Is it a Gold Bubble ?

World of Finance by M.Vijaya Sai

Gold investors have certainly enjoyed a marvelous year. The price of gold has doubled in the last three years and reached an all-time high in the first week of December 2009. As well as the stock market has done, investment in gold has over performed the S&P 500 by 10%, and by 34% on a risk-adjusted basis. Is the impressive performance of gold comparable to that of Internet stocks in the 2000s or house prices between 2006 and 2008? Are we experiencing a gold bubble? I do not think so.

Economists assume that the main driver of the price of gold is the stock market. Gold and the stock market have historically been negatively correlated. In 2009, however, this correlation turned positive. The stock market was recovering from the crisis, and gold prices were up because gold is an inflation hedge, and investors--especially governments--were accumulating gold reserves. This extraordinary relationship between the stock market and gold prices is not worrisome because we saw the disarray of most financial markets at the end of 2008; it is just taking time for them to readjust.

If the recovery in stock markets continues, all the money that is now flowing into gold will return to equities. Gold prices will then land softly. In an article in the Journal of Finance, Malcolm Baker and Jeffrey Wurgler showed that a reliable predictor of the stock market is the proportion of equity issues relative to the total issuance activity of U.S. companies--years of heavy equity issuance are followed by poor stock returns. In 2009, debt issuance relative to equity surpassed all previous records. Therefore it seems that stock markets will show high returns in 2010. Consequently, the negative correlation between gold and the stock market will be restored, and it will be a great year for stocks, but not for gold.

The second driver of gold prices is the weakness of the U.S. dollar. Asian economies such as China are challenging the dollar's long-term role as the world's reserve currency by accumulating euro-denominated instruments and gold. This is a pervasive equilibrium happily welcomed by China and the U.S. China is interested in keeping the dollar low so that it can more easily afford its heavy oil bill. China also balances its need for dollar reserves with its reasonable fear of rising inflation in the U.S. by accumulating gold. The U.S. is comfortable with a weaker dollar, which makes its exports cheaper in Europe. For the U.S., this is a perfect equilibrium because the dollar’s premier status guarantees access to foreign capital. The European economies, however, suffer from an overvalued euro, and their own exports to the US are highly priced.

Only a big political event could break this equilibrium. It could all start with oil prices being re-denominated in euros (this was the threat recently made by Venezuelan President Hugo Chavez).China would then replace its dollars with euro reserves, and the trade balance between China and Europe would do the rest: The euro would weaken against the dollar, interest rates in the U.S. would increase, the dollar would appreciate, stock prices would increase and the price of gold would go down. This is unlikely.

It is impossible to say if the stock market or the U.S. dollar most affects the price of gold. It would be a big mistake to interpret the relationship between the U.S. dollar and gold prices in isolation. The global economy is a complex system where all macroeconomic variables such as inflation, bond markets, oil prices, exchange rates, stock prices and commodities are interrelated. The dynamics of this system are completely unpredictable because there can be unexpected shocks of very many different kinds. I hope that we have learned this lesson at least from the 2008 financial crisis.

Is there a gold bubble? If there is one, it is definitely not rational. In a rational bubble, prices deviate from fundamentals because arbitrageurs cannot eliminate mispricing because of a market constraint. This was the case in the housing bubble of the last years, where home prices could not be arbitraged away by short-sellers (naturally, houses cannot be sold short), even though the mispricing had already been identified. The gold market is very liquid, efficient and transparent, and mispricing is easily corrected through gold short positions.

In an irrational bubble, prices of assets increase abnormally because investors ignore intrinsic values. An irrational gold bubble is also unlikely. That gold prices are artificially inflated seems natural because gold is a commodity with a limited supply and it does not have a fundamental value.

Demand for gold in 2009 skyrocketed because of an increase in inflation and because European countries required financing. However, gold trades are dominated by institutional investors and large traders who do not panic easily. As well, China makes the most claims about a gold bubble and is simultaneously accumulating gold reserves, which suggests it has an interest in purchasing cheaper gold. Finally, a bubble is unpredictable by nature and only confirmed ex post.

In the absence of fundamental value, a bubble happens when the price of an asset is extraordinarily high. Whether the current gold price is artificial, only history will tell. The only thing we know for sure is that the price of gold is at a historical maximum, but so was the stock market in 2008, and not as a result of a bubble. Gold is certainly expensive, but it is worth what investors are paying for it.