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Fabrice Taylor: The gold bubble myth
By Fabrice Taylor
The Globe and Mail, Toronto
Monday, December 14, 2009
It's easy to say gold is a bubble. It's up more than 26 percent in the past six months, so it has to be, right?
Maybe, but I doubt it, for both obvious and less obvious reasons. Gold isn't as attractive as it was when no one wanted to own it a few years ago. Back then it was a no-brainer, trading for less than the marginal production cost. Today there's hot money in bullion, making it susceptible to sharp corrections. But the rally has legs nonetheless.
Let's start with the obvious: Gold is up, true, but put it in a longer perspective and you'll find that gold is actually lagging other assets, and consumer prices. Since the start of the great bull market in 1980, gold is up only about 60 percent. Inflation, officially anyway, is up roughly 175 percent and stocks are up almost 900 percent. U.S. money supply is up nearly 500 percent. The price of something in a bubble tends to zoom ahead of everything. Gold has in the very short term but it's only catching up to other assets.
Another hallmark of a bubble is exuberant investor interest. There's some of that, for sure, but are the masses really clamouring for gold? Yes, demand for bullion-based exchange-traded funds is brisk. They've grown to about US$70 billion in market capitalization since the first one was launched about five years ago.
Bullion ETFs are the most important thing to happen to gold prices in decades, and have stoked demand and prices. But although they've grown quickly, they're still small relative to the trillions of dollars of gold in the world. They have lots of room to grow.
And if gold is in a bubble, why are so many interesting junior gold shares trading below book value? Building a mine is a tough way to make a buck, to be sure, but in a bubble, no one thinks about that. They think about getting rich fast and pay crazy prices for whatever mania might make that happen.
Institutional interest, meantime, doesn't appear particularly high. Gold doesn't feel like real estate or tech stocks, two bubbles I've lived through.
The fundamental supply-and-demand equation argues for higher gold prices. Production hit its high in 2001. It's been down ever since. Even with flat demand prices should justifiably be higher.
If peak oil makes sense, why not peak gold? Yes, there are, of course, differences. Once extracted, oil is burned and can't be used again, while mined gold never disappears. Recycling is not a factor in oil, whereas it is a big one in gold. Nonetheless, the basic supply-demand theory stands.
Perhaps the most important factor is that central banks are buyers. India bought 200 tonnes from the IMF recently. Yet gold is still less than 10 percent of its reserves. For China, which is sitting on a mountain of U.S. dollars, the figure is less than 2 percent.
Maybe most telling, governments, the U.S. particularly, doesn't seem to mind if gold rises anymore.
These are quotes from a letter written to then President Gerald Ford by the Federal Reserve chairman Arthur Burns in 1975, declassified a couple of years ago: "The broad question at issue is whether central banks and governments should be free to buy gold, from one another or from the free market, at market-related prices. ... The Federal Reserve is opposed."
The letter also alludes to the IMF, saying that "the role of gold in the international monetary system would be gradually reduced."
And finally, "I have a secret understanding in writing with the Bundesbank that Germany will not buy gold, either from the market or from another government, at a price above the official price of $42.22 an ounce."
To say that governments didn't at least try to manipulate gold prices is clearly naive. To say they didn't succeed is probably naive too.
Today they may not care anymore, and at any rate they're losing the battle.
As mentioned earlier, there's hot money in gold, but it's not universally owned. It takes a long time to overcome three decades of contempt. The last word goes to John Hathaway, portfolio manager at Tocqueville Asset Management: "While it is no longer enough to observe that the metal is of interest based on universal apathy, it is safe to say that it has a long way to go before it becomes mainstream."
Fabrice Taylor is a chartered financial analyst.
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