10 Comments

  1. » The Case for Gold as the Next Bubble Instrument January 19, 2008 @ 2:34 pm

    […] dudemjk wrote an interesting post today onHere’s a quick excerptThe safest of all, is trading streetTRACKS Gold Shares (GLD). According to their description, the investment seeks to strive to reflect the performance of the price of gold bullion, less the Trust’s expenses. It trades at approximately … […]

  2. Publicus February 26, 2008 @ 3:46 pm

    Interesting post. Before I reply, let me first state I’m not a finance guy. Since I’m considering buying gold right now as an inflation hedge, I was pretty interested in your statement that gold is not a good inflation hedge.

    Right now I disagree, here’s why.

    What I think has happened is a pretty fundamental shift from investors (domestic and foreign) relying on the US dollar for their reserves and also for their purchases; specifically oil. Over the next few years, I think the trend will be for less and less trade to be conducted using dollars with more deals done on either a basket of currencies or with non-dollar currencies or perhaps even sophisticated barter-type deals (I give you oil you give me a nuclear reactor). All of this will lead to less use of the US dollar and more use of both commodities and non-dollar currencies which have a stronger backing.

    So, instead of a gold bubble I see more of a general commodity bubble–where anything that is not a dollar will have more value. Some of these commodities and currencies will be bubbles, others will not–it will probably take time for the markets to agree on what will work the best. But the bottom line is the dollar and US debt in general will not be used at anywhere near the current levels.

    For myself, I’m trying to figure out a way to save for retirement by not owning anything in dollars and also own something that has tangible value; such as gold coins. Obviously, I’m still researching this topic and I could be completely talking out of my a$$, but I just can’t shake the feeling (supported by data of course) that the dollar is fading and something else will take its place.

  3. Franklin February 26, 2008 @ 11:52 pm

    Publicus,
    I don’t think that gold coins have more tangible value than, let’s say, houses. Since this is a bubble economy, I don’t see a problem with smart investors like yourself trading gold and gold derivatives. However, I prefer liquid instruments that are easy to get rid of when the bubble collapses.
    For me to be convinced that investors and foreign nations are abandoning the dollar, I will have to see the Treasury Bonds paying 13% or more interest because nobody wants to buy them. If the US continues being able to sell its debt to foreign investors and the interest rates remain below historical averages, I will have a hard time believing that the current commodity bubble is nothing but a reflection of an over liquid dollar that loses purchasing power.
    At one point, not yet IMO, China, India and the many Latin American countries will not be able any longer to export deflation to the US because the prices of the commodities will make anything manufactured expensive relative to the purchasing power of the dollar. At that point we should see a rather nasty collapse of international trade and bonds from relatively stable nations will be a better bet than gold itself.
    I do not agree, yet, with something else taking the place of the dollar (yet) anyway. I think that the only force behind the dollar is the American military power, for that to change we should see many other things change (above all, in the technology world).
    I am not saying don’t play it, I am saying play it safe, like any other bubble.

  4. Anonymous March 16, 2008 @ 11:06 am

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  5. Anonymous February 11, 2009 @ 10:02 pm

    I think gold is the next bubble. It will no be used as a currency unless a government says it can be, and they won.t

  6. Anonymous February 24, 2009 @ 8:19 am

    GLD shares are the next Auction Rate Preferred. The idea that GLD is a hedge is silly because despite what anyone says, GLD shates are NOT backed by physical gold. This is why they will never let you take delivery on the gold. Buyer beware. There will be a gold bubble, but it will be a paper gold bubble and the last thing you want to be holding is a worthless GLD voucher.

  7. Franklin February 24, 2009 @ 6:53 pm

    Agree with you. In the article I say “The risk of trading these instruments (besides those inherent to the market fluctuations) are that, were we to suffer some kind of cataclysmic financial collapse, you would end up with a bunch of worthless paper. Since cataclysmic financial collapses are much less common than market price fluctuations, I still think that they represent less risk than buying bullion.”

    I don’t think gold is a great investment instrument either. It depends on timing as any other speculative instrument. But I am sure we are going to disagree on that one.

  8. Anonymous March 1, 2009 @ 8:28 pm

    dollar will collapse. can’t stop national debt, huge trade and budget deficit, pumping trillions of dollars in the system, housing is collapsing, stock market is crashing. We abandoned the gold standard cause we couldn’t pay them back, that is self was declaring bankruptcy. Since then all they had to back the US dollar was the faith of the US economy. The US economy was nothing but an illusion created by low interest rates, cheap loans, inflation, credit cards and Home equity lines of credit. US economy is in a shit hole. We have lost 95% of the value of the US dollars since the federal reserve was established in 1913. we have been devaluing the dollar for almost 100 years and we are not turning it around. If an individual maxed out his credits cards, can’t borrow any more money from his friends, and he is income is decreasing by the day, the only way out is bankruptcy or inflating his way out of debt. The US is not going to be able to pay the debt what so ever without hyper inflating the currency and thats the only way out. too many countries have gone down that road and you can’t ignore history. remember the Grace commission? what the hell happened to that? we tried once and no one talks about it any more. remember Clinton saying “the national debt will simply be $0”? its a joke. If the dollar comes to a point where it simply does not have value, people will have to use something with value and convenience to trade with. there will be a black market for gold if they ban it. you can’t ban alcohol nor gold, it will just create a back market.

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    Great article, very interesting and informative, I look froward in reading more , thanks

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The Case for Gold as the Next Bubble Instrument (and How to Play it Safe)

Economics, Finance Comments (10)

I wrote before that gold is a a poor inflation hedge. The myth has its origins in a big run up in the 80s that had as much to do with wild speculators cornering the precious metals markets as with a knee-jerk reaction to two continuous years of double digit inflation rates.

