This Is the End


Markets, Risk and Human Interaction

March 8, 2010

The Gold Bubble

This represents my personal opinion, not the views of the SEC or its staff.

I am not going to spend time here talking about how the price of gold is off-the-wall, that it is not just a bubble in the making, but a bubble waiting to burst. I don’t want to waste your time on that point.We all know it is a bubble.

George Soros has said “The ultimate asset bubble is gold”. Many of the top asset managers, such as Tudor and Paulson, are piling on; Paul Tudor Jones recently said gold “has its time and place, and now is that time.” The banks are echoing this view with their research. Goldman has a research piece that looks for gold to approach $1,400 in the next year. The more ebullient Charles Morris of HSBC has said, “I absolutely believe it’s heading into a bubble, but that’s why you buy it. ” He, along with a number of other professional and otherwise rational managers, looks for gold to move as high as $5,000 an ounce.

More interesting than this almost universal agreement is what that agreement tells us about the dynamics of the market.

The Naked Bubble

Usually the markets have the courtesy of giving cover for bubbles. We adorn the bubbles with some justification. Even if a guy is just after sex, he at least has the decency to act like there is some substance behind his interest. For the Internet bubble, it was that fundamental analysis based on the brick and mortar world did not bear relevance in the New Paradigm. For the Nikkei bubble, it was that the crazy P/E ratios were not considering one subtlety or another in the Japanese accounting system.

But with gold, no one seems even to care about giving a justification, other than “gold has been a store of value throughout 5,000 years of monetary history”. Which is fine as far as it goes, but that doesn’t say anything about what the price of that store of value should be.

Pump and Dump

Given that “hedge fund” and “highly secretive” are usually said in the same breath, don’t you get suspicious when so many of the top managers are so vocally out there about their gold investments? And when their positions are structured in a way that make them open to view? Paulson and Soros have huge positions in gold ETFs. We know that, because if you buy ETFs, they show up in your 13-F filing. Granted, with an equity investment you can’t help putting that information out into the market, but with an asset there are plenty of ways to take the position without signaling it.

That they are taking a highly visible route to their positions suggests the game that is being played is one of leading the herd. The 13-F reports positions with a big lag, so no one will notice if they quietly slip out the side door while the party is still hopping. And how about when the view is backed up by none other than Goldman Sachs? Will they let everyone know when they think it has gone too far before they get out. Or before they go short? Maybe they already have.

Herds, crowds, mobs, and the Top Ten

And yet, we follow the herd, as we have countless times in the past. Herding is a timeless and universal market behavior, but one that seems less than rational. It is broader than markets; think of the Top Ten phenomenon. We feel better if a lot of other people think that our favorite artist or actor is The Best. We like a song better if we know a lot of other people are liking it as well. Thus our love affair with lists. Magazines featuring the Ten Sexiest, the Five Best, the 100 Whatever are all best sellers, even if the list is the product of a story meeting between an editor and five reporters.

Herding can be explained as an artifact of what was rational behavior in earlier times, when we were running around as hunter gatherers. Back then, mob and herding behavior made sense. Mob behavior if attacking a competitive group or killing a large animal; herding behavior if protecting against predators or uprooting to a new location. Whatever it was that got started, you could be pretty sure there was safety in having a crowd on hand to finish it.

The very notion of mobs and herds evokes a certain spontaneity.
But with the gold bubble, we are moving on to a concept of herding by appointment. Everyone seems to be happy in agreeing that this is a bubble, and we are all going to participate in this bubble in a rational, genteel way. We have all decided that this is going to be a number one hit, a Top Ten. Though we might want to ask who is leading this herd, because my bet is they will be stepping aside and cheering us over the cliff.


