset at a higher price. The first person was a fool for buying the asset and disregarding its valuation but the one who buys it from him is an even greater fool. Investors act in accordance to this theory when buying gold. Gold investors buy 1 ounce of gold knowing that it will always be 1 ounce of gold with the hope that someone will value that ounce at a higher price than what it's worth. This greater fool usual hopes to do the same thing to an even greater fool. The strange thing is that this actual works for a long period of time until finally the greatest fool owns the gold. At that point the bubble will usually burst leading to a rapid decline is asset prices. The same scenario occurred in the housing market in the mid-2000s. When it comes down to it an ounce of gold will always be worth an ounce of gold, just as a house will always be worth a house.

    Conclusion

    Gold would be a great investment vehicle to hedge against inflation if gold prices and inflation increased at a similar rate as is believed by many. This belief has come from the many times throughout history that gold and inflation have followed a similar pattern. Gold tends to diverge from this pattern more times than not, however. Often times this divergence is fueled by fear and speculation, causing the price of gold to become overvalued. Much like what happened to the price of gold in January. Investors got fearful, stock prices dropped and gold prices moved higher. The most recent financial crisis has caused fear and speculation not seen since The Great Depression. The same time has also seen some of the highest yearly increases in history. The prices of gold are overvalued and will continue to fall just as the housing market did in 2008-2011. Don't be the greatest fool and let gold correct itself before even thinking of buying this utility lacking asset.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Stocks: GLD
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