Gold: Now a nascent bubble
By Daniel M. Ryan
web posted March 22, 2010
Last November, I wrote "Gold: A Potential Bubble" for this web journal. Back then, I said that gold was in a potential bubble because it was an investment that ended the 2008 calendar year with a gain and was sporting a sizable gain for the 2009 year. This kind of investment sticks out as one that seems to have staying power when others don't.
As ill luck would have it, the article was published ten days before gold peaked. I have to admit that I whiffed the fumes of the bull run that prevailed back then.
Despite the December breakdown of gold's uptrend, gold has gone nowhere since then. Some analysts say that it's currently in a trading range, or sideways all told. Perhaps paradoxically, I'm convinced that gold's trendlessness is a sign that gold has moved from potential bubble to nascent bubble.
In order to see why, I must revisit grounds I first visited last time. A potential bubble exists when an asset that's overvalued by traditional fundamental analysis trades like it's undervalued. This disconnectedness from tried-and-true fundamental analytics raises a conundrum: why should an asset be overvalued and yet stay up, even under conditions that would normally bring it down to earth? Why is the asset apparently immune to its overvaluedness? Why is the asset treated by buyers as if it were at bargain levels when plain analysis shows it isn't?
There are two answers. The first is taken up by the skeptic, who decides that the market for that asset is simply irrational. Resistance to sinking to where it should be is a sign that it's in a "bubble." The trouble with this answer is that it makes the skeptic look foolish or obstinate if the asset does enter a full-scale bubble. Anyone who said that U.S. residential real estate was in a bubble as of 2002, or who said that Internet stocks were little more than equity in no-margin or freebie-pushing garbage companies back in '96, was made a laughingstock when those nascent bubbles turned into full-fledged ones. Tragically, the skeptics tend to be right when the bubble finally bursts…if they stick to their guns and don't get pushed by the wind. It takes a certain constancy of character to do so, the kind that can help a person withstand being the "odd man out" for a three-year period. Happily for skeptics, some incipient bubbles never get off the ground. When one of those comes along, and deflates, the skeptic looks pretty good.
The second answer resolves the conundrum by means of what I call a "New Era story." It's a narrative which claims that an asset which is overvalued by tried-and-true methods is actually undervalued. In the case of the Internet bubble, companies with losses were given high valuations by Net-stock believers on the basis of neologistic metrics like "mindspace" and "eyeballs." These metrics were said to indicate future profitability. It didn't matter if Web companies had no profits as long as their Websites were widely viewed, popular and frequently visited. The earnings would come later.
For some companies, this hope came true. Amazon, for example, is now a profit-maker; so are eBay and Yahoo. Several others are now large and profitable businesses that are valued by fundamental analysis like other established concerns.
As the bubble grew, though, that New Era story turned into an all-out delusion. Instead of companies with revenues but losses, it was said to apply to companies with popular Websites but little or no revenues. This claim makes a good demarcation point between New-Era story and New-Era delusion. Revenues provided a tie, if dubious, to earnings. Many new companies grew their way to profitability by focusing on revenues first and margins later. Once the revenues hit critical mass, attention is paid to profits.
In order for this bootstrapping to pan out, though, the revenues had to be growing at a fast clip - and there had to be a feasible way to squeeze a net profit from them. Obviously, the inflow has to be there in the first place. By 1999, though, it was being claimed that mindspace, eyeballs, etc. were as good as revenues; they represented revenues that would show up "real soon now." When popularity began being confused with cash, the delusive stage of the New Era narrative had arrived. Within a year, the bubble had started to collapse.
This vignette sketches out how a bubble latches upon a New Era story that starts off sensibly, even though in a speculative vein, but transmogrifies into a fantasy-enabler. Gold is not in a real bubble now, but a New Era story is incubating for the metal. It's not yet being used to explain why gold hasn't fallen far more than it has, but it will be.
Why Gold Is Overvalued, By Traditional Measures
Gold is classified as a commodity, one with several uses. The most noticeable, and important, source of demand is for jewelry. Some demand is for "investment" purposes, but tried-and-true commodity analysis treats it as essentially speculative demand. When gold's in a bull market, more people buy it to hitch a ride on the uptrend; vice versa for a downtrend. In the very long term, according to conventional commodity-centric analysis, investment demand should be seen as essentially ephemeral. What really counts is other sources of demand.
On this basis, gold was undervalued for most of the last decade. As of now, though, it's overvalued. Instead of its current price of approximately US$1,100/oz, it should be $800-900.
