Tuesday, May 25, 2010

WSJ Columnist Asks If Gold Is In A Bubble

Although some sections in the mainstream business media are still wondering if gold's in the climax of a bubble, or in the throes of a bubble bursting, ROI's Brett Arends asks if gold's on the verge of one. The graph that accompanies his story paints an eye-opening picture:

Arends is sensible enough to point out that a lot of gold's rise over the last decade was from a really undervalued level, before he returns to the incipient-bubble question.

So far gold has followed the same path as the previous two bubbles. And if it continues along the same trajectory—a big if—gold today is only where the Nasdaq was in 1998 and housing in 2003.

In other words, just before those markets went into orbit.

Maybe the smart money is out of gold today. But how easily we forget that the smart money got out of these past bubbles way too early. The really smart money knows you make the most money in a bubble right at the end, when it goes manic....

Arends lays out the case for gold going in to an all-out mania by noting that analyst coverage, general buzz and the contango on the futures market are all far from mania levels. In other words, gold has none of the earmarks of manic buying right now. His case for gold going into a mania rests on these four points:

  1. There's likely to be another mania somewhere, since we live in a bubble economy.
  2. The floods of liquidity pumped in by central banks has laid down fodder for a New Era story, or a "This Time It's Different" narrative. (Arends' term.)
  3. There are a lot of gold believers who are quite willing to spread word around about gold. This transmission belt of sort will likely generate a lot of demand once the public's ears are ready for the message.
  4. Gold is hard to value, giveing a large zone of indeterminancy (from the quant perspective) that can be filled by bullish imaginations.
Arends also passes along this fact from Dylan Grice: the value of gold in Fort Knox is near an all-time low as percentage of the M1 money supply's. Grice also said that the 1970s gold bubble ended with M1 coverage hitting 100%; it's currently 15%. [The bull market in gold began at a time when gold's purchasing power was at a low not seen for centuries.] Arends ends by saying that these reasons suggest that gold might enter into a bubble, but anyone getting genned up should realize that gold is very volatile and sometimes dangerous.

What can I say? He lays the case out more meticulously than I have, but his position squares with my own.

If gold does go into an all-out mania, the signal question is when to get out. If gold is fated to be popped when only a bubble in the making, then the question is moot. The only way it could be pre-popped is if the deflationists and Japan-comparers are essentially right. Unfortunately, U.S. Treasury securities have a low yield right now: using T-bonds as a hedge is pretty expensive. The last decade, unlike the 1990s, was one where inflation grew with growth. Thus, the most realistic alternative would be deflationary stagnation. Stocks really won't cut it as a hedge.

Using Grice's note about the 1970s peak and his current figure gives a price of about $6,000 as a potential top. Another one like it was the gold/DJIA cross: very briefly, at the top, an ounce of gold could buy one unit of the Dow Jones Industrials. That seems unlikely at this point, as it would imply a gold price well above $6,500 unless the Dow worsens its March '09 low. The graph above suggests a triple from the current price before the mania comes to a crashing halt: that says $3500 or so. Note the wide variance in plausible tops.

The fact is, the ultimate top should a mania ensue is unpredictable. Market karma being what it is, the monthly returns will be hottest right at the end. The people who stay to squeeze a little more of those returns will be the ones caught in the ensuing crash, which will look like a mere dip to be bought at the time.

The only suggestion I have would be to stop buying gold entirely if it gets above $3,000/oz. No matter how compelling the returns, no matter how permanent the rise looks, not matter if cash is trash and other investment ideas look rotten - even if it looks like we're careening into global hyperinflation. In the throes of a gold mania, there will be some plausible, hard-to-ignore, even compelling cases that hyperinflation is "imminent." They'll feed the mania.

When to sell is a decision that, I can almost guarantee, will come with loads of regret if followed through upon. Given bubble karma, that's inevitable. It seems best to get mentally prepared for doing so.

One alternative, that's not often explored, is to ride the bubble to its top and pull out when the sucker's rally gets started. This decision is less regret-laden, but it's very tricky. It could be pegged as the contrarian's finest moment: switching to bearishness when all around are seeing another buying opportunity. What makes this approach very hard is that the earlier in-bubble scare will look a lot like the sucker rally. People will remember the new highs after the 'scaredy cats' exited, like the ones who sold out of Internet stocks in 1998. 2000 looked an awful lot like '98 until the bottom fell out again. By that point, of course, it was too late.

Playing the bubble requires a permabullish attitude. Getting out means shaking it off. Very few people can do that.

Thanks to good old market karma, there really are no good choices. The standard advice is to sell too soon and live with the regret.

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