Is Gold A Bubble?

Posted on 12/10/2010

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What exactly is an asset-price bubble? Economists still argue about the exact definition of a bubble, but in summary a bubble can be characterised by a negative feedback loop of rising asset prices attracting more buyers to a market, in turn driving prices higher and attracting more investors. In “New Palgrave: A Dictionary of Economics”, Charles Kindleberger – author of “Manias, Panics and Crashes: A History of Financial Crises” – defines a bubble as:

A bubble may be defined loosely as a sharp rise in the price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers – generally speculators interested in profits from trading in the asset rather than its use or earnings capacity.

By this definition, because gold has little productive use and as investors are always interested in trading profits rather than gold’s earnings capacity (as it has none) any medium-term rise in prices could be described as a bubble.  We can see from the chart below how the real gold price has increased significantly in recent years above its long-term average.

Jeremy Siegel, in “What Is an Asset Price Bubble? An Operational Definition” defines an asset-price bubble as when the realised returns over a specified period are more than two standard deviation s from the expected return. In “Stocks for the Long-Run”, Siegel notes the gold has returned an average of -0.1% per annum between 1800 and 2001. Now, I don’t have the data-set to calculate the standard deviation (you can buy it here from Siegel himself for a very reasonable $100), but I think it is safe to assume that returns of 14.7%pa since the “Brown Bottom” in May 1999 is highly unusual for an asset that has averaged returns of only -0.1%pa since 1800. The problem with a calculation such as this is that Siegel himself uses much longer time periods in his work to identify bubbles (trailing 30 year returns for stock prices) and believes that “one must wait a sufficient period of time to see how the future plays out before anyone can identify a bubble”. Siegel’s methodology for determining the correct time period is to calculate “the time-weighted average of all future expected cash flows”. Because gold generates no cash flows to its holders, this is a rather unsatisfactory technique for identifying a gold bubble.

Some economists use a definition of a bubble that includes not only a sustained and unusual rise in asset prices outside of historical norms, but also requires the rise in prices to be disconnected from the underlying fundamental value of the asset in question. To calculate the fundamental value of an asset the discounted cash flow methodology is used. So what is the fundamental value of gold? Because gold generates no cash flows for its owners, and indeed, because owners of gold have to pay in order to hold it via insurance and storage costs, gold could be argued to have zero (or indeed negative) fundamental/intrinsic value. The result of this analysis is that gold is always a bubble, again an unhelpful conclusion if we are seeking to determine whether or not the current gold price can be described as a bubble.

Many commodity analysts look at underlying supply and demand trends to understand the factors that are likely to drive future price action. The below chart, sourced from the World Gold Council shows how total demand is broken-down into three components – investment demand, jewellery demand and industrial & dental demand.

Three factors are apparent from the chart: (1) increasing gold prices have been driven by an increased demand for gold for investment purposes, increasing from an average of 163tonnes/quarter from 2004-08 to 467tonnes/quarter since the beginning of 2009; (2) that increased investment demand, via higher prices, has reduced demand for gold jewellery, which has declined from 614tonnes/quarter from 2004-08 to 445tonnes/quarter since 2009; and (3) increased demand for gold has elicited a supply-side response, with total gold supply increasing from 888tonnes/quarter between 2004-08 to 1008tonnes/quarter from since 2009. This leads to to the following conclusion: to remain bullish on gold prices, an investor must not only believe that investment demand for gold will increase, but also that it will continue to outpace new supply (from mines and scrappage) and that jewellery demand will begin to hold-up.

Many of the gold bulls believe the price is justified because of rising indebtedness of developed country governments and the increasing use of quantitative easing (or money-printing) to combat low levels of economic growth. In this scenario holding gold is advantageous as it tends to act as a store of value in the long-term. However, for me, the question this raises is  –  in a scenario where inflation is seen as a threat – why are long-dated government bonds trading at record-low yields? At present, the 30yr US Treasury is trading at 3.75%, the 30yr UK Gilt at 3.94% and the 30yr German Bund at 2.98%. None of these yields suggest inflation is a threat. In addition, we can also calculate market implied inflation from the inflation-linked bond market. With the 30yr US TIPS trading at 1.42%, this implies the market believes inflation will average 2.33% per annum over the next 30yrs, hardly a worrying level. If investors are concerned about inflation, one way to protect against this would be to purchase TIPS and sell nominal Treasuries (or go short via futures) in an equal amount. This will give the investor no exposure to US interest rates but investors will profit if realised inflation is higher than 2.3% over the next 30yrs. To me, this appears to be a much purer way of guarding an investment portfolio against the threat of inflation, and does not have the volatility that comes from investing in gold.

In a recent article, the economist Kenneth Rogoff stated:

Indeed, another critical fundamental factor that has been sustaining high gold prices might prove far more ephemeral than globalization. Gold prices are extremely sensitive to global interest-rate movements. After all, gold pays no interest and even costs something to store. Today, with interest rates near or at record lows in many countries, it is relatively cheap to speculate in gold instead of investing in bonds. But if real interest rates rise significantly, as well they might someday, gold prices could plummet.

In summary, if inflation does make a come-back, and this leads to higher interest rates, then this could actually be negative for the gold price rather than positive.

In conclusion, while gold prices are clearly benefiting from momentum at present (possibly due to inflation concerns and also because the opportunity cost of speculation is negligible given low interest rates) it is difficult to make a fundamental value argument that justifies the current gold price, other more focused investment strategies exist for protecting a portfolio against inflation, gold prices are being driven by significant investment flows that may not be sustainable and historical experience means that losses could be substantial if gold does turn out to be a bubble which deflates (just ask anyone who invested in 1980).  Therefore, I would strongly advise investors to pay heed to this statement from Kenneth Rogoff:

If you are a high-net-worth investor, a sovereign wealth fund, or a central bank, it makes perfect sense to hold a modest proportion of your portfolio in gold as a hedge against extreme events. But, despite gold’s heightened allure in the wake of an extraordinary run-up in its price, it remains a very risky bet for most of us.

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Posted in: Economy, My Thoughts