  1. Gold is best understood as a currency that is competing for the dollar for status as the reserve currency status of the world. And there are a lot of rational reasons for China and other countries to choose gold over the dollar as a reserve currency. If you are selecting a common store of value, you do not want that store of value to be something that one country can abuse by printing excessive amounts of it. Gold is thus a natural currency. If you're interested in reading a fuller case for the scenario in which a currency run from dollars to gold happens, I suggest this essay. Will this actually happen? Probably not in the next few years. The dollar still has a lot going for it. But the U.S. government is certainly not being a financially responsible currency manager. At some point this will catch up with it. When that happens, and people decide to drop the dollar, which alternative currency will make the best Nash equilibrium?

  2. “For what do we live, but to make sport for our neighbours, and laugh at them in our turn?”

    Rick,I'd have to agree with you on this one. To me gold makes sense as a hedge against the dollar, but very little else. The fact that the crowd are being herded towards it, only makes me more suspicious.

    I think a more interesting thing to question though is why does gold, a perfectly useless substances unless you want to conduct heat or electricity, actually have value? Why not some other arbitrary substance in short supply that you can dig out of the ground?

    What, when you get right down to it, is the value of gold? The answer, as ever is "what somebody is willing to pay for it"

    A fool and his money are soon parted :P

  3. I have a 100 trillion dollar Zimbabwe banknote and many Zim citizens have them. Why then are these stupid people scratching the ground all day long for a few grams of gold to buy food with?
    PS: I also have 2 trillion zloty note, 50 and 100 billion reichmarks, and a 50,000 reichmark bond with the coupons still attached. For the 50,000 RM I will take 1.5 million dollars (inflation-adjusted value), and throw the coupons in for free. To cash it, just go to Germany and ask for Ms Merkel...

  4. One has to look at St. Luis Fed Aggregate Monetary Base chart to conclude that price of gold is a function of amount of USD in circulation. More USD in the system = higher price of gold. There could be a bubble in monetary aggregates, aggregates rate of change, but not in gold. Gold price is just a messenger.

  5. if gold is a universal currency.. all the countries which have HUGE GOLD reserves have an undue advantage. ATLEAST OIL is consumed. we make damn use of it.. ALL THE GOLD ever mined in the last 5000 years still exist around. it is not CONSUMED. only minute amounts industrially.

  6. Gold is money. Always has been. Always will be. What gold is "worth" is a silly question. It is not worth anything. It is just what it is -- unique, rare, unprintable. The "worth" question pertains to pieces of paper that governments print. Gold isn't worth 1100 dollars per ounce. 1100 dollars is worth an ounce of gold.

  7. Herb, excellent points on gold and how the value of everything has been falling in terms of gold.

    I would suggest everyone (especially Rick) please take a look at this piece on the factors affecting the supply and demand of gold, which cites none other than Larry Summers as evidence to suggest that the gold price remains in a very favorable environment (note however that I am quite against what Summers has done over the past decade, to put it mildly):

    The most important part of the piece in my opinion is:

    "Per Summers and Barsky's research, the recent investment climate characterized by tepid long-term returns in stocks and bonds, combined with the prospect of continued monetary inflation to combat the credit crisis, strengthens the case for increasing an investors exposure to the gold price and gold equities in spite of the risk associated with short-term oscillations."

  8. ZH with a nice rebuttal.

  9. The U.S Congressional Budget Office (CBO) forecasts cumulative deficits of over $9 billion dollars over the next ten years, assuming constant, steady growth, no intermittent recessions, and stable federal tax revenues. U.S Social Security and Medicare unfunded liabilities, when added to the current outstanding federal debt, is over $100 trillion dollars. However, these liabilities are not calculated in the official government debt to GDP ratio. On December 24th, the funding caps for Fannie Mae and Freddie Mac were removed, and the debt issued by these institutions now for all intents and purposes are guaranteed by the US government- although for accounting purposes they are still not reported as offical liabilities of the Federal government.

    Taxation alone cannot pay off these huge debts as the baby boomer generation has already passed its peak earning years and long-term structural unemployment rises- permanently. A blatant default is out of the question, leaving monetization as the only way to nominally pay off the debts.

