When Will The Gold Party Stop?

Published in Investing Strategy on 9 October 2009

The precious metal is at record highs but will the music stop?

Like paranoid 1950s lawmakers who saw a communist under every bed, investors of my generation have developed a twitch about asset bubbles.

Can you blame us?

First we saw the dotcom shares puffed to extraordinary heights on hot air. Then house prices tripled in a decade. And as commodities soared we were told to stockpile wheat in the loft and oil in the basement, only to find them crashing, with tortilla rioters giving us the Mexican wave and oil dropping from $147 a barrel in Summer 2008 to $30 by Christmas.

Now it's gold that is reaching new highs every day -- $1,068 an ounce is the latest peak as I type. Who wouldn't be bubble-phobic?

Gold's special status

Of course, an asset hitting a new peak price doesn't necessarily mean bubble conditions. There may be a solid economic case behind the price rise.

Gold is hard to value in conventional terms, though, since its value isn't much linked to consumption, in contrast to say oil or copper.

The price of gold is more influenced by perceptions about, well, the future price of gold. Because holding gold yields no income, you only buy it as an investment if you think its value is likely to rise. Ironically given its supposed status as 'the ultimate store of value', gold is one of the most speculative chips on the table.

That doesn't mean you can't make great profits trading gold, as anyone who bought bullion from Gordon Brown for $275 an ounce in 1999 will testify. But the critical thing is to cash out before the game ends. You don't want to be the last mug holding gold, as happened to unlucky punters who loaded up when gold last peaked in 1980.

The new gold rush

Is gold close to topping out? I see ominous signs.

Last week a CNBC puff piece drew my attention to Ounces2Pounds, a US company that has brought its Anne Summers / gold bootsale concept to Britain.

The host invites guests to come along with unwanted gold. Ounces2Pounds sends an expert over who values and buys it, and the host gets commission and some expenses for her troubles. A quick Google finds another company, YourGoldParty, doing the same thing.

I don't have a problem with people getting rid of unwanted metal over a drink -- it's surely better for their finances than buying tat as more often happens at these get-togethers -- though I've no idea if the prices are competitive. (On its website, Ounces2Gold claims in London it pays on average a third more for gold than pawnshops).

The key point is these companies haven't emerged in isolation. There's a rush of outfits looking to turn unwanted gold into cash, with the likes of Gold Traders and CashMyGold doing it through the post.

With gold at record highs, it makes sense to melt down surplus jewellery.

But the heightened awareness of such services reminds me of news stories about church roofs being stripped of lead during the commodity boom, or the famous one-bedroom cupboard in Knightsbridge that marked the top of the late 1980s property bubble. It smells of weird behaviour caused by a market distortion.

So is gold in a bubble?

Asset bubbles tend to start with some rationale explanation that eventually gets stretched beyond breaking point.

The Internet did change the world, but that didn't make flawed dotcoms worth a bean, let alone billions. We're not making land any more, but that didn't mean first-time buyers could afford to pay any price for a home.

The gold rally/bubble also has credible-sounding explanations, though they've constantly changed over the past 18 months.

First we were told gold was rising because of increased demand from India and China. With such demand looking soft in the recession, fears of an economic meltdown was cited as supporting the price. After government stimulus measures saw off that threat, gold's supposedly classic status as a hedge against inflation was trotted out -- despite the fact the gold price slumped in real terms for two decades.

Now we're being told it's the demise of the US dollar as the world's reserve currency that justifies higher prices.

Only this week, a report by The Independent alleging that countries including China and the key Gulf States were secretly planning to ditch the dollar for oil trades has been cited as keeping gold above the $1,000 mark.

But gold bugs must realise it's simply not in the interests of countries like Saudi Arabia and China to do in the dollar. These states hold a vast stockpile of dollar assets as a result of deliberate policy. They are no more likely to talk down the dollar than you are to tell an estate agent that your house is over-valued.

