The Gold Bubble

I correctly called bubbles in the stock market in the late 1990's, in the housing market, and in oil [See Oil Bubble to Burst, [March 11, 2008]. I believe there is a bubble in gold right now. I am not saying the bubble will pop soon, or at what price; seeing a bubble is a lot easier than saying when it will pop.

The magic of gold is purely psychological, and mainly a historic artifact. Gold is pretty and does not tarnish, so it makes nice jewelry. It is just uncommon enough that finding and mining it is usually not easy. Hence when money was invented, gold was adopted for use in coins.

Gold has more uses now. Of course it is used in dentistry. Its main use, besides jewelry, is in electronics. Gold is an excelent conductor of electricity, and does not corrode, so it is used to plate contacts on the best-quality electronic products. Because they are much cheaper, silver and copper are more widely used.

Gold investors often believe that gold is the ultimated measure of value. But its intrinsic value is negligible. If it were more common it might be regarded as a cheap anti-corrosion metal.

A lot of gold is being hoarded around the world. As in typical in auction markets, as long as the price is going up, people are given incentive to hold onto their gold stock, no matter how high it goes. That is how auction markets create bubbles.

But study history and you will find there have been many times and places where gold was not highly valued in comparison to other commodities. If something else is desirable enough, it is worth its weight in gold. Famously, salt was once traded in some places in Africa weight to weight with gold.

A new gold find can cause gold inflation. This happened when the Spanish stole the gold of Mexico and Peru in the 1500s. Europe at that time could not aborb that much gold, so the price of gold relative to other commodities swooned. Much of the gold migrated to China and India, which then had far more robust economies than the European nations.

The ratio of the price of gold to silver used to be a big, big deal back when money mostly meant metal coinage. It was the prominent issue in the U.S. Presidential campaign of 1896, in which the Democratic Party "declared for the unlimited coinage of silver at the ratio of sixteen ounces of silver to one of gold, though the market ratio was about thirty-two to one" as a means of getting more money into circulation [The American Pageant by Thomas Bailey, p. 599]. The Republican Candidate, William McKinley, won the Presidency after his campaign outspent his pro-silver rival sixteen to one.

Today, as I write, the quoted values of ounces of gold and silver are $1141.30 and $18.42. That gives a price ratio of about 62 to 1. Historically they have mainly fallen between 10 to 1 and 40 to 1. So if history is any indicator, either the price of silver has to skyrocket or the price of gold has to plunge to get us to equilibrium. It is possible that when the bubble bursts both will plunge in tandem.

One relatively sound source of gold's strength has been the weak dollar. The theory is that gold stays stationary in value. Therefore, if the dollar falls, the value of gold in dollars should rise. Of course normally financial brains would see right through that simple equation. The dollar should fall against any currency that rises against the dollar, if the theory were valid.

More fundamental is the usual fall in the value of goods versus currency when there is slack demand. In other words, deflation. There is concern that the astonishing amount of fictional money pumped into the American economy by the Federal Reserve starting in 2008 is going to cause the opposite, a great inflation. So the high price of gold, under that theory, is about looking ahead to the coming inflation. But the newly pumped money, so far, has not even replaced the money that dissappeared in the Great Panic of 2008. So it is a bit early to place heavy bets on inflation. If the Fed starts raising interest rates in 2010, and raises them fast enough, inflation should be held to its normal pace.

Like everything auctioned, the price of gold at any given time is highly dependent on the dynamics of the auction system. On an upswing people have every reason to delay selling in order to get higher prices at a later date. This in itself can create shortages that cycle into higher prices.

But there are always mini-cycles within the larger cycles. No one thinks much of a drop of a few pennies in the price of gold during the course of a trading day.

During a bubble at some point enough people will bail out to drive down the price of the asset enough for other holders to notice. If this trend become prolonged or deep, all the theories in the world won't support the price of the asset. Once gold starts falling consistently, people will realize it is not a magical store of value. They will trade their gold for something they can actually spend or invest more profitably.

Of course a gold bubble could also be popped by the discovery of a new gold field.

What confirms for me that we are in a gold bubble is that normally, during a severe recession, all asset classes are sold by investors. Gold should have come down subtantially in price in 2008 and 2009. Perhaps gold investors are more conservative by nature than those who invest in asset classes, so that they were not leveraged, and did not need to sell. I don't get that impression from the few big-time gold bugs I have met, but some times anecdotal evidence is misleading.

Remember, gold could go a lot higher before the bubble bursts. Shorting gold is no more a sure thing than going long on it.

Hedge your bets: keep diversified!

William P. Meyers

Show Me The (Lost) Money!

Are American subprime mortgages the Black Swan that will lay low (for a while) our securities market and even the global economy?

Everyone can agree that if you buy a house and then sell it later for a higher price, you have made money in some sense. You might want to take out the transaction fees. You may want to take out real estate taxes and the cost of maintenance and upgrades. On income (as opposed to residential or purely speculative) property there is another whole set of calculations. But basically, you lose money if you sell for a lower price than you paid originally, and you make money if the sale price is higher.

In 2005 selling houses almost always resulted in making money. In 2007 selling houses is resulting in losses mainly for people who bought in 2006 or 2005, rarely for people who bought in 2004 or earlier.

Mental calculations of loss may be higher because people who are selling now are thinking about what they could have made if they had sold in late 2005 or early 2006.

So the reality is that not very much money, on a macroeconomic scale, is being lost in housing right now. Think about the scenario we read so much about: someone who took out a subprime mortgage, with no money down, in 2005 whose house has gone down in value and who has allowed the house to be repossessed.

How much did they lose? They invested no money down. They came out of the deal, two years later, with no money from the repossession of the house. They actually did not lose any money at all. In effect their mortgage payments were rents. We all tend to forget that while a house is mortgaged, we have a partner in the real estate, the holder of the mortgage.

In a slightly different scenario the house value may not even have gone down. Instead, after the ultra-low interest rate introductory period, the interest rate has jumped. Unable to make the new higher payments, the owners allow the houses to be repossessed. Again, the residents did not lose any money at all; they just had their hopes dashed. In this case the mortgage company has not even lost any money except to the extent that interest rates had been subsidized.

This whole scenario could change if we had a recession before the glut of houses for sale dries up. Home owners who sell could lose real money they put in as down payments and as principal payments on mortgages. In some specific geographies this has already happened: people and mortgage companies have lost real money. But there has always been a component of this in the housing and mortgage markets. It has been a long time since it has been a good idea to invest in residential housing in Detroit and other rust-belt cities.

So how did the Bear Stearns hedge funds lose so much money? They made a bet on mortgage default rates than seemed smart at the time. To the extent that there were potential real losses of money, they concentrated it in their funds. They bought collateralized debt obligations, CDO's, and other mortgage-releated securities.

How CDOs work has been covered by most major financial news organizations, so I won't go into that. I want to point out the contrary fact: On the whole, investors have not lost any money. Not yet. Not people who bought residential housing; not mortage companies; not holders of investments in mortgages.

What has been lost, in aggregate, is expected streams of income. Only those investors who bought mortgage-backed securities that concentrated the risks of subprime mortgages are suffering serious losses.

As a result, risks are being recalculated. Usually in situations like this, after risks have been under-assessed, they jump to being over-assessed. Which is safer for us all.