Sunday, May 2, 2010

A Golden Bubble

This week's Financial Sense Newshour podcast had little to say on gold, So I'd like to discuss an article appearing in Stockhouse that discusses the potential of gold going in to an all-out bubble:

It's entitled "Gold price and 'the' parabolic peak." Its author, Dudley Pierce Baker, expects an imminent bubble in gold. Although it opens by debunking the claim that gold's in a bubble right now, the bulk of it is a review of two assets classes, a commodity, and two stocks that went parabolic in what were clearly bubbles. Four of them - the Nikkei, Toll Brothers stock, the NASDAQ 100 and crude oil - are charted before gold is brought in. The chart of the fifth, Homestake Mining in the 1930s, is shown after gold is discussed. The author's point is that, if gold goes into an all-out bubble starting now, the parabolic rise will be great enough to push the metal up to at least $2,450 an ounce and likely above $3,000.

That's what the author thinks. He could be right, as gold is beginning to act in unexpectedly bullish ways - most obviously, its rises in tandem with the U.S. dollar. The amount of fear that accompanied the December drop - in retrospect, a mere correction - was about the same as the level that accompanied the '08 financial panic.

Speaking of '08, I'd like to point out something that not many have, because the "nine-year bull market" characterization makes sense overall. Going by standard definitions, the bull market that began in '01 ended in early '08. The fall from $1,035 in February of '08 to $700 in October of that year was a 32.4% drop. Using the standard definition of a bear market, a drop of 20% or more, there was a gold bear market during the credit crunch. When over, gold entered into a new bull market. It started on October '08 at $700 and is currently less than two years old. By this interpretration, the "new gold bugs" have come in because of a new bull market getting rolling.

There is a parallel to gold in the '70s. The metal did see a drop of about 50% between 1974 and 1976, which would count as a severe bear market had it been the stock market. The 1976-1980 period saw the second gold bull market of the '70s.

Using this framework, the commodity cycle that we peg as a single bull market is really composed of two. The first one is longer, and starts off in general apathy. Gold starts off in the most encouraging contrarian environment of all: except for a dedicated few, no-one cares enough to be bullish or bearish. People who would otherwise have been bearish have consigned gold to the dustbin. So have a lot of people who wind up being bullish later. At the start, the buying of those few bulls is enough to move the metal upwards.

The best comparison would be to Wall Street in, say, 1949. Public sentiment wasn't overwhelmingly bearish; it was overwhelmingly dissociated. Bulls and bears are lumped together in the popular mind as belonging to a kind of cult. "Stocks? Why would anyone care outside of a Wall Street [you fill in]? Do I look like one of them to you?"

The first bull market proceeds in a draining of that apathy as more people discover the metal and its fundamentals. With respect to the gold cycle, the first bull ends when the fractional-reserve system is hit by an economic disaster that threatens to tip the economy into outright deflation. Yes, there were deflationists in the '70s - and their arguments are quite familiar to anyone following the inflation/deflation debate right now. An economic wound, such as the 1973-5 and current recessions, will precipitate massive money destruction caused by massive defaults. Scared, depositors will trigger bank runs that will overpower the Fed's response. It'll be like 1929-33 all over again.

For obvious reasons, the deflationistas enter in to the public consciousness. When the stock market's cracked and times are tough, "another Great Depression" finds a ready audience. Because of the economic gutting, the case for future inflation is easy to debunk. "Inflation how? Have you seen the unemployment figures? The unused capacity figures? With that kind of slack, inflation is yesterday's worry." Yes, those arguments were made in the mid-1970s too.

Consequently: the second bull market in the cycle begins with widespread skepticism. The first bull market feeds on the return of inflation, which becomes painfully evident at its peak. [Remember '07?] The second bull market, initially, feeds on reflation and goes into a parabolic peak when reflation turnes into an inflationary crisis.

What gives it is parabolic nature is, the skepticism barrier falls more easily than the indifference barrier. We're already seeing the gold skeptics fade away, and gold itself being mainstreamed for essentially pragmatic reasons. The first bull market, as compared with the range-bound behaviour of the stock market, makes for an easier sell than learned discourses on the nature and flaws of fiat currency. Once inflation returns, the bull market kicks into high gear and ends up in a parabolic ascent. The second bull market is the bubble.

Of course, it's easier to think of gold's bullish phase as comprising one large bull market with a vicious decline in the middle of it. The final push gibes well with standard characterizations of the third and final stage of a single bull market.

That being noted, I have another point to make: in all assets that have gone into bubbles, there's a pseudo-popping that scares the willies out of bulls and encourages a lot of skeptics to proclaim, "see? I told you it'd pop!" Yes, Internet stocks were besotten by that pseudo-popping in late '97 and early '98. David Dreman, in his Contrarian Investment Strategies: The Next Generation (1998), treated the Internet stock boom as a bubble that had come and gone.

The same pseudo-popping visited the oil market in late 2006. I have to admit to being caught out by that drop; I thought at the time that the big bull run was over. For a time, I was right - but, of course, I was proven to be wrong as the oil bubble got rolling again in '07.

Should gold go into a parabolic bull market, there almost certainly will be a fake-out drop like the Internet stocks suffered in '97-98 and oil went through in '06. This pseudo-popping will be widely vaunted as the end of the bubble, and lots of bulls will act as if they believed that to be the case. After all, common sense will say that gold went too far, too fast at that point; it'll look like a popped bubble for a time.

The only ones that'll stay steadfast, and loudly proclaim that gold is going back up, will be the "true believers." When it does, they'll be the ones who'll be right when a lot of others were wrong.

At this point, the final climax is on its way. Everyone except for true believers, who will become bankable, will have been shown up. At this stage, the credulous will be the big winners. Naive bullishness will look like genius.

It's at this point that the legendary shoeshine attendants, waiters, taxi drivers, homemakers, etc. will be bending people's ears about gold. What they'll see is the credulous and naive are really becoming rich simply by being gold hyperbulls. What better invitation could there be than seeing your likesake making easy money hand over fist?

At this point, the gold bubble is on its way to really popping. Sad to say, anyone who pulls out at this point is going to feel pretty stupid for doing so.

We're far from this stage yet, as many gold analysts have noted, but we may be in the next few years.

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