Friday, October 5, 2012

Gold Bubble, Toil & Trouble

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I haven't seen so much talk about whether Gold is a bubble or since around 12 months ago when Gold peaked at a record high above US$1900.

After writing my piece on Gold/Silver (and my expectation they will head into a bubble) nearly 3 weeks ago:


I have seen several pieces since discussing whether or not Gold is already in a bubble or heading into one... including a video from Santiago Capital, posted on Zero Hedge which outline several reasons Gold is not a bubble (reasoning included not having reached inflation adjusted peak from 1980 and being under owned by investors). There has been recent discussion on CNBC about whether Gold is in a bubble or heading into a bubble. There was this piece from The Daily Gold which included a chart showing Gold's share of global allocations (relative to the 1980 peak):


And then there was this article yesterday from David Llewellyn-Smith (of Macro Business / Macro Investor) aptly titled "Gold is not a bubble".

I agree with the ultimate conclusion, however disagree with some of the statements made in the article, for example:
When thinking about gold, the frame of reference is entirely different to that used for other investment classes. Gold is not an asset you can assess in terms of yield. Its “dividend” derives from something else entirely. It is a pure currency hedge. And not against just any old peso, rial or dong. Gold is the undollar, the US dollar’s shadow, and on that basis it is not in a bubble at all.
The suggestion here that Gold is only a hedge against the US Dollar (and not against other fiat currencies) is deeply flawed. In fact a chart used in the article a little further down from the above text shows how little truth there is to the statement:
Blue & green lines added to highlight USDX tracking sideways as Gold rose
The majority of Gold's bull market (from a price just over US$400) has played out as the US Dollar Index tracked sideways. Granted some of the euphoric Gold spikes have been driven by the troughs in the US Dollar, but ultimately the rise has not played out in the shadows of a falling USD.

Another way that we can show Gold's rise has been far from just an "antidollar" is to measure it in the same basket of currencies (EUR, JPY, GBP, CAD, SEK, CHF) which make up the US Dollar Index. Kitco already does this with a price index they call the KGX (Kitco Gold Index). A chart of the past 5 years shows an almost identical performance of Gold in USD as in the basket of currencies (heavily represented by the Euro):
KGX shows performance of Gold almost identical in USD vs basket of currencies
Gold may have started the bull market as an unDOLLAR, but it has clearly morphed into an unFIAT (currencies not the car manufacturer!) over the business end of the bull market (past 5-7 years).

Further on in the article David lists 4 environments where Gold might begin to struggle:
First, a shift in Washington towards genuinely addressing its fiscal problems would hurt the gold price. If the Republicans were to win office, the fiscal conservatism of the Tea Party and the leap off the fiscal cliff may cause markets to conclude the US was serious about budget repair and, most likely as well, was headed into recession. That is two reasons to buy the US dollar in a panic.

Second, if the US housing recovery and manufacturing onshoring were to gather real momentum then we might see the prospect of no more quantitative easing, and even rising interest rates. In the near term, that seems to me even less likely than a Republican win in the election.

Third, a serious outbreak of global inflation might also – counter intuitively – be a problem for gold, compounded again if it caused a rise in US interest rates. But it would likely also bring with it a blow-off in the gold price first. So, not something to really worry about.

The fourth possibly is the spontaneous outbreak of global peace. Here’s hoping.
The only example above I can take seriously as a risk to the price of Gold would be the Republicans winning office and trying to return the United States to a fiscally responsible state. That said there has been talk of the Republicans launching a Gold commission which would consider a return to the Gold standard. If this were the case Republicans returning to fiscal prudence could bring about a higher Gold price, although it's my suspicion the talk was only in aid of gaining the support of Ron Paul (wasn't successful!) and his supporters.

I do strongly agree with the final points made in David's article though, namely that the Australian Dollar is likely to weaken making the shiny metal even more favourable for local holders (though I have been expecting the AUD to fall for sometime, it has proven more resilient than I could have imagined):
For Australians, there is an additional attraction to the shiny metal. As the commodities boom ends, the Australian dollar is going to fall (as our own monetary and fiscal conditions fray). The price of gold in Australian dollars is already close to record highs and if it breaks through $1800 per ounce, may run handsomely:

Conversely, if the Australian dollar does not fall, it can only be because the US dollar is so weak. Therefore, gold will rise anyway and likely faster than the local dollar. It is a natural hedge for the transition ahead.

