Thursday, April 18, 2013

The Gold Bubble: End Game In Sight?

This week’s collapse in the price of gold was no more than I expected, and no less than I feared. I’ve never bought into the rationalisation of gold as an inflation hedge, or gold as a good investment.

My biggest worry with gold was that, as in the Genneva case last year, ordinary Malaysian investors were going to be caught in a bursting asset bubble, holding assets worth considerably less than they paid for. So far, that worry is slowly being realised – based on the current price, if you had bought gold anytime in Ringgit terms over the last two and a half years or so, you would’ve likely have lost money:


You’d still be in the black if you’d bought before that, but for how much longer is an open question.

The problem is that while gold does operate as an inflation hedge, the price is so volatile that for all intents and purposes it’s a pretty useless hedge, as this somewhat prophetic paper (it was issued in January) finds (abstract):

The Golden Dilemma
Claude B. Erb, Campbell R. Harvey

While gold objects have existed for thousands of years, gold’s role in diversified portfolios is not well understood. We critically examine popular stories such as ‘gold is an inflation hedge’. We show that gold may be an effective hedge if the investment horizon is measured in centuries. Over practical investment horizons, gold is an unreliable inflation hedge. We also explore valuation. The real price of gold is currently high compared to history. In the past, when the real price of gold was above average, subsequent real gold returns have been below average consistent with mean reversion. On the demand side, we focus on the official gold holdings of many countries. If prominent emerging markets increase their gold holdings to average per capita or per GDP holdings of developed countries, the real price of gold may rise even further from today’s elevated levels. In the end, investors face a golden dilemma: 1) embrace a view that ‘those who cannot remember the past are condemned to repeat it’ and the purchasing power of gold is likely to revert to its mean or 2) embrace a view that the emergence of new markets represent a structural change and ‘this time is different’.

As Carmen Reinhart and Kenneth Rogoff have argued, when people start saying “this time is different”, it’s time to head for the hills.

There are some fundamental factors supporting the price of gold, largely to do with its increasing financialisation i.e. the increasing use of gold as an investment vehicle. But that in turn means new sources of volatility, such as the use of leverage to purchase gold or gold-backed investment instruments. Demand for gold from China and India also underpins the market – according to one source, as much as 20% of gold demand comes from those two countries.

The problem is that even these structural changes don’t fully explain gold’s run-up in the past decade. The paper examines all the rationales for holding gold, from inflation and currency hedge, to gold role as a safe haven asset and for portfolio diversification.

The discussion in the paper focuses on two main criteria (the others are more or less quickly debunked) – inflation hedge and portfolio asset.

The data on gold as an inflation hedge is highly illuminating – gold appears to keep its purchasing power over the long term. Unfortunately, the long term here is defined in centuries, not years or decades, as the real (inflation-adjusted) price of gold tends to vary considerably over years and decades.

Also, in consequence, the implication is that gold’s very long run real rate of return is effectively zero, but rate of return can (and has been) both positive and negative over most realistic investment horizons.

That more or less jives with my own investigations into the relationship of gold with other commodities –their prices are very volatile in gold terms, exhibiting large multi-year price swings. I couldn’t find any stable long run relationship at all, but that’s probably because my sample period was too short (50 years compared to the 220 years the authors used).

Combine that insight with the current market price, and the tentative conclusion is that gold is sooner or later due for a very deep and very long bear market. The authors calculate a negative return of around -6% a year for 10 years (from the 2012 price) just for the real gold price to return to its historical mean – that translates to about US$780 in today’s prices. Of course, it could take much longer, or much, much shorter.

The second criteria – gold is underrepresented in investment portfolios – offers more hope to gold investors, though also offers grounds for greater concern.

Within the investment category for gold (the other two are industrial and jewellery), gold demand shows a remarkable tendency – it has a positive price elasticity from 2001-2011 i.e. an upward sloping demand curve. For the layman, what this means is that as prices increase so does demand, which is the exact opposite of the way demand should behave in theory. This offers some support for gold prices, in the sense that with the increasing financialisation of gold, more people have access to gold as an investment and desire to hold some, especially since it appears to have a very low correlation with other asset classes.