The status of the dollar will diminish eventually, but that's a very long-term story that can't explain the short-term surge in gold.

All golden things must come to an end

Certainly dollar weakness is playing some role, if only because gold is priced in dollars. If dollars are worth less, you need more greenbacks to buy your dollar-denominated gold.

But ultimately, gold appears to be going up because investors want more of it, whether they're buying gold via the ETFs that now own more gold than Switzerland, or via a vending machine.

As is probably clear, I'm sceptical gold is a good long-term investment at this price. Bubbles can run for years and who knows where gold will peak, but my suspicion is that when the US starts raising interest rates, the gold price will melt.

More from Owain Bennallack:

Owain is partial to the new Wispa Gold chocolate bar, but he doesn't hold the precious metal directly.

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Comments

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AsterixTheScot 09 Oct 2009 , 3:21pm

Hi, good article that makes a lot of good points. I tend to agree with you but still think this 'gold rush' has some more to go.
However rather than buying gold I've started to look at some of the gold miners as surely the current or even forecast price helps their balance sheets?

Mike10613 09 Oct 2009 , 4:04pm

Some investors have been getting out of gold and buying equities in a buyers market. But they are now worried the recession will continue longer than expected and so the supply side has been cut; demand continues to increase from investors. When the world begins to come out of recession, demand will increase from the jewellery trade and in particular India will start importing again. So there will be a much greater demand. Some equity investors will sell equities and get back in to gold to diversify investments; further stimulating demand. So the gold rush is far from over. I expect gold to go well over $2,000 a ounce and possibly even more and it's not a bubble because there are good uses for gold in the electronics industry and that will grow at a very fast pace once economies start to pick up.

LetsGoa 09 Oct 2009 , 4:14pm

Gold has been going up for 10years and still writers are finding excuses not to own it.

At least i know my money is safe [/b];-)[b].

rober09 09 Oct 2009 , 5:10pm

Mike10613/LetsGoa - Is that a pig I see flying by!!!

keirfamily 09 Oct 2009 , 7:29pm

Good article - though I'd suggest that people buy gold if they don't trust their own currency. We have some gold for of a mix of reasons - if the recovery starts then people will want more jewellery, if things get worse they might not trust government paper money. Supply is weak, demand is often strong, and although gold pays no dividend, neither do most of our (inherited) bank shares.

I agree with AsterixtheScot, gold miners are a better (more geared) bet than physical gold.

francisgroves 10 Oct 2009 , 6:45pm

I think you're right to be wary. There were plenty of good reasons to buy gold when other assets' prices were inflated and currency fears have been a good reason since the credit crunch. Now, though, gold seems to be becoming so popular that it's time to keep a watch on gold investors' behaviour.

The one thing that could give gold a sustained further boost is worrying developments in international relations - not something to wish for!

LetsGoa 11 Oct 2009 , 9:28am

@francisgroves and Shares, Bonds, Housing is not inflated by stimulus?

I Would'nt put money in cash when a tidal wave of inflation is coming.

I can't believe how short memories are. The banking system nearnly died. Goverments are trying such stupid things that if anyone would have predicted it pre-crisis they would have looked insane.

And instead of going to the Saftey of gold there is still talk of it rise coming to an end.

Investors or should I say speculators deserve everything their about to get. You have been warned!

Gengulphus 11 Oct 2009 , 11:54am

And instead of going to the Saftey of gold ...

What safety? Gold wasn't safe in 1980, and it still isn't.

There is no such thing as a safe investment. Gold isn't safe - buy it at the wrong time (such as 1980) and its value can plummet. Gilts aren't safe, despite what the government claims - the normal ones are vulnerable to inflation, and the index-linked ones to manipulation of the inflation measures (which is probably quite a low risk in terms of its effects on the value, but then again, the rewards of index-linked gilts are also pretty low).

