How to Invest Your Money » Investing

Is Gold In A Bubble?

This is part two of the bubble series here at MapleMoney. Part 1 explored whether the run up in Canadian housing prices was a bubble. Today, let’s talk about gold.

As Warren Buffett has famously said:

[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.

Of course, astute readers will know gold’s main purpose, which has evolved into a tool to enable speculators to place bets on the direction of world economies and their monetary policies. Basically, investors will buy gold if they think major governments will be printing money to stimulate the economy. Or, these people can take it one step further in their thinking, buying gold because they feel a major economic catastrophe is upcoming. Gold also has some industrial uses, as well as being used in jewellery, but these actual demands doesn’t really move the price.

Naturally, as the economies of the developed world have gone through their problems over the past few years, gold has done well. The yellow metal closed 2011 at $1564 per ounce, declining from a high of nearly $1900 just a few months ago. 5 years ago, gold was trading at just $600 per ounce, meaning the precious medal has gone up more than 150% over the past 5 years.

Is gold just beginning it’s upward trajectory? Or is there a gold bubble and gold bugs in for a world of pain?

The Bullish Case For Gold

Central banks around the world are loosening monetary policy. Essentially, they’re both printing money and giving banks a ridiculously low rate to borrow money, which they hope will help kick start lending. Every central bank needs to slowly increase the supply of money in an economy, because a growing economy needs a growing money supply. But, what happens if the supply of money grows faster than the rate the economy is growing? In that situation we’d have inflation begin to spiral out of control, since printing too much money essentially devalues the current money supply.

This is what gold nuts are banking on. They believe that, over the long term, large government debts around the world are going to lead to economic disaster. To get out of their debt problems, governments will either be forced to admit defeat and default on their loans, or create enough money to pay them off. If either of those events happens to a large economy, (like say, Japan) this would be extremely positive for gold.

And if it does, you know your neighbour/friend/whatever who bought into the gold hype will be happy to profit off of others’ misery.

The Bearish Case For Gold

There’s two reasons why gold may not be a good investment going forward.

Firstly, there’s no guarantee that these large government debts lead to defaults. Remember, after World War 2, governments around the world were stretched thin because of the massive borrowing it took to fund a war. The soldiers came back home, the economy picked up, and the world grew out of its debt problem. It’s still quite possible for governments to do the same thing now. Even guys like me can figure out there are certain countries with debt problems. There’s still time for governments to do something about it.

Secondly, it’s possible the bad news scenario is mostly priced into the current gold price. If every gold bull thinks the same thing is going to happen, then they’ve already bid up the price in anticipation. If bad things happen, the price might actually go down, because so many people will want to take profits on the catastrophic event.

What Do I Think?

This is why you’re here, right? To get my awesome unsolicited advice? Well, here it is.

I’d stay away from gold. Firstly, as the investing axiom goes, buy low and sell high. Gold is trading close to an all time high. It has already priced in some pretty bad things happening. But what if they don’t? By buying after such a run-up, you’re setting yourself up for a long tumble down.

The faster an investment goes up, the faster it comes down. When the bubble pops, things go badly, quickly. One only has to look back a few years to the subprime mortgage crisis to see how quickly the market can turn from positive to negative. By buying an asset near the top of the cycle, an investor is setting themselves up to be caught up in the panic selling.

Look at silver, which is often thought of as a poor man’s gold. In the past year alone, silver has lost 25% of its value in a week twice. Those types of price movements aren’t characteristics of a rational market.

I won’t be putting any of my money in gold soon. How about you? Do you think there is a gold bubble?

Comments

  1. Victor

    Are your thoughts the same for silver?

    Doesn’t silver have many more practical uses than gold has? For example, cellphones use it. The price of silver is still within the reach of the average joe while gold is not.

  2. Janet Hutchins

    Buy low, sell high. But how do you tell the difference? Real estate was at the top of a bubble a few years ago. It was obviously time to sell, rent for a few months, then buy after the crash. But the price never did fall. It just kept on going. It was not a bubble after all. Betting on gold is like sitting down at a Vegas table.

  3. Ken Faulkenberry

    I agree, most people should stay away from gold at today’s prices. For those considering gold I have written an article about THE crucial question investors should ask themselves before investing in gold: Is gold an investment or a store of value? For anyone interested you can find the article at:
    http://blog.arborinvestmentplanner.com/2011/12/is-gold-a-good-or-wise-investment-for-2012

  4. W-at-Off-Road-Finance

    Gold is, more or less by nature, always a speculative bubble. Production exceeds consumption by a huge margin. The rest is subjected to a magpie-like instinct to collect shiny objects in one place, the only difference being it’s a vault rather than a nest. That’s all well and good – demand is demand. But I have to think demand based on bird-brain desires is rather fragile. If the losses start to mount, especially in conjunction with a CME margin increase in gold, the rush to the door is going to be rather dramatic.

  5. youngandthrifty

    Interesting take on gold’s ups and downs! Looks like you’re bearish on gold. I don’t blame you 🙂

  6. Ken Faulkenberry

    Excellent advice and analysis on the prospects for gold. I believe THE question every investor should ask before investing in gold is “Is Gold an Investment or a Store of Value” and have written an article on the subject for anyone interested at:
    http://blog.arborinvestmentplanner.com/2011/12/is-gold-a-good-or-wise-investment-for-2012

  7. richardcarlson

    The quick answer: yes. Gold is definitely in a bubble – It has no value outside of being used for trade and jewelry and a few select other things. You dig gold up, and hide it in a safe – That’s about all there is to gold. Since 1971 our currency hasn’t been back by gold, and many other currencies are pegged to the US dollar, so if our dollar tanks, then we can’t exactly pull an arbitrage deal and sell our gold for another currency because their values will tank as well…

  8. Derek Shevkenek

    You answer the question “Is gold in a bubble?”, with the response “Gold is trading close to an all time high.” You really need to re-visit that assumption because it is key to your conclusion. Gold’s record high of $850 USD per ounce is far from having been matched to date. Inflation adjusting is critical for an apples to apples comparison of price. Gold would need to be around $2,500 per ounce today to match the old record. But wait! Inflation calculation methods have changed significantly since 1980. Gold would need to be around $8,900 today to match its old record – when using the same inflation methods in place back when the old record was set. Interestingly, this inflation issue was brought up at a Berkshire Hathaway (think Warren Buffett) annual shareholders meeting a couple of years ago – 2010 I believe. At that meeting they even used gold’s price as an example to illustrate it, thought back then gold would have had to be around $7,700 per ounce according to their quoted numbers. For a further look at this inflation issue, google “john williams inflation” as it is his work that was referenced at the Berkshire Hathaway meeting. Finally, regarding government debts and default, Allan Greenspan made an interesting comment last summer when the U.S. credit rating was called to question. He said something like there is no risk of the U.S. government defaulting on their debt (meaning missing interest or principle payments on their bonds, etc.) because they can always just print the money. Gold can’t be printed. Think about those ramifications.

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