The reason for this overvaluation is that same investment demand, which has become quite an important component of overall demand for gold. To an old-style commodity analyst, this emergence raises an alarm bell. Investment demand, although the term itself connotes permanence, has traditionally been fickle. Counting on it as part of permanent or "real" demand, from this perspective, is like counting on momentum to push an overpriced stock higher. There is, after all, a positive correlation between investment demand for gold and its price.
Skeptics, like this analyst, see high and rising investment demand as something akin to Wile E. Coyote running off a cliff. Everything's all right until the look-down.
A New "New Era" Story
In my earlier article, I said that the New Era story for the gold bubble will be the dethronement of the U.S. dollar as a world reserve currency to the (partial) benefit of gold. I have to admit to inhaling the vapors generated by the excitement over the Indian central bank purchase of some IMF gold. There's a much more quotidian New-Era story available, which centers upon gold's gentrification as an investment class. The underlying technique is already spreading through the mainstream media.
Beforehand, gold investment was something of an acquired taste. Gold investors tended to be politically libertarian, and often insisted that gold is real money and currency isn't. There's an entire goldbug subculture, with elements that may be off-putting to some. Consequently, goldbugs have been viewed as the oddballs of the investing arena – and investing in gold has been seen as falling in with the goldbugs. Hence, investing in gold was seen as a little strange by the mainstream; this distancing made gold an alternative investment. The only time when gold was mainstreamed was during the 1970s, when a major bull market turned goldbugs from odd ducks into the flavor of the year (actually, two: 1979 and 1980.) Uncharitable as it sounds, it wasn't inaccurate to say that gold being mainstreamed was a sign that it was in a bubble about to burst.
That's changed in recent years. Gold is still an alternative investment, but not in the on-the-fringe sense. It's being recommended as a means for a regular investor to diversify his/her portfolio. The recommended percentage to set aside in gold is usually 5-10% of the total portfolio value. Since gold has tended to go up when other asset classes either stagnate or go down, it acts as a kind of portfolio insurance in this role. The granddaddy of this asset-allocation strategy is the "Permanent Portfolio."
Ostensibly innocuous, which it is at the individual-investor level, it carries the seeds of a real New-Era story from the vantage point of a commodity analyst. As the portfolio-insurance role of gold spread, it becomes easier to claim that investment demand for gold is essentially permanent and even ratchet-like. Based upon the way that gold investment demand is normally treated in gold analysis, this claim is fairly radical. (It also contains a flaw, as portfolio rebalancing requires selling off some gold if it's up relative to the other assets held. That rebalancing, ceteris paribus, lessens investment demand as gold outpaces other asset classes.)
The Nascent Gold Bubble
<a href="http://www.businessinsider.com/citi-no-obvious-relationship-between-gold-and-inflation-2009-9">Although debunked, the popular perception of gold is that it's an inflation hedge. Consequently, there won't be any real gold bubble unless high inflation comes back. Inflation is tame right now, and the prevalent fear is of deflation. The right investment clime for gold as a hot investment doesn't exist right now. Thus, gold is not in an outright bubble.
It is, however, in a nascent one. That New-Era story, although more analyst-centric than my first attempt, will sound more plausible to investors as the portfolio-insurance technique spreads. Insurance, after all, is meant to be kept in place. The resultant demand can credibly be called semi-permanent in nature. Plus, it can be extended upon and even exaggerated by calling attention to the rolling gold-as-insurance bandwagon.
In fact, recent investment demand could be explained by it. During the December downtrend and this year's doldrums, there hasn't been that much disinvestment from gold – nothing like the net investment that was seen in 2009. It can thus be claimed that a New Era for gold has arrived, one where it's appropriately mainstreamed and is becoming an essential part of the typical investor's portfolio. One where the old commodity analyst's rule about the long-term ephemerality of investment demand doesn't count as much.
I may be wrong about gold being in a nascent bubble; it may still be in a potential bubble, which may be burst by an all-out bear market that would end at, say, $850. The speed and ease which the portfolio-insurance meme is spreading through the mainstream investment community, and the popularity of gold ETFs that are bought and sold like stocks, suggest that the above-italicized New Era story is salable…even palatable. At the very least, it neatly explains why gold is overvalued yet won't fall.
In retrospect, I don't think the gold bug worldview will spread beyond its natural subculture of libertarians and the politically disaffected – not unless a real gold bubble gets rolling. As I noted above, there's no driver for a gold bubble in today's investment climate.
Disclosure: I have some money in gold stocks, and my circumstance may have influenced what I've written above to the bull side. In order to compensate, I've used hypotheticals in certain places. 
Daniel M. Ryan is currently watching The Gold Bubble.