Gold is not a bubble. Not yet, anyway. It is a prudent position for any Australian investor.
Another interesting observation about the article was that it was written as if Gold will always remain but a simple "hedge", it will rise or fall in dollar/fiat currency terms (within the monetary/financial system which we have today), but The Burbwatcher left a comment following the article which leads into another possible scenario...
I would also add my 2c, that PMs (precious metals) are “non-system”, in that they are not just “undollar” but a place where Faith/Trust can run to when the system itself (being inherently US fiat) is failing….an “out”, if you will…

In this environment, IMO, PMs will do well as a preferred store of wealth – a currency – as Faith reluctantly but gradually net transfers from the Fiat System to the Un-System (whatever that might be); PMs as a “last resort”, as the system is failing people’s expectations. It is not so much that PMs are “the obvious way to go”, it is just that they are “not the System”, an “out”, which is what many may look for. 
If the public starts exiting fiat currencies to store their wealth/labour out of an obviously corrupt and failing system, what exactly will it take to bring that wealth back? The Burbwatcher speculates later in the comments:
More likely route ahead is increasing government decree to “make sure….so that the ‘Greater Good’” is preserved/prioritised.

Enforcing certain systems of trading is such an example of a more likely path, IMHO. eg. banning PM trade, price setting, increased protectionism, etc.
Such tactics may be used, but if the wealth transfer into Gold has already taken place and spot price is multiples of the price today then the US Government (and others) may be in a position to return to a system where Gold becomes an important reference point in our monetary system (whether that be a traditional Gold standard or something else). Should that happen then Gold might be held in orbit at much higher prices, the bubble to end all bubbles where the "new paradigm" really becomes so.

There are so many ways this could all play out, but almost any scenario should see Gold (& Silver!) perform favourably. 

The problem can be summed up in only a few words "too much debt". Whether this is resolved via pegging currencies to Gold at a much higher price, inflation, hyperinflation, default, a debt jubilee or something else, we can be sure that the trust/faith in the system will continue to erode pushing people into ways to "opt out", looking for non-system ways to store their wealth.

Personally I will continue monitoring Gold's valuation versus other assets (Oil, Houses, Stocks) or labour/wages:


If Gold reaches an overvalued level which I consider to be bubble territory then I will start transferring a majority of my precious metals into more productive assets. That said my trust in Governments and Central Banks has eroded to practically zero over the past 5 years, there is no way I would sell all my metal until such a time that we can see fiscal/monetary responsibility has returned to those in power.

BB.

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8 comments:

  1. Hi BB,
    Your advice has always been to hold physical metal and also to hold them in smaller denominations so its easier to dispose when at peak.

    How do you think big firms (like Perth Mints etc) behave during the peak? Is it easier to dispose/sell the metal to them or will they suddenly stop buying-back metal?

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    1. I think if your plan is to sell back to Perth Mint then you may as well hold larger denominated bars as they won't pay a premium or even consider a depository account with the Perth Mint.

      I expect demand will be very strong at the peak so don't think Perth Mint will stop buying, but do think there will be more profitable ways to sell (e.g. privately for much higher premiums).

      Even in early 2011 we saw some delays on certain products (e.g. 2/5oz coins) and the premiums spiked on these...

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  2. The interesting story of my venture in metals tell me that there was a major glitch in SUPPLY of silver during the times when it took of from $30 to reach $40. Only 16KG slabs been offered back then in any significant QTY at Brisbane dealers. One dealer actually put a limit on how many small 1-5kg pc per person he would sell if you lake to come when he had them.

    Now, I would suspect, during next run-up event it will be not much different. Gold or Silver, demand will be high. If dealer or mint will put brakes on buying it back, what stopping you to stand at the door and ask around who likes to purchase some of you :)
    You may have to look for a buyer to take 1kg gold bar, but anything smaller, should not be a problem.

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    1. Yes I recall those shortages and IMO they will only get worse as the bull market progresses and more people invest in the metals.

      +1 to standing in front of a dealer to offload, definite possibility, although perhaps high risk to personal safety depending on how you approach it!

      I recall reading about some entrepreneurs in the 1980 bubble who would run up and down the line outside a dealers store and match up buyers with sellers for a small fee!

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  3. Still struggling with that graph and its point. Keep seeing it describes nothing.

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  4. Hey, BB,

    The BurbWatcher here.

    Heard about gold being discussed on The Today show??

    http://wired.ivvy.com/g/symposium/campaign/view/index/campaign/9502/report/3906/contact/224909/j/72f9c861bf14b7a76d3c2001ce0929a0

    How very 3rd phase!!

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    1. Interesting, thanks :) media coverage is definitely increasing!

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