    The discovery rate for new gold mines peaked decades ago and the outstanding paper claims on gold through ETFs and short positions by bullion banks outmatch the amount of bullion actually available for delivery by several multiples. Worldwide gold production has peaked, and settlement (when large buyers actually take physical possession of the metal) is increasingly made possible by lease and buyback agreements since there isn't enough real metal to satisfy all the oustanding claims.

    The Chinese approach to owning gold has been to avoid the COMEX and the London Metals Exchange at all costs by buying up mines and downstream industries in sub-Saharan Africa to avoid sending price signals to the market in order to hedge their $800-billion plus US government debt and $2 trillion overall in USD denominated assets while central banks are no longer net sellers of gold.

    Given a long-term time horizon (more than 8-10 years) I would have to conclude that paper gold is the bubble, since its gold's de facto securitization through ETFs has resulted in a situation where we have a fractional reserve gold market baked by dwindling amounts of the metal in an environment where the supply of paper dollars is already on the path to an exponential growth function.

    Just as AIG raked in fees by writing CDS on securities they never thought they would have to post collateral on, the major bullion banks have allowed multiple claims per good delivery bar while artificially suppressing the price by massive net short positions.

    Should major institutional buyers start demanding physical delivery, this entire situation could unravel very quickly. Although legally many prospectuses reserve the right to settle in cash at a premium above spot in lieu of physical delivery of the metal, the preponderance of this could cause speculation that the entire gold market is in fact a giant ponzi scheme. The spot price could begin to rise dramatically, trapping the major bullion banks in what would truly be a Demon of Their Own Design.

  10. i have been a fulltime investor and trader for 10 years...
    this may be the single most poorly reasoned argument i have encountered in my career.

  11. To me it's only a matter of interest rates.
    As long as the FED keeps the rates close to zero, alle big banks and institutes will put their free cash into stocks and commodities.
    The moment interest rates start rising again to around 5%, you will see an unprecedented drop in all stock exchanges and commodities around the world.

  12. Chris Wyser-PratteMarch 13, 2010 at 2:52 PM

    Those who think gold is going to $5000/troy oz. were apparently too young to be in the markets when the Hunt Brothers cornered the silver market in 1979-80. Driving the price from under $2 (or $5 when they really got going with their Arab-related buying syndicate that cornered half the world's deliverable silver) they got it up to about $55, and then had no one to sell it to.

    Women were taking their unused silver candelabras, given them by a great aunt as a wedding present, to shops that melted them down on the spot against the spot price in cash. Supply came out of the woodwork. Changed commodity trading rules and intervention by the Fed did the rest. The Hunts declared bankruptcy, proving that it takes only one generation to turn a hard-earned large fortune into nothing.

    You, too, can go broke buying gold. I, of course, do own a little, as does anyone born in France during WWII. I have it so that when the Muslim terrorists set off their dirty bomb in NYC, I will have a currency of exchange with which to bribe a Pakistani cab driver into taking me north out of the city. But as an investment? Don't make me laugh

  13. Chris Wyser-Pratte just made my day! Hilarious! The problem I have with the gold bugs, the little ones, is there are other ways to hedge against all of the things they think they are hedging against by buying gold. (And their shares of GLD certainly aren't going to get them bupkus if the fit really does hit the shan, civilization-wise.) Yet all they want to do is buy, buy, buy gold even though there is no way to value it (isn't that just PERFECT! -- no way to truly find its intrinsic value...). I have avoided gold religiously, but when I really started to worry was when the glassy-eyed gold bugs also started talking about other metals, too: silver(!) and paladium(!) and ooh, did you hear about vanadium! and etc., etc., etc. Every day it seems some random metal company sees a 5+% pop. I feel sorry for the little guys. "This time it's NOT different."

  14. How about shorting the *PAPER* gold ETF and use the profit to buy *PHYSICAL* gold :)

    Now that will be the best trade ever.

