Friday, March 14, 2008

bubblicious gold!

Awhile back, I asked what the next bubble would be. The answer from Harper's magazine (thanks, Louis!) was clean energy investments. That may be true (or may not -- since it hasn't happened yet). But it's possible that we'll see a bubble before that eventuality -- in gold. This might be financed by the Fed's expansionary monetary policies (the efforts to save the U.S. credit markets) while spurred by fears of inflation.

Assume that a gold bubble has started, i.e., that recent price upsurges do not just represent a short-term blip. If anyone wants to wants to buy and hold gold for long periods as a hedge against inflation, it's then too late, since prices are too high.

The exception to this outrageous assertion would be if the end of the "long period" is (by coincidence) either at the peak of the bubble or some time after the bubble pops when gold prices start rising again. (Gold prices should be measured in real terms, corrected for the ability of gold to buy actual goods & services, by the way. It's only when real gold prices rise that they're a successful investment.) As the bubble grows, the "too late" verdict will become more and more true.

On the other hand, if anyone wants to speculate by buying now (when prices are low compared to the future peak) and selling right before or at the peak price, that actually encourages the bubble, by increasing demand.

We can tell if a bubble is actually happening if we start hearing about how "gold is a perfect hedge" or "you can't lose by investing in gold" or "gold prices have nowhere to go but up." These kinds of statements reflect the hopes of the aforementioned speculators -- and their later efforts to ensure that their speculation pays off by driving up gold prices further.

Of course, it's a big gambling game. The gold-bugs who win at the peak (buying low and then selling high) have to find others who are willing to buy at the high price. (These are called the "greater fools.") Note that the winners' loot corresponds to the losses of those left holding the bag: as the bubble pops, the sellers drive prices down, imposing capital losses on the late buyers.

(In addition, the "house" wins to the extent that there are brokerage fees in the gold market.)

Of course, gold pays no interest or dividends. That makes the popping worse, since the only way to win in a bubble is to grab for all the capital gains one can.
J.M. Keynes's "betting on a beauty contest" theory of bubbles doesn't add anything to this discussion (because, unlike corporate stocks & bonds, gold is a well-known asset). But his "snap" analogy does say something. It's more familiar to U.S. residents as the "musical chairs" analogy.

As people begin to think that the bubble is reaching its peak size, their fear that the music will stop heightens. However, because everyone wants to avoid sitting down until a second before the music stops, they hold on to their gold. Then, for some reason -- the scary sight of an advertisment for beer projected on the Moon? -- some people start sitting down. This causes a panicked rush to the chairs. In other words, everyone tries to sell, driving gold prices down steeply.

Jim Devine

7 comments:

Econoclast said...

comments?

Jack said...

"Note that the winners' loot corresponds to the losses of those left holding the bag: as the bubble pops, the sellers drive prices down, imposing capital losses on the late buyers."
This was the point of my post on Angry Bear which asked "where did the money go?" Jim is referring to commodities trading on a grand scale. There are likely to be financial instruments which are tied to the price of gold which should be bubbling at the same rate. That was the issue with the so called mortgage crisis.
The initial paper, the mortgage, the property that was the collateral for that mortgage and those CDO's that were created to expand the market for the original mortgages were all bubbled up and there was money put up for each of those entities. Where is it all? In the pockets of some very clever early players in the game.

There are now several posts on AB discussing the fact that the Fed will make every effort to bail out the "losers" in the banking industry. Losers who's executives need a wheel barrow to take their rewards to the bank. That's what bubbles do. As they expand some central players are rewarded with gold plated incomes. When they burst the fall out seems only to dirty the many small investors who's money was being played with all through the expansion.

Bruce Webb said...

Well the following could use some historical qualification.

"We can tell if a bubble is actually happening if we start hearing about how "gold is a perfect hedge" or "you can't lose by investing in gold" or "gold prices have nowhere to go but up." "

Because there has rarely been a moment in history that you haven't heard similar comments from Goldbugs. My local paper has and has had a full page ad for gold coins that has made these claims for months and months, that is both preceding and following the huge move (about 35% gain) gold has seen over the last six months. Separating out a real bubble signal from the standard froth you hear from Goldbugs might be more difficult than you suggest.

A better signal, if it were actually available, would be participation rates. I suspected the end of the tech bubble was near when a friend of mine, a smart guy but not really educated, took out a second mortgage on his house to buy stocks. When sheet rock hangers start taking a flier in the market you pretty much know the end is near.

Sandwichman said...

"When sheet rock hangers start taking a flier in the market you pretty much know the end is near."

That is soooo funny and so true. Toward the end of the tech bubble I actually had a couple of sheet rock guys in to repair a wall in my living room and damned if they weren't talking about taking out loans to buy tech stocks!

juan said...

I'd say that it's pretty straightforwards: As cap gains from equity markets break down, 'investors' seek to compensate through portfolio reallocation towards expected to be and/or actually better performing sectors. Justifying stories are produced; the process gathers momentum, becomes self-fulfilling and runs well beyond what fundamentals would dictate.

In a sense, price and value become increasingly divorced; tension between the two sharpens; the process becomes increasingly fragile; breaks, and those unaware of how rapidly commodity markets can 'correct' (including those who have become true believers) are left holding large losses.

As might be evident from these Commodity Research Bureau charts, the commodity bubble began in 2002:

Reuters-CRB Index 1990-2008
http://www.economagic.com/em-cgi/charter.exe/crb/crb01+1990+2008+0+0+1+290+545++0

CRB Precious Metals Sub-index 1990-2008
http://www.economagic.com/em-cgi/charter.exe/crb/crb19+1990+2008+0+0+0+290+545++0

Bruce Webb said...

Irony is so ironic sometimes.

A week to the day after this post we get a 10% correction right before a long holiday weekend for the markets. We'll see if this is just a speed bump or whether $1000/oz is the new ceiling. Because if I bought in at $1008 I would be feeling kind of sick by now.

Econoclast said...

Bruce Webb writes: >A week to the day after this post we get a 10% correction right before a long holiday weekend for the markets. We'll see if this is just a speed bump or whether $1000/oz is the new ceiling. Because if I bought in at $1008 I would be feeling kind of sick by now.<

yes... I forgot to mention that recessions tend to undermine commodity prices, including that of gold.
Jim