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Is Gold In a Bubble?

|Includes: SPDR Gold Trust ETF (GLD)

With the price of gold having skyrocketed since mid-April (and tripled over the last 5 years), there has been a lot of talk about the yellow metal being the next big investment bubble. However, before we get to the heart of the matter and to the question of whether or not gold is bubbling over into something bordering on irrational exuberance, we would like to point out that the real bubble in the investing world right now can be seen in the number of investors spending their days looking for a bubble.

Therefore, the very first exhibit we’d like to present in our case that gold is not in a bubble, is the fact that bubbles occur when no one is looking for them! For example, at the turn of the century, investors were busy making up ways to argue that tech stocks could continue to romp higher for years to come. No one was talking about technology stocks being in bubble. No, they were too busy looking for the next IPO that would double or triple on the open.

Next up is the housing market. Did you or anyone you know run around yelling that the sky was about to fall on home prices? Or were you more interested in refinancing (again) so that you could take cash out to build a pool, or buy a boat, or remodel the kitchen, or to buy another house?

So, before we get too far into our analysis, let’s understand that most investors are very good at fighting the last war – or in this case, preparing their portfolios for what has already happened.

Getting back to the matter at hand… If one looks at the chart of gold on a daily basis this year, it is hard to get too worried about the rally as the chart doesn’t look too terribly different from that of the S&P 500. And speaking of the S&P, we should point out that while the S&P has rallied 64% off its March 9th low, the price of gold has moved up a lot less (something on the order of 35%). Thus, if we are looking at the short run, it would be easier to argue that stocks have run too far, too fast; not gold.

Gold Daily 2009

However, if one steps back a little – in this case, let’s say 10 years – the picture changes quite a bit. While stock market investors have been dealing with a “lost decade” during which time the S&P lost about 25%, the price of gold has increased four-fold. So, okay, now we might be approaching a bubble standard.

Gold Daily 10 Years

But then again, if you back up even farther – this time to say, 1926 – the picture is different still. According to Ned Davis Research, the average annual gain of gold bullion since 1926 has been 4.9%. This is a little better than T-Bills, which have averaged 3.8% and inflation (3.0%), but is below the annual return of Treasury Bonds at 5.5%, and a far cry from the S&P 500, which has averaged gains of 9.7% per year.

To put those long-term numbers into perspective, if one had started with $100 on 12/31/1925, the investor in gold bullion would now have something on the order of $5700 to his name. This is obviously preferred to the $2300 the T-Bill investor would have, but is nowhere near the $236,000 the investor in stocks would have accumulated. And in short, this is why they call the compounding of returns the 8th wonder of the world.

But enough about history; let’s get to the question of whether or not gold is in a bubble. Michael Widmer, a metals strategist at Bank of America/Merrill Lynch in London says no. In an interview on CNBC Thursday, Mr. Widmer suggests that central bank buying is behind much of the current move and is something that will continue in the future.

“If you look at what drove some of the buying, we do still see a lot of reserve diversification from central banks. Reserve diversification by definition means they’re not necessarily buying into gold markets because they expect huge price rises; they buy gold because it’s good diversification,” Widmer said.

From a geopolitical standpoint, this makes a lot of sense. It is no secret that many countries have been talking rather loudly about the idea of moving away from the dollar as the world’s reserve currency. While no one expects to see such a move happen in the near-term, one of the ways that foreign countries can express their views is by voting with their feet in terms of where they put their cash. And gold appears to be one of the preferred alternatives.

Think about it; if you were a banker in another country taking in dollars and have been watching those dollars depreciate, doesn’t it make sense to put at least some of those dollars into an asset that tends to hold its own in this type of environment? So, the idea of central bank diversification actually makes a lot of sense.

The globe-trotting Jim Rogers, who is famous for his macro investing calls, brings up another point. Although we will have to put this one into the anecdotal category, during a meeting in Prague recently, Rogers asked the 300+ money managers in the room how many had ever owned gold. Given that this was a meeting full of European money managers, one might have expected to see a fair amount of gold aficionados.

When the electronic votes were tallied though, Rogers found that 76% of the money managers had NEVER owned gold in their portfolios. Talk about potential demand!

With economic uncertainty around the world, geopolitical issues in the Middle East (remember Iran’s nuclear ambitions?), a declining dollar, and the potential for more problems with sovereign debt, it is little wonder that gold has been running higher lately.

So, does this mean the recent pullback presents a buying opportunity? If your timeframe is longer than the next 6 months, the answer is yes. In the long run, both Rogers and Widmer expect the dollar to continue to weaken - after the requisite counter-trend bounce, of course. And this alone suggests that central bankers, who may be concerned about their currency holdings, will want to continue to diversify.

Disclosure: GLD