  15. You do not buy gold as an "investment." It is simply a currency conversion.

  16. Rick - Most of your other posts have been excellent and insightful, but this one was sub-par. I can tell that you have not exposed yourself to the bullish case for gold and the calculations of an equilibrium market price for gold, as articulated for example in Mike Maloney's recent book.
    If you could read that book, show that you understood it, and give a rebuttal, then you would distance yourself from the many other bloggers that have written "gold is in a bubble, I know because the price went up and I presume the buyers must be stupid" articles.

  17. A note to those giving comments: I appreciate those who give comments. I do read these -- I am the one who moderates them -- but cannot often provide responses. (Also note, however, that I do not post comments that are off the topic).

  18. Sir: Perhaps the gold market is simply a reflection of your post from January 2nd???

    If you regress gold prices against CPI for the past 60 years, you will note that it's finally caught up with CPI...

    In contrast, the dollar has lost well more than half of its purchasing power over the same period.

    The first test of your thesis will arise when real short term interest rates turn importantly positive...

  19. I side with rick here. With gold there is only plan A, you have to sell it to some willing buyer to derive some value from your investment. There no long term plan B, no dividends, no coupons, no rent. But that's no problem, many would say, you just have to be disciplined and set your stops and your stop is your plan B... sure. Seen how well that works time and again.
    In the end it's just a damn metal with very limited practical use, and some people think of as "valuable" for reasons they themselves can't explain. Yours :) I will buy another house.

  20. The problem is, it's not a a gold bubble but a dollar debasement disaster now that central banks have squandered so much of their gold in trying to artificially keep its price low for decades that they're finally too exhausted to keep it up while at the same time ratching up the unbacked money supply to an extent that would require ten times the gold at their disposal to sell as a counter-weight.

  21. There is currently a realisation that we are beginning to live long after our working life is over. At the same time, cultural change, demographic change and sheer economics means that we wont be able to rely on our descendents to support us in our unproductive consuption period.

    Hence the demand for a store of wealth mechanism. What we have is a store of wealth bubble, not a gold buble.

    As I see it, the only way to cope with this is for us to work longer, and to be productive for a greater part of our lives. With a population pyramid that is shrinking, this may even be of benefit to the various economic systems we are part of. Otherwise, ANY store of value becomes meaningless as we try to exchange it to satisfy day to day requirements. Where is the productive capacity to satisfy our wants if we dont produce it ourselves? Imports? Then we have to make sure the items we store will be acceptable to foreigners.

  22. When stocks go down gold goes up is a risk aversion hedge. When risky assets go up gold goes becouse it belongs to the commodity complex.when inflation goes up gold goes up is an inflation hedge.when deflation is around the corner gold goes up becouse of the expanding monetary base. Wake up gold means norhing to the system. Nobody would bail out gold holders if the price went to zero. It meams nothing and nobody would exchange it for real goods if thw system collapces. If you want to hedge the next depression buy a buys you your survival ... Gold is not the bubble it is the pessimism bublble that is drovimg its rum. The sad thing is that indeed is a very poor hedge in case your fears cone true.

  23. Rick, Were you warning of a tech stock bubble in 1999 or of a housing bubble in 2006? If not, then why gold now? In 1999 very few talked about a tech stock bubble. Now everyone sees bubbles everywhere, from China to bonds to gold. My guess is, the more people think something is a bubble, the less likely it is a bubble. Everyone knows that inflation adjustments are understated by CPI, yet even with these understated inflation stats, the price of gold is far below its inflation adjusted peak from 1980. That is hardly the sign of a bubble. Also, how many people do you personally know who own any gold or gold stock in any form? How does that compare to the percentage of people you know who owned tech stocks in 1999? I was making large purchase of gold and gold stocks in 1999-2001 when most everyone hated gold, so don't feel bad for me if gold tanks. However, as long as the economy is weak and Ben Bernanke has his electronic equivalent of a printing press, there is little chance of that.

  24. It is not a matter of if.
    It is a matter of when.
    The game is one of chicken to see which of the big players sells off first.

    And the sheep keep following...

  25. Well I think the gold bubble is still being blown. It is going to pop and went it does look out below. This is going to send alot of people to the poor house.


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