Weekly Words on Gold and the Economy WE – 2-27-10

Is gold in a bubble? Please!

I keep reading articles in which financially savvy people allegedly claim that gold is “in a bubble” or “sparkling,” or whatever term these folks did not apply to the real estate market in 2006. They profess alarm at the “speed” of the rise of the price of gold, or suggest that all the late-night infomercials encouraging people to sell their “junk” gold suggest that the prices are too high. And then they go on to suggest that people buy something else (in the case of the article I read most recently, cigarette and junk food companies).

With all due respect, such advisers are clueless.

I’m not saying that to belittle your actual recommendations. Although one might think, or even hope, that companies that sell death-dispensing products will not fare well in a general economic downturn, that is not the basis of my criticism. My review is for people who never noticed that gold was in a bull market for the first ten years, and then their first comment is that the bull market is over. And in such absurd tests.

To take the most absurd claim first, consider late-night commercials. They yell that gold is at all-time highs and encourage people to sell it as quickly and conveniently as possible. Market analysts apparently think that advertisers are either ignorant or just … extremely helpful in offering to get all this high-priced “junk” out of the hands of a group of people notoriously vulnerable to emotional promotions. Rather, any rational analysis of infomercials would lead to precisely the opposite conclusion: Infomercials seek to tap into their audience’s desire for instant gratification (or simple desperation) and buy something they hope to increase substantially in value. Or to put it more bluntly, the infomercials are trying to separate the suckers from their money.

So a proper view of things suggests that the creators of infomercials believe that the price of gold will soon go up. And the most economically ignorant and desperate people in the population are susceptible to the belief that gold is overvalued. To the extent that that suggests anything, it is a clear sign that the price of gold will soon rise. Something dramatic in the wind will be when infomercials suggest ways for people to buy, rather than sell, more gold. The top comes when the rich sell to the poor, not the other way around.

So how precipitous has the rise in the price of gold been? The low occurred in the late 1990s and was about $ 275 an ounce. The recent high was about four times that price. Quadrupling in twelve years hardly brings us to a country with a nosebleed, considering the price increases of tech stocks before their 2000 crash or recent crude oil price turns, but perhaps it raises the question of whether such growth pricing is justified. And it’s likely to continue given the fundamentals.

Like the infomercials, I firmly believe that the price of gold has a long, long way to go before it reaches the top. You could compare the high price of gold that occurred in 1980 (it took almost twenty years after that to bottom out) of around $ 850 per ounce. Adjusting that price for inflation would suggest a much higher price for gold, assuming gold reaches those heights again (as I do). The supply and demand analysis would produce a similar result.

In my opinion, however, the best place to base your analysis of the price of gold is its role as a monetary resource. Some people claim that gold is money, others the opposite, but it is undeniable that it suggests that the largest holders of gold in the world are central banks. Barbarian relic or not, gold is treated like money by the people who count. It should be considered as a form of money.

And the supply of gold has remained almost constant while the number of “fiat” currencies issued by the government has skyrocketed. Governments around the world have vastly expanded the amount of their money in existence, while gold has become relatively much rarer. This suggests that the price of gold should rise much higher to return to its relationship with national currencies.

Perhaps most significantly, the supply of gold is almost completely independent of government action and, among other things, the value of gold becomes a kind of barometer of global confidence in the integrity of government. As governments become increasingly unable and reluctant to control their spending, and as they competitively devalue their currencies, people are slowly losing confidence in government. The slowness is probably more a function of people’s unwillingness to believe that their lives will actually change than anything else – the facts are absolutely clear. It is this gap between reality and what people accept that convinces me that the price of gold must continue to rise.

And it will grow, at the very least, until public perception matches the extent of the problems facing the financial world. I think this is at least several years away.