But, this also suggests a bubble mentality in the market for gold, which as in all bubbles, tends to end badly because the inverse is possibly true as well – as prices fall, demand falters, and prices spiral down further.

I’d tend to believe the latter is the more likely as the valuation of gold, as the authors remark, is very much like a Keynesian beauty contest:

The Keynesian beauty contest framework suggests that the price of gold is not determined by what you think gold is worth. What matters is, for example, what others think others think others think others think gold is worth.

Technical Notes:

Erb, Claude B. and Campbell R. Harvey, "The Golden Dilemma", NBER Working Paper No. 18706, January 2013


  1. Dear En Hisham

    Salam and thank you for your enlightening post on gold prices and the reference to the article by Erb and Harvey. Your analysis certainly has been very helpful for me, as have often wondered about the increased interest in gold investment especially in the last few years.

    - Megat

  2. The smash in gold prices has absolutely nothing to do with gold, the metal, and everything to do with market manipulation through naked shorting of futures. To say that gold has "rate of return" problems ignore the fact that it is money, and hence should be compared to cash, not equity with dividends.

    The problem with Genneva is that it's a LEASE not a SALE, i.e. you're betting on gold prices to go down, and not up, plus that they had a 100% markup. People ignorant of this get bashed, as they should be. This has nothing to do with gold per se, and is more related to ignorant customers and the usual MLM scammers.

    As the Keynesian-based economy continues to crash, people in the real world will continue to accumulate gold, including quite a few central banks in the BRICS community. This price smash, orchestrated through naked shorts in the futures market, is an awesome opportunity to buy both gold and silver, and anyone aware of the fundamentals in PMs, including myself, will take advantage of this.

    1. Rickard,

      Wow, in just three paragraphs you managed to hit almost every one of the points listed here:

      You might want to refer to Graeber on the history of money:

      It's from an anthropological perspective, not an economist's, but even more fascinating as a result. The conflation of gold with money doesn't have as long a history as one might think.

    2. You are using a guy who doesn't know the difference between currency and money as your reference? Now that's funny.

    3. Rickard,

      I assume you're talking about Ritholz? Graeber doesn't make that mistake.

  3. Warrior,

    That's got to be the shortest post I've ever seen you write.

    It's a nice hypothesis, but suffers from an identification problem. It also doesn't appear to explain what's happened over the last couple of years (he lost me right about at the "more money chasing less goods" remark).

  4. Let me come in briefly on his behalf. ;)

    Firstly, the global economy has become more interlinked with comm. tech transforming the paradigm at warp speed since the 1990s.

    Over the last two years while money supply has admittedly remained high due to QE, but US growth has been anemic at best with unemployment still a prime concern. Additionally, Europe has gone into a funk while the ROW especially China has slowed down, Japan being what it is, Japan and countries like India skirting recession. Then you had systemic shockers like the PIGS, especially Greece hogging the limelight for different reasons. Add to that the persistent relatively high price of crude despite anaemic growth.

    Now the price of gold is dropping cos there is talk in Washington of tougher money policy, cutbacks on the fiscal side due to sequestration etc etc and generally better growth slowly kicking in.

    Given the above, excessive money supply sans strong growth seems to hold up fairly well with regard to gold.

    Shortish comment? As they say there is beauty in brevity and sophistication in simplicity.....hahahaha. Actually, I am busy unpacking after all that silly talk by the Pakatoon charlatans about a debt mountain crushing Malaysia. Trust democrazy to deliver that!

    Warrior 231

  5. Having said the foregoing to hypothetically explain the phenomenon, let me assure you that I concur with warren buffet on gold's lack of utility value:

    " you dig gold outta the ground in Africa, melt it and bury it again in Fort Knox and pay folks to guard it day and night. It has no utility. Anyone watching from Mars would be scratching their head.

    Other factors: tanking Indian economy slows gold purchase for grand golden nuptials. Ditto, slowing Chinese economy for different purposes. BoJ QE has not induced Yen carry trade, instead you have Japs selling gold and bringing money home.

    Cry wolf fatigue. Cyprus being the cause of Eu meltdown, North Korean saber rattling, Iranian nukes not having the same fear inducing factor as the story about the boy who cried wolf goes........,,,.....

