Why Gold's Going Up, Mania or Not

Includes: GLD, GOLD
by: Denis Ouellet, CFA

Obviously just a coincidence but two reports on the potential gold mania reached me today. One sees clear signs of a mania which could bring gold at $3,800 in 3 years. The other one, from gold’s uber-marketer, demonstrates that there are “unambiguously” no signs of a bubble in the gold market but, don’t worry, the price of gold will likely keep rising since there is “ample scope for continued robust growth in gold market demand.” Sounds like a win-win situation to me. Here are the stories:

RBC Capital Markets summarizes three general features that have often set the stage for past investment manias and place today’s gold market within this context:

1) The asset must be difficult to value. Gold generates no income and is of little economic use, unlike other commodities such as copper or oil. Meanwhile, the fundamental anchor for gold appears to be a nebulous concept tied to the loss in faith of paper currency. While this latter psychological construct is real, it is also impossible to measure except by the reaction of the gold price itself. Gold is morphing into a “no lose” asset class, benefitting from the scenarios of inflation, deflation and variants in between.

2) A story of “limitless” potential. Wireless in the 1990s and accessibility to the internet by 1994 offered the major displacements that worked in the stock market’s favor. Limitless stories for gold have been passing across our desk with increasing frequency these days. One story points to the deep under-ownership of gold among both the investing public and the official sector. Another is linked to the monetization of government deficits to accommodate the effects of the “Great Recession.” In any event, this narrative provides the fertilizer necessary for trees to grow to the sky.

3) Channels that easily allow for social contagion. For most historical manias, this really wasn’t a problem since all you’d have to do is to place a call to your local broker to buy your favorite publicly listed Nifty Fifty, Japanese or dot.com stock. We think the introduction of the gold bullion ETFs has made it much easier for large and small investors to catch the gold bug.

So, how far could bullion prices run? We have determined the best fit between the recent gold price dynamic and a price index which summarizes the average path followed by several historical and well-known investment manias. These past euphoric episodes have usually generated a 10-fold increase in the price of the underlying asset. If history rhymes, this fun little exercise tells us that a terminal gold price of close to $3,800/oz could be achieved within the next three years.

Gold Tracking the "Bubble Index"

Click images below to enlarge


If convinced that gold is in the early stages of a bubble, most investors would want to participate and jump on the bandwagon before it is too late. That, in itself, helps feed the latter stages of a bubble. In the case of gold, signs of a self-feeding bubble process are already apparent. In spite of the fact that few, if any, investors can rationalize the price of gold, investment demand for gold is rising in sync with the price of gold.


Meanwhile, non-investment demand gradually decreases as jewelry prices rise. Trailing 12-month gold jewelry demand is currently 1882 tonnes. This is 24% less than the yearly average for 2002-2008, and 41% less than the 2000 level.

Jewelry Demand


When the more rational users are being replaced by less or non rational buyers, and in ever greater quantities the more the price rises, this sure looks like a bubble in the making.

Yet, the World Gold Council, the marketing arm of the gold industry, is arguing that there is no bubble in sight. Instead, it is helping investors rationalize buying gold:

While reserve managers and investors are increasingly recognizing the strategic case for including gold in a portfolio due to its diversification benefits and the protection it can afford against macroeconomic risks, successive new records in the gold price have increased concerns that gold may be overvalued relative to other assets. Some investors and market commentators have even questioned whether the gold market is in a “bubble.”

In a recent report entitled The 10-year gold bull market in perspective, the WGC explored this question and using econometric tools analysed the recent developments in the gold market. Unambiguously, the results showed that gold price developments do not resemble the statistical characteristics of past bubbles, including those of the US housing market, the Nasdaq technology bubble, and the Japanese Nikkei equity market bubble. Additionally, the report found that the gold price is consistent with its long-run average-level compared with a range of different assets including equity indices and hard assets like oil.


It also demonstrated that there is ample scope for continued robust growth in gold market demand, due among other reasons, to the strength of emerging markets, a fundamental shift in the behaviour of central banks.

Moreover, the WGC also explored the role that gold plays to help manage risk more effectively in a portfolio by protecting against infrequent or unlikely but consequential negative events, often referred to as “tail risks’. In Gold: Hedging against Tail Risk, the WGC shows that gold can be an integral part of cost-effective strategies which provide protection without sacrificing return for both short- and long-term investors. For example, it finds that unlike other assets, gold tends to exhibit lower volatility for negative returns than it does for positive returns and that gold also tends to have little correlation with many asset classes, thus making it a strong candidate for portfolio diversification. It also shows that, conversely to other assets which are typically considered diversifiers, gold’s correlation to other assets tends to change in a way that benefits portfolio returns.

So, the bubble process is on. If this is not, currently, a bubble as per RBC Capital, the WGC sees gold demand and price rising. This would likely, eventually, create the bubble.

Just in case, RBC Capital provides a potential negative scenario:

What might short-circuit the gold story? Noted acceleration in U.S. GDP growth and/or a signal by the Federal Reserve that its next move is to tighten might place gold in the penalty box. In our opinion, this would most likely raise the opportunity cost of holding gold by placing upward pressure on real interest rates. We view this as an unlikely scenario over the next 6-9 months.


Jewelry buyers, the longer term investors, are running away while suppliers like miners and recyclers are feeding the pipeline with ever greater quantities as the price is rising. When the price of gold turns down and sentiment reverses, many investors will find that the exit door has gotten pretty narrow. For now, however, there is nothing to fear but the lack of fear.

Disclosure: No positions