Thursday, May 6, 2010

Gold Too High?

Instead of the usual mention of the nine-year bull market, Kathleen Brooks of City A.M. says that gold has performed quite well over the last two years. "It’s been one of the only assets to march higher during the financial crisis, and is now getting a boost from the sovereign debt problems in Europe." Most of her commentary is devoted to explaining the reasons why gold is rising: gold is becoming a crisis hedge, near-zero interest rates mean the opportunity cost of holding gold is also near-zero, investor demand is spreading because investing in gold is more convenient now than in times past. Thesw point come largely from Adrian Ash.

She ends, though, by relaying a bearish call that plays off against gold's crisis-hedge role:
“One of the main drivers of the gold price is crisis. In times of crisis the gold price can be driven up by 20-40 per cent,” says Crook. “However, once everything calms down we almost always see crisis premiums come out of the market.”

Crook says that the gold price could fall even more than normal because he believes that even at 0 per cent interest rates in the US are still too restrictive. Usually the gold price falls when interest rates are too high, and then rises when rates are too low. Crook believes that US interest rates are far from restrictive: “We think that with unemployment this high, interest rates should be negative, but of course the Fed can’t lower rates from here.”
In other words, a return of low-inflation growth will push gold into a bear market and send its price down to $800/oz.

Crook doesn't seem to be a deflationist. His forecast is a bet that things will return to the same conditions that essentially defined the 1990s: growth with low inflation. The $800 figure is fairly close to the level at which gold would be at if investment demand is essentially ephemeral. It's the figure that can be justified by non-investment demand for gold as paired with extraction costs.

Again, we have an analyst who sees gold at a level that's too high to justify in terms of traditional fundamentals. By that measure, the metal's been at the significatly-overvalued point for more than a year now. The December decline followed by the early-January sucker rally which prefaced the early-February rout, still left gold at four figures even at the panic low. There were a lot of people expecting gold to subsequently collapse after the December drop; what they got was a standard correction. Even at its lowest Feb 4th interday value, as measured from its high point on December 2nd, the metal dropped 15%. That's less than half of the decline from the February 2008 high point ($1,035) to the October low ($700.) Had there been people saying that gold was in a bubble when it broke above $1,000 in February '08, they would have been more credible than the current crew is. As far as I know, there were far fewer then than now. There might not have been any.

In my second look at the gold-bubble question for Enter Stage Right, I reiterated the point that a real bubble incubates when an asset stays overvalued by traditional measures and doesn't get knocked down. The resultant explanatory gap is filled by a "New Era story," which proffers an answer as to why the asset trades as if it were undervalued albeit at elevated levels. The traditional measure for gold, which treats it as a commodity, uses non-investment demand as balanced with supply. By that measure, gold should be around $800.

And yet, despite the near-panic that enveloped the market last February, gold hasn't even come close to that level.

The New-Era story that focuses on the gold market specifically claims that the rise in investment demand is essentially permanent, and deserves to be treated as if it were as legitimate as jewelry or indutrial demand. The macro New Era story is gold as an alternate currency, which will eventually be remonetized as a real one. It's only a matter of time before one wins mainstream acceptance as explaining why gold skeptics have been confounded. Based upon the mainstream media reports I've read, investment demand is the plausible candidate; the remonetization one is too wild, even though its more moderate offshoot - gold as a crisis hedge - is acceptable.

As regulars already know, I think gold is on its way to going into an all-out bubble - one that won't be veering towards an end until the "cocktail-party" indicator signals a mania. Perhaps strangely, that puts my own opinion in line with many goldbugs; they prefer less charged terms like "third stage of a bull market."

We're not there yet. There has been some excitement in the junior-exploration sector, but it's been intermittent. During bad stretches, the juniors are still flattened. But, the gold market is approaching the take-off point. Once it does, the point that gold didn't have a down year since 2001 will be all over the place. Although omitting the 1/3 drop between February and October of '08, it connotes a kind of safety from market risk. That kind of point has been a traditional attractant for the bubble-prone punter.

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