Is Gold a Bubble?
Over the last decade or so, the price of gold has risen from under $300 per oz to highs of over $1,800 per oz in 2011, causing many people to become concerned that gold has become the next speculative bubble.
So, just how high is the price of gold likely to go to over the coming few years? And is gold really the next bubble? In this article, I am going to attempt to answer these questions as honestly as I can.
Gold: Is it a speculative bubble?
In order to answer this question, I should probably first attempt to define exactly what I mean by the term 'speculative bubble'. I regard any situation where the price of any asset, commodity, currency or whatever rises far above its underlying value, with ever increasing prices being the justification for paying ever higher prices, to be a speculative bubble.
A speculative bubble is therefore not unlike a Ponzi scheme – investors, if they can even be called investors I personally consider them to be speculators, buy a commodity or asset not for its underlying value or the income that it can generate for them, but because they believe that whatever price they have paid they will be able to find someone else willing to pay an even higher price for it in the future. And like a Ponzi scheme, someone always ends up coming late to the party and loses. All bubbles eventually burst, they have to as there are only ever a finite numbers of speculators willing to speculate, when in reality it would take a never ending supply of speculators, each willing to pay more than the last in order for the bubble to go on growing forever.
So, does gold at prices of around $1,800 per oz now meet the criteria of being priced way above its underlying value? And has it been driven to these heights mainly as a result of speculators being willing to pay any price for gold regardless of its underlying value; simply because they believe that someone else will be willing to pay them even more for gold tomorrow than they paid for it today?
My honest answer to that question is that I suspect that gold probably is a bubble, but I can't be too sure of this due to the difficulty I have in actually placing a 'true' value on the price of gold.
At any given time the value of any commodity or asset is obviously what someone will pay you for it, that is, its market value. But the market it a very fickle beast and the market is not nearly as good at valuing things as many people would have you believe. On any given day the market merely measures the general feeling as the price simply reflects the public mood about the asset or commodity in question. But in the long-term the price will usually come back towards its 'true' value, regardless of the highs and lows that the public mood has driven to in the past.
When an asset, stock/share or commodity is out of favour with investors it will usually be priced below its true value, and when an asset, stock/share or commodity is fashionable it will often be priced above its real value. Assessing the real worth of an asset, stock/share or commodity is very difficult, but all true investors must at least make a serious attempt to do this before buying it, otherwise they're not really investors at all and are really just speculators buying in the hope that the price will soon rise and that someone else will be prepared to pay them more for it than they have paid, regardless of it's actual worth.
There are many methods that can be used to assess the real value of things, for example, property is often thought to be worth around 15 times its yearly rent; and some even value homes at multiples of the average household income – for example, you could say that a home should cost around 3.5 to 4.5 times the yearly income of the person or household that you might expect to live in such a place, with the average home having a 'real' worth of around 3.5 to 4.5 times the average house hold income. Using such a model, a property investor could look to buy property when property was under valued and define the property market as under valued when the average home could be purchased for less than three and a half times the average household income. Likewise, a property investor could use such a model to tell them if the property market was over valued and heading for a crash, selling their properties (or at least not purchasing any more properties) when the average home was priced at more than four and a half times the average yearly household income.
As with real estate, there are many methods that one can use to assess the value of stocks and shares too. For example, we could say that if a company were to fail then its value in a fire-sale would be the value of its assets minus its debts and liabilities – however to assess this value correctly you would have to correctly value the price that the company's assets would fetch in a fire-sale, and this may be very different to the price the company's accountants valued company's assets at on the company's balance sheet. But the most reliable way to value a company however is probably to say that a company is worth x times its yearly profits. One would only tend to value a company at the value of its assets minus its debts and liabilities if they thought there was a significant risk of the company ceasing to trade for whatever reason. Companies are usually said to be worth around 10 to 17 times their yearly profits, or 10 to 17 times the company's average yearly profits over the last 10 or 20 years. However, when a company is rapidly growing it can often be worth more than 17 times its yearly profits, and likewise, when the company is expected to do badly in the future it may not even be worth 10 times its previous yearly profits as profits in the past are no guarantee of profits in the future. This system of valuing companies based on their previously yearly earnings is known as the P/E ratio (price-to-earnings ratio).
Assessing the true value of commodities is much harder than assessing the value of companies and property. And this is especially true of a commodity like gold. Commodities such as oil that are produced purely for their usefulness can be said to be worth at least what it costs to produce them and yield the producer a profit great enough to make it economical for them to re-invest in producing enough in the future to meet the expected future demand. Although in the case of oil, the cost of producing it the future can also be difficult to estimate and I suspect the world may have already hit peak oil.
The price of gold does not seem to reflect its production cost or the industrial demand for it. And unlike profit making companies, rental yielding properties and even interest bearing currencies, gold cannot be valued based on the income (or yield) it generates for its owner as there is none. If anything, the price of gold is something like an economic confidence index, with the price of gold rising during times of financial uncertainty and the price of gold falling during times of great economic confidence. Some financial commentators have even called the gold market 'the fear index'. I think there is a lot of truth in this; financial institutions, central banks and savvy investors often buy gold when they don't trust fiat currencies (paper money).
But a lack of confidence in bank credit and paper money still doesn't help us assign a 'true' value to the price of gold. Even if there were a financial meltdown tomorrow and all fiat currencies collapsed there is no guarantee that we would return to a gold standard, and even if we did it would be impossible calculate what the value of gold would be then. I have heard some people say that in the event of a return to a gold standard the price of gold would have to rise so that there was enough gold in existence to purchase everything that could be purchased, but I can see no reason to believe that the new rules of the economic game would be constructed to make this so. If the world did this then South Africa would become one of the richest countries in the world overnight and the Indian people (who buy more gold jewellery than anyone else) would be some of the richest people in the world. I just can't see the powers that be getting together to make this happen. Markets are never truly free and the economic system, indeed all economic systems, are effectively nothing more than a set of rules that the big powers have agreed to play by and are able to force on the rest.
When Richard Nixon took America (and effectively the world) off what was left of the gold standard in 1971 the price of gold was $35 USD per oz, it is difficult to assess what, using those figures, that makes gold worth today. If you were to say that in the forty years since 1971 the world economy has grown about 20 fold then gold should be worth around $700 per oz going by those numbers. But if you were to adjust the price of gold for US inflation since 1970 then gold would be worth considerably more than this, probably around $2,000 per oz.
In short, I suspect gold is a bubble and the price will fall in the future as the economic outlook improves, but this may take many years and I can't be to confident in my predictions anyway since I really can't even put an accurate figure on what I think gold should actually cost.
Gold: How high is the price likely to go?
I'm going to stick my neck out and say that gold hit its peak in 2011. I'm not too confident that my prediction will turn out to be true mind you, but I though I'd best stick my neck out and make one rather than simply say, 'it might go up or it might go down' and then claim I was right – so much that passes for financial analysis these days seems to do little more than that. It is hard to value gold and the price of gold does indeed seem to be little more than an economic fear index but it is now December 2011 and there seems to be more economic uncertain than ever with crisis in the Euro Zone, yet the price of gold has not (yet) surpassed the highs it made several months back. In the last couple of months when the stock market has fallen gold has not rallied either. And it is this, and this alone that I'm basing my prediction that the price of gold has peaked on. Saying that, without a serious economic recovery, the gold bubble might be very slow to deflate...
David 10th December 2011.
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