No Signs of a Gold Bubble Despite Record Advances in 2010

Includes: GDX, GLD, PHYS, UDN, UUP
by: Przemyslaw Radomski, CFA

History has been peppered with financial bubbles -- but is gold in a bubble?

So far it's been the amazing, runaway investment of the past decade. If you'd put your money into gold at the lows of about 10 years ago, you'd have made approximately a 400% return. That's left pretty much everything else — stocks, China, housing — in the dust (and we don’t mean gold dust).

We would be willing to bet that if you asked for a show of hands of how many people own gold in an audience of 100 seasoned investors, probably less than 10 might raise their hands. If you asked the same question in a room of average, random people, probably one or two hands at the most might go up.

Gold is clearly not in the bubble stage yet.

What do tulips, Mississippi, the Internet,, the South Seas, and Florida housing have in common? They were all at one time bubbles that burst, leaving financial ruin in their wake.

Although some of these bubble episodes happened centuries ago, the events are eerily similar to today’s bubbles and busts: Low interest rates, easy credit terms, widespread public participation, bankrupt governments, price inflation, and frantic attempts by government to keep the booms going and government bailouts of companies after the crash. Gold, however, is not plagued by any of these problems.

Niall Ferguson in his book The Ascent of Money distills the formation of bubbles into five stages:

  1. Some change in economic circumstances creates new and profitable opportunities.
  2. Euphoria sets in, whereby rising expected profits lead to rapid growth in share prices.
  3. The prospect of easy capital gains attracts first-time investors.
  4. The insiders realize that the now-exorbitant price is unsustainable and begin to take profits by selling.
  5. As share prices fall, the outsiders stampede for the exits at once, causing the bubble to burst.

Following this analysis, gold is probably only in stage one, where changes in economic circumstances create profitable opportunities to buy the yellow metal. We are still far from euphoria. Although gold has attracted some first-time investors prompted by fear and searching for a safe haven for their capital, gold is far from being a crowded trade. With crumbling infrastructure, runaway debt, paralyzed government, a military bogged down in pointless faraway non-wars, and troubles in the eurozone, there are plenty of motives to buy gold.

Gold will correct during its run-up, and when it does all the people shouting “bubble” will smirk ... and we will be out there buying more. We think that the bubble is not in gold, but rather in what is driving the price of gold: Fiat money creation.

Moving to short- to medium-term signals, let's take a look at the precious metals market through the perspective of currencies and the general stock market (charts courtesy of The Euro Index chart below highlights attempts to move below the medium-term support line. The head-and-shoulders pattern (which might be completed, even though it appeared rather unlikely just a few days ago) formation is about to signal a significant move lower.

[Click all to enlarge]

Note that the breakout below the rising trend channel was verified a little over a week ago. Since that time, Euro Index levels have steadily declined, with close to a 3% drop seen as of Tuesday. The outlook here remains quite bearish.

In this week’s long-term USD Index chart, we see trends that are the exact opposite of those seen in the Euro Index -- which is normally the case.

The resistance level (dashed declining line), which is now in play, is rather weak, having been formed from two highs, one of which was formed very recently. Please note that the upper border of the previous trend channel (thick blue line on the chart) was much stronger, as it was based on two tops that were a few months apart from each other, and also from the moment when the resistance was in play (in November). Please also note that this level stopped the rally for a while.

The relationship between the USD Index and gold, silver, and mining stocks, however, is not as clear as it once was. This seems to be due to the changes seen in the eurozone, the euro being a very large part of the USD Index.

Overall, there appears to be a slightly greater chance that the USD Index level will move higher, and the outlook for precious metals is therefore slightly bearish at this time.

The very long-term SPX S&P 500 chart is virtually unchanged from last week. The RSI level is now at 68.41, and this level has corresponded to local tops several times in the past. Perhaps stocks are near a local top also this time.

Summing up, the sentiment for the general stock market is now bearish, as a local top appears to be very close and it seems that the breakout visible on the very long-term chart might turn out to be a fake-out. The implications are slightly bearish for the precious metals sector as well.

However, long-term fundamentals are intact. Just because gold has been in a long-term advance does not mean it represents a bubble. Neither does volatility, as long as it is within a reasonable range and there are reasons other than demand from traders that justify such a move. We don’t see any evidence of that in the case of gold and silver.

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