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Gold has recently
broken out to new highs, topping $1150/ounce. The financial media
doesn’t trust this move. Widespread commentary has it that gold is in a
bubble. Google reports numerous hits for a search on "gold
bubble nov 2009." Financial writer and frequent television guest Dennis
Gartman agrees:
"It is a
gold bubble and to say otherwise it’d be naïve," Gartman
said. He called the trade on the precious metal: "mind boggling and
unbelievably crowded," but also said he is currently long – or
betting gold will go higher.
To be fair to
Gartman he is a short-term trader who has been both long and short gold at
various times in the last ten years. I am not original in the following
observation (I think it was Bill Fleckenstein but I can't
remember for sure) but it is worth saying again. Gartman aside, many of the
financial media have a pronounced anti-gold bias. Of the writers and news
anchors now calling gold a bubble, not only did they fail to identify the
stock market bubble in the 90s or the subsequent housing market boom as a
bubble, they actively promoted the excesses of those unsustainable booms,
encouraging their viewers or readers to participate. For the most part, these
pundits have failed to identify a rising gold price as an investment trend at
any point in the past ten years (during which gold had a positive return each
and every year); and most have never recommended any form of gold as an
investment to their viewers – who probably don’t own any gold
either.
Few if any of the
financial commentariat are presently warning investors of the government bond
bubble. Yet if there is any financial event more certain than the eventual
default of most government debt in the developed world, I cannot identify it.
Witness the irony
of the financial media transformed from hypesters who never saw a bubble they
couldn’t promote into bubble vigilantes, issuing concerned
warnings to "get out, now, before you get hurt."
But so far all I
have done is to make ad hominem
attacks on media figures. In spite of their past failures, they could be
right. Let’s have a look at the data and try to figure out whether gold
is or is not in a bubble.
A bubble is a
deviation between price and fair value of an asset. Because fair value is to
some extent a matter of opinion, identifying a bubble involves opinion as
well. There are various widely accepted methods for valuing assets, but these
methods use inputs that involve judgment and opinion. Stocks can be valued on
the underlying earnings or the balance sheet of the issuing corporation.
Housing can be valued on the basis of rental income. While these numbers are
also open to interpretation, a firm call of a bubble can be made when values
are in an uptrend and reach multiples of historic valuations.
But estimating
the fair value of gold is at best, less straightforward, and at worst,
impossible. Other assets are valued on the income stream that they produce,
or by breaking them down into pieces that have independent market prices.
Gold cannot be analyzed the same way as other assets because it can't be
broken down into anything more fundamental than itself. Its current price is
its only indication of what it might be worth. Its price can change from day
to day. This makes it difficult to determine what is a low or a high price.
Various models have been proposed to calculate the fair value of gold, but
they all run into assumption-making at some point.
Paul van Eeden
has published some articles (1
2) in which he proposes that the fair
value of gold can be calculated on the basis of purchasing power parity of an
ounce of gold, relative to the end of the gold standard (when gold was last
official money). He projects the current gold price based on the growth in
the supply of mined gold over this time, compared to the growth in the supply
of fiat money over the same period.
I do find value
in van Eeden’s work, mainly for emphasizing that gold is a global
asset, one that is in demand in terms of all fiat monies. Gold has one price
in each currency. The dollar price of gold is not the price of
gold, only a price of gold. The dollar price of gold reflects
the foreign exchange value of the dollar against other fiat monies as well as
the global valuation of gold itself. Van Eeden shows, for example, that gold
was not in a global bear market throughout the entire period from
1980–1995. On the contrary, much of the decline in the dollar price of
gold was a rise in the exchange rate of the dollar over this time.
Gold’s price over this period in other fiat currencies was not uniformly
down (a fact frequently cited to "prove" that gold is not an
inflation hedge). The gold price went up in some currencies and trended
sideways in others, depending on their foreign exchange rate.
However, I am not
convinced that gold should trade at van Eeden’s theoretical price. The
exchange rate between fiat money A and fiat money B tends toward purchasing
power parity because participants buy and sell goods and currencies to
arbitrage away differences. This arbitrage process assumes that goods are
sold in the market in terms of both A and B. But there is no good reason to
expect that the price of gold should reflect purchasing power parity when it
is no longer used as currency because goods are not sold on the market for
gold. It is purely a financial asset at this point. Van Eeden’s model
might be approximately true because gold functions as a sort of shadow money but
that’s not exactly the same as actual money.
