Gold Price Bubble

Given the recent activity in gold markets, it now seems to us that gold prices are in a bubble and are likely to experience severe drops from current all-time highs. Gold - long seen as a safe haven - has started to experience the volatility that has come to characterize equity markets and property markets over the past decade.

In the past, investment gold was held by large institutions such as the IMF and central banks. Used to back foreign exchange reserves, the metal rarely changed hands. The only way for the average man in the street to hold gold was to buy the physical product and keep it at home which meant it was hard to trade.

However, with liberalization of financial markets particularly in Asia gold has become an easily tradable commodity for anyone. ETFs now purchase physical gold and allow people to buy and sell with the vagaries of the market. Bank accounts are now even offering interest components based on gold or direct gold holdings for savers.

Meanwhile, large institutions such as the IMF continue to offload gold. While the likes of China have been purchasing much of the extra supply, much of it is moving towards short term investors eager to make a quick buck from rising prices.

The problem with these short term traders coupled with a large number of private investors with little or no experience in the gold market is that they can turn a bull market into a bubble. When that bubble begins to deflate we can see a fast bursting and a crashing of prices.

Many private investors particularly in Asia are under the impression that Gold is a safe investment. Gold is seen as a flight to safety for large institutions such as sovereign wealth funds and hedge funds. This is because gold has been worth something for the last 10,000 years and it will likely be worth something for another 10,000 years.  However, Gold prices can fluctuate massively. Gold is not an alternative to cash or bonds. In previous bull markets gold has gone from as much as $700 an ounce to $300 an ounce in just one year. Significantly more volatility than experienced by stocks in 2000 or property in the 2008. Previous falls in gold markets were in an all professional market without the kind of hot money we see emptying in to gold markets today.

Many investors sight gold as being a useful inflation hedge. Their concern is that with central banks printing money the value of cash will fall and the value of gold will at least keep pace with inflation. Gold has always been an important hedge against inflation. When the Deutsch mark was devalued in the 1930s and inflation in Germany was 400% gold was a good investment. The oil shocks of the 1970s and 1980s that saw UK inflation soar under Thatcher to more than 20% was the catalyst for the last gold rally. However, inflation today is a very different beast. US inflation is less than 2% and likely to fall as the US economy slows down. Gold can move up and down by more than 2% in an hour. Is this really a realistic way to hedge against inflation in comparison to an inflation indexed bond?

All commodities at present have supply constraints; especially when economic growth begins to quicken. The one commodity that does not have a supply constraint is gold. The reason is that every other commodity is used in production in one way or another. The vast majority of the gold ever discovered on earth is sitting in basements gathering dust. There are a number of industrial uses for gold, particularly in electronics. However, a number of other metals can be used to substitute for gold and at prices of $1700 an ounce manufacturers will be doing everything they can to reduce gold usage. Other precious metals such as platinum or silver are far more widely used have fewer substitutes and we do not have significant stores of these metals sitting in basements.

China is looking to increase its gold holdings.  This is true. As China’s Foreign Exchange reserves grow it is seeking to acquire more gold. However, China purchases many commodities with its foreign exchange reserves. It tends to purchase these when markets are low, and stop purchasing when things over-heat only to start buying after a crash. At $1700 an ounce China is not buying. Many have talked about the need for governments to move away from US treasuries as the basis and back to Gold. However, most gold is not held by the new emerging market power houses but by western governments.

 

World Top 5 by tonnage 2010

1/ USA                       8133 tonnes

2/ Germany             3401 tonnes

3/ IMF                       2846 tonnes

4/ Italy                      2451 tonnes

5/ France                  2435 tonnes

 

Western governments and the IMF have been offloading gold for a number of years. This is largely because they realize in the modern world they do not need to hold gold as the basis of their monetary system.  Many of these governments are looking to take advantage of current highs to use the cash to reduce their debts. Greece has already had to sell gold held by the central bank as part of its austerity package. Italy is the 4th biggest holder of gold in the world some 2400 tonnes. Italy desperately needs to pay down debts to avoid default. Any Euro area’s rescue is likely to require offloading of gold.

What we are seeing with Gold today we have seen in the past with equities in 1999 and property in 2006. Many commentators come on to tell us why things have changed. Markets can keep moving higher because we live in a different world than the one we live in before. Inevitably, private investors get swept up in the excitement with the belief that it’s a “safe investment” that “always goes up in value”. In fact nothing has changed. The world today is the same as the world yesterday. Eventually sanity returns to prices.

When prices start to fall we discover that many of these private investors are geared heavily in the investment, prices start to plummet people lose their shirt and panic ensues. One key difference between Gold and previous property and equity crashes are that governments will not intervene to protect prices. Any landing is likely to be hard and at least 60% below the top of the market high. If previous gold bear markets are anything to judge by it will be 20 years until prices fully recover.

 

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