With gold hitting new “all time highs” it is time, again, to revisit how high gold actually is. The following chart shows gold yearly average prices since 1969 in an imaginary currency that adjusts only following yearly official inflation rates. The currency is based on the price of Borodium, and it uses base 1-1969, that is, it measures the prices of gold adjusted for inflation starting in 1969.

image

As you can see, the 1980 peak was B$ 4377, and the 2007 average was just B$ 2014. That should provide enough fodder for gold bulls to argue that gold is “cheap”. Regardless of the absurdity of valuating any good by the price in the past, that may become a convincing argument to feed an speculative frenzy.

If gold were to reach previous highs, the next yearly high average should be at $2196 in 2007 US dollars. Depending on how long it takes gold to reach that, the price could be much higher. I expect these arguments to start percolating into mainstream media (right now is mostly gold permabulls who make the argument), and stories about fortunes made in gold starting to circulate in cocktail parties.

Since the myth of the relationship between gold and inflation seems to be prevalent and the current and future administration policies will be highly inflationary, it is reasonable to think that a bubble may form around gold. The difference between a normal rise of the price of any good and a mania, is that during manias a number of illusory assumptions reinforce themselves until there is a sense of inevitability to increase of prices of the manic good.

As I said yesterday, gold may lend itself to become the instrument of such mania mainly for these reasons:

  1. It is relatively easy to become a “gold expert”
  2. It is massively available
  3. We all can have the illusion we understand it
  4. Most of us have some of it
  5. It has a strong emotional history from where to drive examples to reinforce the mania
  6. It is easy to trade
  7. It has prestige
  8. Buying it and holding it produces instant gratification
  9. It has some utilitarian value
  10. Who does not like bling!

Based on that, expect a lot of people starting to talk about $2200 gold and beyond. Again, the arguments will be that

  1. By “historical measures” gold is cheap (of course they will ignore the fact that they are talking about a 1 year manic high)
  2. Gold is real money
  3. Since gold is real money, it is an inflation hedge

The strongest rational argument against such scenario is that if gold were to keep rising to reach those levels (we are talking about more than 200% from today’s prices), the current global economy would collapse in a global depression. To understand this you need to understand that the current global economy runs on slave labor from China and other 3rd World countries.

If the prices of commodities were to keep rising at these levels, the price of labor in those countries should rise accordingly, and added to the increase in the price of goods, it would create an increase in the price of final goods that would stop exporting deflation (as it does today) and it would start exporting inflation to an already overheated inflationary economy. In that scenario, you would not be able to buy at Walt Mart if you are a Walt Mart employee, and the economy will screech to a halt with high levels of unemployment, which would create a over production crisis in the manufacturing countries, which would make it necessary to destroy a large chunk of the means of production. And that would be just the beginning of it. If that were to happen, you would end up with an excess of gold at high prices.

However, if gold does become the object of the next bubble, rational arguments will be laughed at.

Do you want in?

Before even thinking about playing a possible gold bubble remember that the most important aspects of investment are market timing and money management. If you are going to to “all in” most probably you will end all out of money. Think on the real estate speculators who went all in in the past 4 years. They are now licking their wounds or bankrupt.

That said, I am all against buying bullion or gold coins to play a gold bubble. If you doubt me, think that had you bought gold coins in 1980 you would have today a bunch of shiny pieces of metal worth half of what you paid 27 years ago. Bullion and coins carry high commission charges and are less liquid than paper instruments. There are some electronic forms of gold bullion, but that defeats completely the purpose of buying a good.

However there are many relative safe ways the middling classes can participate if gold were to become the object of the next bubble.

The safest of all, is trading streetTRACKS Gold Shares (GLD). According to their description, the investment seeks to strive to reflect the performance of the price of gold bullion, less the Trust’s expenses. It trades at approximately 1 tenth of the price of gold, so you will need 10 shares to invest the equivalent of 1 oz of gold. This is a highly liquid instrument that can be traded in almost every type of account. I prefer this type of instruments over bullion because you can benefit of the short term moves without having to worry about storage costs, high commissions and the risk of having a material good that you need to actually sell in order to realize any profits.

The risk of trading these instruments (besides those inherent to the market fluctuations) are that, were we to suffer some kind of cataclysmic financial collapse, you would end up with a bunch of worthless paper. Since cataclysmic financial collapses are much less common than market price fluctuations, I still think that they represent less risk than buying bullion.

In the more speculative side of things, you can try trading mining stocks. The mining stocks right now are lagging behind the gold move. Bulls will argue that for that reason they are cheap, bears will argue that for some reason companies are not purchasing their own stock and large speculators are not moving the prices higher.

If you decide to dibble into mining stocks, you should know that there are essentially three groups of mining stocks, American, Canadian, and South African. Whenever you buy Canadian or South African mining stocks you are making a double bet: that the company is going to benefit from higher gold prices and that the Canadian Dollar and Rand will rise against the US Dollar. Another problem with mining stocks, is that you need to know how the companies are hedged (if they sold most of their future production at today’s prices, you will not see the stock price following the price of gold). So you will need to bet that gold prices are going up, that the Canadian Dollar and the Rand are going up and research the hedging situation of the company whose stock you are going to buy.

Most of the mining stocks trade options as well (GLD does not have options yet), and more seasoned traders may want to play the gold rush (if it happens!) with options or gold futures. Of course you must know that leveraged instruments present higher risk than non-leveraged instruments.

As usual, do not jump into any important financial decision without researching the risks and if any given instrument is right for you.

Franklin @ January 11, 2008

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