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Bubble Bubble Toil and Trouble - Not Gold, Not Yet

May 16, 2012, 5:37 PM

You often identify a bubble only in retrospect. The “bubble” metaphor indicates that the price of the stock or commodity was inflated and fragile – expanded on nothing but air, and vulnerable to a sudden burst. The crash that usually follows an economic bubble can destroy a large amount of wealth and cause continuing economic malaise. The perennial truth of financial history is that sooner or later every bubble bursts. Sooner or later greed turns into fear.

History has been peppered with financial bubbles and we’ll get to that, but first, is gold in a bubble?

So far it's been the amazing, runaway investment of the past decade. If you'd put your money into gold at the lows about 10 years ago, you'd have made approximately 400% return. That's left pretty much everything else—stocks, China, housing—in the dust, and we don’t mean gold dust.
Needless to say, no one knows with certainty whether or not gold will become “the ultimate bubble,” as George Soros predicted, or continue in a stable, secular bull market for many years to come. (If you had listened to Soros when he issued his warning at the World Economic Forum (WEF) and had shorted gold when it was trading at less than $1,150 per ounce, you would be in a lot of pain today.)

So is gold in a bubble?

Bubble, Shmubble

We would be willing to bet that if you asked for a show of hands of how many people own gold in an audience of 100 seasoned investors, probably less than 10 might raise their hands. If you asked the same question in a room of average, random people probably one or two hands at the most might go up.

Gold is clearly not in the bubble stage yet.

People have many reasons not to own gold. As Warren Buffett put it: "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."

In addition, gold is volatile (gold investors have to endure gut-wrenching corrections); it is hard to value and generates no income.

So back to the bubble question--what do tulips, Mississippi, Internet, Dot.Com, the South Seas and Florida housing have in common? They were all at one time bubbles that burst leaving financial ruin in their wake.

Although some of these bubble episodes happened centuries ago, the events are eerily similar to today’s bubbles and busts: low interest rates, easy credit terms, widespread public participation, bankrupt governments, price inflation, and frantic attempts by government to keep the booms going and government bailouts of companies after the crash.

What can we learn from history about financial bubbles?

The Granddaddy of them all - the Tulipmania

We have all heard of the classic bubble, Tulipmania, which took place in the 1630s in the Netherlands, where derivative futures in tulip bulbs were exchanged for astronomical prices. Aristocrats, maids and chimney sweeps all got Tulip Fever. At the peak of tulip mania in February 1637, a single tulip bulb sold for more than 10 times the annual income of a skilled craftsman. The bubble held until a terrible crash that was caused, according to legend, by a sailor who mistakenly ate a high-priced tulip bulb after he confused it with an onion.

The Bank of Amsterdam dominated the Dutch financial system in the 17th century, and possessed one of the toughest monetary systems of all time-- 100-percent reserves of gold and silver backing all of its monetary promises.

So the question arises as to how did this mania get started under such a strict monetary system?

Douglas E. French, president of the Ludwig Von Mises institute, offers an explanation in a book, Early Speculative Bubbles & Increases in the Money Supply.

In a nutshell, French claims that it was a government intervention that dramatically exploded the money supply and fueled the tulip-price bubble, not unlike the bubbles that were formed in modern times.

The Dutch instituted a policy of "free coinage", whereby any amount of precious metal brought to the Dutch republican state would be minted "free" of charge and returned as the same weight of precious metal in the form of coins. Dutch taxpayers were forced to subsidize minting, thereby sucking in precious metals from all over Europe. The Dutch state policy of providing "free coinage" meant that more bullion was turned into coin than a free market would otherwise have produced. So there was a dramatically rising flow of precious metals flowing to the port of Amsterdam, especially from the Spanish silver mines in South America. Amsterdam was ripe for speculation and everyone got into the act.

The Five Stages of a Bubble

Niall Ferguson in his book “The Ascent of Money,” distils the formation of bubbles into five stages:

  1. Some change in economic circumstances creates new and profitable opportunities.
  2. Euphoria sets in whereby rising expected profits lead to rapid growth in share prices.
  3. The prospect of easy capital gains attracts fist time investors.
  4. The insiders realize that the now exorbitant price is unsustainable and begin to take profits by selling.
  5. As share prices fall, the outsiders stampede for the exits all together causing the bubble to burst.

If we look at the above analysis, gold is probably only in stage one where changes in economic circumstances create profitable opportunities to buy the yellow metal. We are still far away from euphoria. Although gold has attracted some first time investors prompted by fear and searching for a safe haven for their capital, gold is far away from being a crowded trade. If you’re not sure, just ask your friends, acquaintances how many of them have bought gold. With crumbling infrastructure, runaway debt, paralyzed government, military bogged down in pointless faraway non-wars and troubles in the eurozone, there are plenty of motives to buy gold.

To put the current price in perspective, gold's 1980 high was about $7,000 in today's dollars when using the original CPI methodology, and $2,200 when using the new methodology. On that basis, today's price looks cheap. More importantly, China, India, and Russia all want to diversify away from the dollar and are looking to buy gold, and central banks have turned into buyers from sellers, creating something akin to a price floor.
Just because gold has been in a long-term advance does not mean it represents a bubble. Neither does volatility as long as it is within a reasonable range. It is when prices rise sharply in a short period of time, and then drop sharply in an equally short period of time that you can conclude that a bubble had formed, and then burst. We don’t see any evidence of that with gold.

Gold will correct during its run up and we hope that it does. When it does, all the people shouting “bubble” will smirk and we will be out there buying more. We think that bubble is not in gold, it is in what is driving the price of gold—fiat money creation.

The Austrians Predicted the Subprime bubble

We often like to write in the Premium Update about the Keynesian versus the Austrian schools of economics. Please note that it was the Austrian School of Economics that accurately predicted the financial meltdown of 2008. The Austrians correctly identified the influence of easy credit on human action. Altering the price of money alters incentives and changes individual calculations across the breadth and depth of an economy.

The Austrians pointed out that government-controlled interest rates are the real cause of the business cycle inasmuch as they lead to credit booms and inevitable busts. When the price of money is rigged, the market isn’t free. Only if you understand the “root cause” of the business cycle can you learn how to prevent bubbles from blowing up and popping later. The Austrian answer is sound money.

Still, let's keep in mind that in order to make the most of investing in gold and trading it, it is imperative to conduct through analysis and dedicate a lot of time and resources to it... Or to read the professional analysis written by experience authors. This is where we can help. In our Gold & Silver Trading Alerts we provide detailed analysis of the precious metals market in a daily basis and in our Market Overview reports, we conduct monthly fundamental analysis of the gold market. Regardless of which is of the above seems more appealing to you, the best course of action at this time is to sign up for our free gold newsletter. In this way, you'll be up-to-date with our free analyses and at the same time, you'll receive 7 days of access to our Gold & Silver Trading Alerts as a starting bonus. Again, it's free so all it takes to sign up is just several seconds of your time. Sign me up!

Shula Kopf
Sunshine Profits' Contributing Author

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