The closest you can come to safety in investment terms is to have a well-diversified portfolio of different types of investment, working on the basis that while some will decrease in value, others will increase. And even that isn't completely safe - but it's one heck of a lot safer than piling into a single investment because you somehow misperceive it as being "safe"...

You have been warned!

Gengulphus

LetsGoa 11 Oct 2009 , 1:36pm

@Gengulphus Wrong when all markets are rising from a tidal wave of stimulus they will go down when the markets correct. Diversing your portfolio would be a recipe for disaster.

Gold got crushed in the 1980's because Paul Voclker jacked up U.S interest to 18% to slay inflation.

When inflation takes off the fed will not be able to repeat this feat without bankrupting the U.S Treasury. They were a creditor nation in 1980 they are now the world's biggest Debtor nation.

This means either the U.S defaults on its national Debt or we have a extended period of very High inflation to erode the debt.

Now all you have to do is ask yourself which asset class in the next decade will profit from the above scenario's.

bimber 12 Oct 2009 , 11:52am

What's the fixation with buying in 1980? In 1979 you could buy below $300, in 1981 you couldn't. By comparison with the last gold bull we're not even at 1979 yet.

http://www.the-privateer.com/chart/usgmonth.html

supasap 12 Oct 2009 , 3:14pm

I have read about Gold increasing in value as inflation becomes the only way of US and UK to reduce the size of their debt........ but as with us ordinary folk who owe debt on cards and to building societies don't interest rates increase when inflation takes off otherwise debtors of all shapes and sizes would create / encourage / welcome inflation?

keirfamily 12 Oct 2009 , 5:24pm

Supasap - I agree, and the biggest debtor in the UK is the government. But they issue fixed rate bonds, so have less to fear from inflation. That's why I'm worried about QE and subsequent inflation, and why I think gold is a good medium-term holding.

UpHillAllTheWay 13 Oct 2009 , 11:07am

People put so much faith in gold, that I wouldn't expect it to crash. If its value is too high (and it probably is), I would expect it to fall more slowly than a "crash" might suggest. What do others think?
What happened in 1980?

For the record, I don't have any.

5753225 13 Oct 2009 , 12:40pm

I hold gold. All the profit I've made has been because the £ has fallen in value. Currently we hear much of gold reaching record values in US$... but the US$ is falling, so this would be expected if the value of gold remains constant.

I expect the current government to do its best to devalue the £ (and beggar the country in the process, but then why would they care? After all anyone who's deliberately beggared pension savers isn't going to baulk at beggaring the population in general). Consequently, I hold gold to protect myself from the depradations of my elected representatives. When I perceive that sterling strength has become government policy (possibly following a regime change) then I shall reassess my investment in Gold. (No, actually I shall reassess my speculation in gold. Investment is the process of exchanging a capital sum for an income stream, and since gold provides no income stream, holding it is a speculation not an investment).

afamiii 14 Oct 2009 , 2:25pm

I don't know who the author (Owain) has been speaking with who has been giving him different reasons for buying (increasing price) of Gold.

I started buying Gold in 2006 on advice from some newsletters in the Agora stable. Their argument (and most metals analysts I subsequently consulted with) have been speaking the same message all along; that governments are mismanaging paper currencies, that inflation is running higher than is stated officialy (remember that inflation is just a concept and their is no universaly agreed or calculated definition of it) and will run higher as real but off balance sheet government obligations begin to be called.

What has been added in recent months has been the accelerated threat of inflation and the accelerated acquisition of debt obligations by many governments.

Overall in real terms, we expect gold to deliver about 20% per annum over the next 5 to 10 years (i.e. as long as monetary policy remains constrained by irrisponsible fiscal policy and weak economic demand.)

The time to get nervous about your Gold horde is when someone like Paul Volcker is brought back to the Fed and interest rates start to march upwards. However, it will not happen under this government, they remember too keenly that the people don't want honest government and how they beat up Jimmy Carter for daring to tighten the belt. www.smartinvestorafrica.com

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