As gold prices soar, we’re starting to hear rumblings that it’s in a bubble.
That’s not surprising, given its performance. The yellow metal has catapulted from a rock-bottom low of around $250 an ounce back in 1999 to around $1,380 recently. That’s about a 10% annualized return, far better than US stocks yet considerably lagging the best-performing emerging markets.
And there’s much anecdotal evidence of growing enthusiasm. Media coverage is picking up. Central banks, which notoriously sold at the bottom, are buying again. Famed hedge fund managers George Soros, John Paulson, and Paul Tudor Jones have piled into gold exchange traded funds and mining stocks.
But when I look harder at past bubbles—like those in stocks and housing—I don’t think we’re in the full-fledged buying panic that usually marks the end game.
In fact, I think the decade-long gold super cycle does have some time to run. But we’re closer to the end than the beginning, and I’m watching very carefully for signs of the blowout phase before selling any of my small position in the SPDR Gold Shares (NYSEARCA:GLD).
Gold is traditionally seen as an inflation hedge, yet it has racked up its biggest gains in a decade when the most widely used measures of inflation have been quiescent. Lately, it has moved up sharply amid fears of deflation.
But during gold’s “golden decade”—which coincided almost perfectly with the “lost decade” for stocks—the Federal Reserve under Alan Greenspan unleashed an easy money policy the likes of which we’d never seen—until his successor Ben Bernanke did him one, or two, or even three better.
In the Greenspan era, that led to the housing bubble, an orgy of speculation on Wall Street, and ultimately the crash and financial crisis from which we’re just beginning to emerge.
Their legacy: a hobbled US economy. Bernanke’s Fed already has pumped $1.75 trillion of cash into the system in its first round of “quantitative easing” (money printing). Another $1 trillion or so may be added when the Federal Open Market Committee meets in early November.
All these moves have one thing in common—they have debased the value of the US dollar, which has declined dramatically in the last ten years. For many, gold has become an insurance policy against a weaker dollar, still the world’s reserve currency. So, in the current bull market for gold, the weakness of the dollar (and other paper currencies)—not inflation--has driven gold’s rise.
At the moment, I can’t see much that would reverse the dollar’s long-term decline. As long as it continues to drop, gold will continue to rise—until it reaches the speculative stage, when price increases take on a life of their own.
How far away are we from that? This chart, developed by Jean-Paul Rodrigue, a professor at Hofstra University, tells the tale:
Rodrigue, whose specialty is transport geography, has the advantage of not being a finance professor, so he is not bound by the orthodoxies of efficient-market theory, which focuses on bell-curve normal distributions and discounts “black swan” anomalies and markets’ periodic irrationality.
In fact, this chart first appeared on Rodrigue’s blog in January 2006, with a specific warning of a housing bubble. “Over the last decade, we have experienced the largest bubbles in human history back to back: the stock market (which deflated in 2000) and the real estate (which is likely to deflate in 2006).” Great call, professor.
The chart depicts the stages of bubbles as “backed up by 500 years of financial history,” in Rodrigue’s words. “Each time the situation is obviously different, but there are always a lot of similarities.”
Phase one is “stealth,” where the smart money gets in first and quietly builds positions. Phase two, “awareness,” is when more investors get interested while the early movers continue to buy and the media take notice.
Phase three, mania, is one of increasing exuberance, when “floods of money come in, creating even greater expectations and pushing prices to stratospheric levels.” The media is filled with variations on the theme of a new paradigm or “this time, it’s different.”
The final phase, “blow-off,” is when “the house of cards collapses under its own weight and late comers (commonly the general public) are left to hold the bag while the smart money has pulled out a long time ago.” We’ve seen this movie too many times in recent years.
So, what does Rodrigue think about gold now, based on his own model?
“I do not think gold is in a bubble–yet,” he wrote in an e-mail. “Although gold ‘prices’ have increased substantially in recent years, they simply reflect deteriorating faith in fiat currencies and the policies of central banks who have blown bubbles on their own.”
“Gold is money, and if it enters a true bubble stage it will be mostly the consequence of central banks /government actions, or more likely their desperation and incompetence,” he continued. “I would say that gold is currently emerging from the awareness phase.”
That’s what longtime gold bugs Mary Ann and Pamela Aden believe, too, “Gold is still far from the mania stage,” they wrote recently. “The average investor is just starting to appreciate the rise in gold.”
The numbers appear to back them up. Brett Arends, columnist for the Wall Street Journal and MarketWatch, estimated that “individuals bought $5.4 billion worth of gold, and sold about $2.7 billion, [so] their total net investment comes to $2.7 billion” in 2010, through early summer. He contrasted that with the $155 billion they shoveled into bond funds through July. That may be the real bubble.
Arends also concluded that “if it continues along the same trajectory [of past bull markets]—a big if—gold today is only where the Nasdaq was in 1998 and housing in 2003.”
That sounds about right to me. We’re starting to hear the big predictions from Paulson and Wall Street that gold could hit $4,000, even $5,000 an ounce. (It would have to hit $2,400 to match its previous all-time high on an inflation-adjusted basis.)
Those numbers sound like the infamous Dow 35,000 fantasy to me. Remember, these people are always talking their book.
As Rick Bookstaber, former top Wall Street risk manager and author of “A Demon of Our Own Design,” warned: “Don’t you get suspicious when so many of the top managers are so vocally out there about their gold investments?
“Will they let everyone know when they think it has gone too far before they get out—or before they go short? Maybe they already have.”
So, I’d be watching for any news that Soros, Paulson, et al have lightened up on their shares of gold-mining stocks or gold ETFs. But Rodrigue has a simpler measure to determine when the end is nigh:
“The day you hear your uncle Ted, who bought Pets.com stock on margin in 1999 and three condos in Florida in 2006 with a negative-ARM adjustable rate mortgage at 120% [loan to value], telling you that gold is the opportunity of a lifetime and a no-brainer, then it is time to sell most of your gold assets, preferably to him.”
And throw in a gold watch for good luck.
Disclosure: position in GLD.