    Warrior 231

  6. The post-crisis run-up in gold prices resulted in part from speculation triggered by the massive amounts of cash created by aggressive monetary policy. It had been thought that the massive creation of credit would support a "re-inflation" of the world economy - but the recent pullback in gold, oil and copper – the latter two assets linked closely with global industrial growth – suggests that this may just not be happening.

    The recent rush into the safety of U.S. Treasuries – which has pushed yields close to four-month lows – is another sign that the global economy is far from humming. Treasuries are often seen as a shelter when the economy is weak or unstable.


    Over the last two years while money supply has admittedly remained high due to QE, but US growth has been anemic at best with unemployment still a prime concern.

    Comment : Looks like the money supply - growth = > gold price does hold grain silo of truth, after all. ; )D

    Warrior 231

    1. Warrior,

      I've got the data, and I don't see the same thing. The charts are pretty dissimilar. If US money supply alone was to blame, the sell-off should have happened in 2010, when M2 growth tanked. Instead, gold went steadily up. But right now, with the Fed still engaged in unrestricted QE, the measures are going in opposite directions.

      On the other hand, I was going to comment that we're looking at the wrong country's money supply, but Lars beat me to it.

      Per Danny Quah, the centre of economic gravity in the world is moving steadily East.

    2. Based on the latest WGC stats, China and India alone account for 53.9% of global gold demand for Q42012.

      It's not fear of QE-driven inflation in the developed world that's driving gold demand, it's inflation in China and India, helped by financial repression (underdeveloped financial systems offering few savings vehicles) and desire for official reserve diversification.

  7. 1. Instead, gold went steadily up.

    response: Precisely because of the other factors like Europe which I mentioned at 7.58am

    2. But right now, with the Fed still engaged in unrestricted QE, the measures are going in opposite directions.

    Touche ;D investors are cottoning on that there is no growth for dint i say this at 7.58 am:
    "excessive money supply sans strong growth seems to hold up fairly well with regard to gold.

    You need growth for gold to ride on the expectation of inflation. The Indian Express excerpts clearly imply that.

    check it out.

    Warrior 231

  8. Per Danny Quah, the centre of economic gravity in the world is moving steadily East.

    Response:Wishful thinking at its best for it would be a cold day in hell for the yanks to allow that to happen, dude.And dont cha think that China is waiting for an implosion of its own..the signs are slowly showing themselves.....

    Warrior 231

    1. Actually, he meant it quite literally and in economic terms, not metaphorically or geo-politically:

  9. Dont mean to be a wet blanket, but think Quah would be well advised to do a reality check plus a history scan.mmmmm....Quah...sounds as if he has a genealogically vested interest in saying that...wink wink...haahahahahahaa

    Talking about shifting poles of economic influence were rife in the 1980s vis-a-vis Japan, in the 1990s, heard of the Asian Renaissance crap? Ultimately it boils down to whether the biggest gorilla in the block would meekly relent to that or take us all down with its nukes. Smoke on that, Joe!

    Warrior 231

    1. Warrior,

      I could point out...gently...that the chart Danny comes up with is based on historical GDP i.e. this is all in the past, not a statement of the future.

  10. Come on dude, you don't have to be gentle with a warrior as I do rather go raging into the night........hahaha. Just forgot to add up there that after Japan, the Asian Renaissance, they were all talking up Europe until the EU kinda dropped off 'Europe' to leave everyone with the 'rope' to hang er........their stupidity with. Trouble is, this is the era for Pax Americana whether one likes it or not, and they will blow the world up if need be then go gently into the night.......oops some revolution I made , dint I to join the dots of the first sentence and the last! (LOL).

    Anyway,when I first read this article by Kruggie, I was flabbergasted by his strangely alluring yet aromatic logic, an exotica by a great mind worth pursuing. Well looks like Japan has embraced the ' managed inflation' paradigm or paradox whatever, after all:

    Apologies all the same for foisting it upon your good self on your weekend off which I gather from past data is code to mean no blogging or responses thus no articles......gotcha?

    Warrior 231