Gold and Market Bubbles

With gold prices still amongst their all-time highs, even after a serious market correction last week, many are wondering if now is the time to get out of gold?  The idea that many investors including myself have, is that gold is one of the ridiculous market bubbles that will inevitably pop and leave many investors left holding the bag.  This raises the question, what exactly constitutes a “bubble” in the market?

When Emotions Rule Logic

Market Bubbles
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In short, a bubble in the market is what happens when investors’ emotions get the better of their logic.  Many people will claim that the market is perfectly efficient and that the “invisible hand” of a free supply-and-demand economy will ensure that the price for a stake in any company or commodity is fairly priced.  The crazy changes we see in the value of many different types of investments beg to differ.  How can a company that has exactly the same assets and prospects as the day before suddenly grow its value by 10% overnight?  How does a bar of gold that is the same weight and purity suddenly worth 9% less than the day before?  What has fundamentally changed about these investments?  The answer is that nothing has changed, and the majority of the time these huge swings in value are caused by factors that have nothing to do with the long-term value of an investment.  If everyone invested their money after looking over stacks of financial documents and consulting numerous experts in the field, then the market would be close to perfectly efficient.  It can even be argued that over the long-term, this efficiency eventually bears through the emotional trading; however, in the short term, the value of an investment is often determined more by the emotions of investors as opposed to any rational or logical process.  This is what creates absurd amounts of positive and negative investment momentum and in turn, market bubbles.

Tulip Mania

The first economic bubble in modern history is usually referred to as the Dutch tulip crisis.  For various reasons, the Dutch people placed an increasingly high value on tulips leading up to 1637.  They became important status symbols and a huge store of wealth for many people (sound familiar to you gold enthusiasts out there?).  The price of tulips ascended so rapidly and unexplainably that in 1637 a single tulip bulb sold for about 10x the annual wage of a regular craftsmen.  Clearly people didn’t believe that tulips would so rapidly loose their value, which of course they did, quickly destroying the wealth of many tulip owners.

The Gold Bubble

Let’s compare the recent rush to gold with the tulip mania of the 17th century.  For much of modern history, gold has proven to be a very poor investment, not even covering the rate of inflation for many people in the Western World.  In 1985 the price of gold was about $300.  It would stay within the range of $200-$500 all the way until 2004.  At this point gold started to takeoff.  People started to put forth claims that gold was the only reasonable store of wealth, and that it was the only hedge that would work in the upcoming reckoning for equities.  The self-fulfilling prophecy really took off when the stock market crashed in 2008, and the dooms-day advocates really started pushing the gas pedal.  Within 8 years gold has quadrupled in value as it flirts with the $2000 level (per ounce).  That is a 400% return!  Almost unheard of in an asset class throughout history, and almost certain to be followed by an equally fast decline.  As the internet has brought more information (most of it totally irrelevant) and more stock-trading capability to a wider audience than ever before, we have seen market bubbles grow in speed, quality, and quantity, due to more exposure to the emotions of inexperienced investors, and short-term focused money managers (I’m looking at you mutual fund barons).  Another great example is the technology bubble that occurred early in the new millennium (just Google “NASDAQ Charts”).

Is Glenn Beck Really A Guy You Want Investment Advice From?

Gold enthusiasts everywhere – led by the comical Glenn Beck – love to claim that gold is the oldest historical currency, and that it has retained its value over millennia, whereas currencies have no intrinsic value, and the stock market could crumble at a moment’s notice.  I guess I must have missed the part where gold has all kinds of uses that are essential to humanity and consequently has intrinsic value.  The bottom line is that both gold and money are relatively useless and only have the value that we have given them as a common form of exchange.  While the stock market may be subject to the whims of emotion in the short-term, I find it impossible to argue that the raw physical and non-material assets of companies such as Wal-Mart, Coca-Cola, and Johnson & Johnson do not have more intrinsic value than a brick of a mineral that can’t be used for very much.

So Why Does This All Happen?

The fact is that precious metals do well when other areas of investment are suffering because investors are looking for “safe havens.”  Big time Wall Street types make loads of money by exploiting inefficiencies caused by runaway emotions; therefore, it is in their best interests to see huge bubbles built up and then torn down so that they can make money going both ways (we’ll talk about how to make money by “shorting” a stock another time).  They hire pitchmen like Beck, whip the media up into a frenzy, get everyone on a bandwagon that has no real reason for existing, and then watch as the bottom falls out and the eventual realities of the underlying asset drive values back to earth.  As long as people refuse to educate themselves on the fundamental value of a company, and invest for the long-term (yay Warren Buffett), while trying to get rich quick off of “timing the market,” these bubbles will continue to be created and smart people will continue to exploit them.

The gold bubble will most assuredly burst and people will see their assets vanish to a third of their value within a couple years or so.  I believe the only real questions are when will this happen, and more importantly, what are the next market bubbles to get in on the ground floor and take advantage of?

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It’s very interesting to me how many people have jumped on the gold bandwagon in recent years. I think it goes back to the same philosophy behind investing in index funds and dollar cost averaging. The market will go up and down, the price of gold will go up and down, but consistent and even investments are the best bet. You will also likely sleep better at night.

Interesting chart and interesting source for your graph. I am not sure if all your readers would understand that the chart was produced in 2006 and was created by shifting the 1980’s gold peak graph to a point in the future. Your graph suggests that gold might peak somewhere above $4000 per ounce which actually might seem reasonable. I would agree that a bubble is forming. Does that mean that one exists? I don’t think the peak will occur until inflation is truly out of the bag and interest rates start to rise from their current negative real state. I… Read more »

I’ll play a little safe and invest in divy stocks, they a little more stable, comes with divy income:D

@Teacher Man — I apologize. I think my comment was a little ambiguous. I completely agree with you. I was arguing for the value in investing in index funds and NOT investing in hot commodities like Gold. Owning an index fund and making consistent investments is what will let you sleep at night, not taking a pot shot at a rising gold price.

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