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Is Gold in a Bubble?

July 03, 2012 | Comments: 0 | Views: 165

One question I receive frequently from clients, "is gold in a bubble?" Gold has been the best performing asset class since 2001 with an average 11% annual return and not one negative or down year over this period. So it isn't a silly question, especially considering we have experienced a tech stock and real estate bubble within the past decade. Additionally, many folks remember the gold bubble from the 1970s and 1980s so it is natural to assume this meteoric rise could easily crash.

If you prefer not to read this missive, the short answer is no. There is no bubble. For those who are intrigued as to my call, seven reasons exist why gold is not in a bubble: gold as money, debt relative to gold, gold's ascent relative to the 1980s rise, low portfolio allocation of gold and gold miners, and central bank ownership of gold.

Gold as Money

Since biblical times, gold was a primary means of exchange for goods and services. Merchants, craftsmen, and bakers would gladly exchange their wares for the shiny metal. This is the definition of money. Gold was money. Even in America, our dollars could be exchanged for the metal until President Nixon took the US off the gold standard in 1971. Even though the dollar is no longer backed by gold, its price has been strongly correlated to the US dollar.

Since 2002, the amount of money at the Fed and in the economy has exploded as has the price of gold. As more money circulated in the economy, the dollars you hold lose value, but the price of gold keeps up with the increased supply in dollars. You hold your purchasing power with gold. For example, in 1940, it cost approximately $1,000 for a mid tier car. At that time, the price of gold was $35 per ounce so it cost roughly 28 ounces of gold to buy a car. Today, a mid tier car runs around $40,000, which is close to 28 ounces considering gold costs $1,600 per ounce.

On a graph, one could see its price tracking the global monetary base almost perfectly. In 1984, the global monetary base was around $1 Trillion. It grew consistently until it reached a $2 Trillion plateua in 2002. From 2002 until the beginning of 2011, the worldwide monetary base increased from $2 Trillion to just under $12 Trillion. From 1984 until 2002, gold hovered between $200 per ounce and $350 per ounce. When the monetary base increased six-fold over the ensuing decade, the it's price did the same.

Increase in Debt relative to Gold

The second reason the yellow metal is currently insulated from a precipitous fall is our national debt compared to it's price. This is really a deviation of the first reason as the Federal Reserve will be forced to print money to cover our escalating national debt, but excessive debt reduces the value of the dollar, which means it's price should rise. With $1 Trillion deficits estimated for years to come, gold should avoid a large decline.

From the 1980s until 2006, our total government debt to Gross Domestic Product (GDP) ranged between 40% and 60%. Today, we are passing 100% government debt to GDP. The price of this precious metal correlated tightly with this rise.

Gold's ascent this period relative to the 1980's gold bubble

While it's price appreciation over the past decade has been impressive, it pales in comparison to the gold bubble of the 1970s and 1980s. At its peak in 1980, it's price had climbed 2,400%. The current rise in its price, while impressive, is below 600%.

To reach the total percentage gain from the 1970s and 1980s bubble, gold would have to appreciate another 249% from its current price levels according to Frank Holmes, a specialist at US Global Investors.

Despite its recent performance, gold is still well below its 1980s peak on an inflation adjusted basis. To reach the 1980s peak based on inflation, the yellow metal would have to reach $2,543 an ounce. This means gold could experience another 30% climb from current price levels.

This assumes we use the current measurement for inflation and not the inflation calculation used before 1980. Based on the old metrics (as calculated by founder, John Williams), gold would have to reach $15,234 to equate to the 1980s inflation based high for a return of 755% from current levels.

This calculation is probably extreme, but it isn't hard to argue that the actual price may fall between $2,500 and $15,000. Of course, the question is where. This does show that gold could continue when factoring inflation to its historical return.

Low portfolio allocation to gold and gold miners stock

In all asset bubbles, the speculation reaches such extreme levels that everyone is buying. John D. Rockefeller always told the tale that he knew it was time to sell stocks in 1929 when his shoeshine boy tipped him off on a stock. The same story probably could have been told in the tech bubble of the late 1990s. During the real estate bubble, people who never dreamed of being a landlord purchased four or five rental properties. The bottom line is bubbles only form when everyone dives head first into an asset class.

