Canadian Finance Blog

Posted: 05 Jan 2012 02:00 AM PST

This is part two of the bubble series here at Canadian Finance Blog. Part 1 explored whether the run up in Canadian housing prices was a bubble. Today, let’s talk about gold.

As Warren Buffett has famously said:

[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.

Of course, astute readers will know gold’s main purpose, which has evolved into a tool to enable speculators to place bets on the direction of world economies and their monetary policies. Basically, investors will buy gold if they think major governments will be printing money to stimulate the economy. Or, these people can take it one step further in their thinking, buying gold because they feel a major economic catastrophe is upcoming. Gold also has some industrial uses, as well as being used in jewellery, but these actual demands doesn’t really move the price.

Naturally, as the economies of the developed world have gone through their problems over the past few years, gold has done well. The yellow metal closed 2011 at $1564 per ounce, declining from a high of nearly $1900 just a few months ago. 5 years ago, gold was trading at just $600 per ounce, meaning the precious medal has gone up more than 150% over the past 5 years.

Is gold just beginning it’s upward trajectory? Or is there a gold bubble and gold bugs in for a world of pain?

The Bullish Case For Gold

Central banks around the world are loosening monetary policy. Essentially, they’re both printing money and giving banks a ridiculously low rate to borrow money, which they hope will help kick start lending. Every central bank needs to slowly increase the supply of money in an economy, because a growing economy needs a growing money supply. But, what happens if the supply of money grows faster than the rate the economy is growing? In that situation we’d have inflation begin to spiral out of control, since printing too much money essentially devalues the current money supply.

This is what gold nuts are banking on. They believe that, over the long term, large government debts around the world are going to lead to economic disaster. To get out of their debt problems, governments will either be forced to admit defeat and default on their loans, or create enough money to pay them off. If either of those events happens to a large economy, (like say, Japan) this would be extremely positive for gold.

And if it does, you know your neighbour/friend/whatever who bought into the gold hype will be happy to profit off of others’ misery.

The Bearish Case For Gold

There’s two reasons why gold may not be a good investment going forward.

Firstly, there’s no guarantee that these large government debts lead to defaults. Remember, after World War 2, governments around the world were stretched thin because of the massive borrowing it took to fund a war. The soldiers came back home, the economy picked up, and the world grew out of its debt problem. It’s still quite possible for governments to do the same thing now. Even guys like me can figure out there are certain countries with debt problems. There’s still time for governments to do something about it.

Secondly, it’s possible the bad news scenario is mostly priced into the current gold price. If every gold bull thinks the same thing is going to happen, then they’ve already bid up the price in anticipation. If bad things happen, the price might actually go down, because so many people will want to take profits on the catastrophic event.

What Do I Think?

This is why you’re here, right? To get my awesome unsolicited advice? Well, here it is.

I’d stay away from gold. Firstly, as the investing axiom goes, buy low and sell high. Gold is trading close to an all time high. It has already priced in some pretty bad things happening. But what if they don’t? By buying after such a run-up, you’re setting yourself up for a long tumble down.

The faster an investment goes up, the faster it comes down. When the bubble pops, things go badly, quickly. One only has to look back a few years to the subprime mortgage crisis to see how quickly the market can turn from positive to negative. By buying an asset near the top of the cycle, an investor is setting themselves up to be caught up in the panic selling.

Look at silver, which is often thought of as a poor man’s gold. In the past year alone, silver has lost 25% of its value in a week twice. Those types of price movements aren’t characteristics of a rational market.

I won’t be putting any of my money in gold soon. How about you? Do you think there is a gold bubble?

Is Gold In A Bubble? originally appeared on Canadian Finance Blog on January 5, 2012.

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