Van Eeden also
ignores the likelihood that the purchasing power of gold would have grown
since the end of the official gold standard, since the growth rate of the
goods and services in the world economy has exceeded the growth rate of the
gold supply.
Another problem
with van Eeden's model is that, while under the gold standard, currencies
were redeemable for a fixed amount of gold. In that regime, any measurement
of money supply should count either currencies or gold.
Counting currencies and gold would be double counting. His model
compares gold against currency, which would be correct if we went back on a
convertible gold standard, but right now, gold trades along side currencies,
so it should be counted as an addition to total money.
Professor Mike
Rozeff has written several articles for LewRockwell.com
showing calculations of what the gold price could be using different models.
As Rozeff points out, "Numbers such as [those presented in certain
models] surely give the impression that gold can go higher, but we knew that
already. Any asset can go higher. These numbers give the illusion of
certainty and necessity, or in other words they suggest that gold will go
higher. But the model has no reasoning in it to say why this has to happen,
if it has to happen at all." I agree with Rozeff’s point here: if
you assume that a particular model is correct, it can be used to generate a
theoretical price. But the models all depend on an assumption that gold
should behave as it is modeled.
How expensive
does an asset need to be to be called a bubble? During the stock market
bubble, equities traded at three to four times historic valuations, with
the NASDAQ index trading at something like six times or more times a
realistic valuation (notwithstanding the large number of NASDAQ companies
whose value proved to be zero). During the housing bubble, home prices averaged over the entire country were about twice historic
valuations, but the major bubble cities saw homes
reach three or more times historic valuations.
If you think that
gold is in a bubble, is it trading at two times fair value? Three times? Five
or six times? That would imply a fair value of anywhere from $550 to $200.
During most of the last ten calendar years, gold has experienced a decline of
20% at least once during the year and then resumed its upward climb. Would a
fall in gold from the recent $1100 to a low of $900 validate the bubble
hypothesis? Or would it only be a medium-term correction in an ongoing
bullish trend?
Can an analysis
of trends and cycles tell us whether gold is in a bubble? I recall a speaker
at an investment conference in the mid-00s stating that gold's bull run was
over because "the average gold bull market lasts for four years."
But where did this average come from? Prior to 1971, the "price" of
gold was a fixed convertibility ratio between fiat money; or at worst, an
administered price. Gold has only had a market price in fiat money terms
since the day when Nixon closed the gold window. How many gold bull markets
have we seen that time? At most: two. Can we average together all two points
of data and get a meaningful statistic?
Relying on
historical valuations is useful for stocks and houses since we have a century
more of data for both of those asset classes. But for gold, the world has
only been on a pure fiat money standard for 40 years. How many complete bull
and bear cycles have we seen during that time? Nassim Taleb, in his book Fooled by
Randomness, emphasizes that, when you are collecting
data about some observable phenomenon, it is difficult to know when you have
seen enough data to encompass the full variability of the phenomenon. In
other words, if you have 100 years of data about floods in a river bed, your
data set might not include any occurrences of the once-every-200-years flood,
or the 500-year flood.
It seems
implausible to me that in the last 40 years we have seen the full range of
variability in the relationship between gold and fiat money. I suspect we
have not experienced multiple bull/bear cycles in gold; it is more likely we
have not even seen one complete cycle yet. In our 40 years since Nixon
closed the gold window, we have not seen the 100-year flood. It is more
likely that we are now reaching the end of the first full market cycle
of gold in a pure fiat world. This is now the 100-year flood. The current
cycle will end with a world-wide currency crisis and a wipeout in the value
of most government debt.
If I am correct,
then the next phase of monetary history would almost certainly involve an
informal or formal recognition of gold as a monetary reserve asset by central
banks. Gold would then be revalued at a much higher level of purchasing power
relative to recent history.
Robert Blumen
Also
by Robert Blumen
Robert Blumen is
an independent software developer based in San Francisco, California
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