To date, gold ownership is still largely ignored. A study conducted by Knight Frank found that high net worth individuals still favor real estate and stocks to gold (71% favored the previous asset classes while 38% liked the latter). Among the wealthy, only 5% currently hold a position in the yellow metal. Pension funds, the largest investment players in the world, still only hold a sliver of their assets in gold bullion and mining stocks. With only 1.5% of assets in gold or silver, pension funds will feel pressure to get allocated to precious metals as its price increases.

As a percentage of total global assets, gold bullion and mining stocks represent less than 1% of total global assets. This compares to an average of 26% from the 1920s to the early 1980s.

Until we see gold and gold mining stocks in everyone's portfolio, and probably a hefty allocation, we aren't experiencing a bubble.

Central Bank purchases of gold

The last reason gold hasn't reached bubble proportions deals with central bank purchases. From 1999 through 2009, central banks were selling their gold in their vaults resulting in the largest supply source for gold over this period. Today, it is a different story. Central banks are net buyers. Many of the central banks in emerging markets are buying the precious metal to protect against the falling value of fiat currencies. These foreign central banks fear the U.S. dollar, Euro, Japanese yen, and British pound will continue to lose value. Since these emerging countries typically have large trade surpluses with developed nations, these countries have to invest their cash surplus. Rather than putting more money into fiat currencies, the central banks are buying the yellow metal.

What would cause Gold to decline?

This question can be answered by looking at what caused the gold bubble of the 1970s to implode. Again, gold is seen as money. As more and more money is pumped into the economy, the higher the price of the precious metal. In 1979, President Carter nominated Paul Volker as the Chairman of the Federal Reserve. Volker promised a cure to the staggering inflation inflicting the 1970's economy. He delivered. He did so by raising the Federal Funds Rate (FFR). The FFR is the interest rate that banks charge when lending to each other. As this rate rises, banks find it harder or more expensive to borrow from other banks. Essentially, this draws money out of the economy. The price of gold started its precipitous fall when the Fed Funds Rate climbed above 9%.

So as the Fed Funds Rate increased drastically, banks slowed their borrowing from one another, which meant that money was not entering the economy as quickly. In fact, the money supply started to shrink. When the money supply shrinks, the price of gold will usually decline because the value of the dollar strengthens. If the Federal Reserve starts to raise its Feds Fund Rate then the price of gold may face headwinds. However, the Fed has already publicly stated it will keep its key interest rate at 0% until 2014. This bodes well for gold.

Ultimately, gold is not a bubble like tech stocks, real estate, or the 1970s gold market. Considering the low allocation to gold by large investors and the government's propensity for debt and money printing, gold probably has room to run for years to come. This is not to say the price won't fluctuate with some declines. If we enter a deflationary event like a recession, gold could drop back 20% or even 30%. However, the general trend will probably be up as the government and Federal Reserve weaken the dollar.

Kirk Kinder, CFP® is the Founder of Picket Fence Financial, a fee-only financial planning and investment management company dedicated to saving folks from Wall Street.

Picket Fence Financial does this through a few different ways. One, our fee-only approach ensures our advice is tailored to our clients needs and not driven by commissions. Two, we minimize costs for clients by utilizing low cost Exchange Traded Funds (ETF) and aligning our internal operations to keep our company costs down (and passing this along to our clients). Third, we offer a la carte planning, which means our clients decide how they want to work with us. Rather than forcing clients into our model of planning, we offer hourly, retainer, or asset management options (or a combination thereof).

You can learn more about Kirk Kinder and Picket Fence Financial by visiting While there, you can also sign up for Kirk's free monthly email newsletter that provides actionable financial information with a different approach than Wall Street.

All information on this site are the opinions of Kirk Kinder, CFP® and should not be construed as investment, tax, estate or insurance advice. Please consult your own specialist for personal assistance.

Source: EzineArticles
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