Thursday, March 12, 2009

Ready to Ride the Golden Bubble

First the chart, then my explanation…

People seem to forget this, but all bubbles start with a seemingly strong premise. In the case of gold it's that the printing press is going wild, thus gold should strengthen relative to the dollar. This makes sense to a degree. The Internet DID change the world, but didn't become a worldwide leader in pet accessories; oil SHOULD have increased in price due to a global economic boom, but at $145 / gallon businesses failed and people stopped driving; financial innovation DID allow many first time buyers the access to finance a new home, but someone making $20,000 a year should not be buying a $1,000,000 house.

In other words, a great story can explain why the boom begins, but it doesn't justify the price if it becomes outlandish. As money pours in and the bubble gets larger, investors pour in more money. Gold has been a similar story as the shiny metal formerly used in jewelry vs. 401k's has become exceptionally self-feeding as gold has been one of the few asset classes that has shown strength, attracting new capital.

The following are a few reasons why I believe gold may be entering the next bubble:

  1. The same people that argued gold is a BUY BUY BUY because of inflation are now coming up with well-articulated reasons why gold is a BUY BUY BUY because of deflation. I personally don’t have a clue how deflation or a decrease in credit can possibly be good for gold.
  2. Pre-house bubble pop, everywhere you looked there was housing TV show this (i.e. Flip that House), housing seminar that, become a realtor this. Now there are "gold guys" preying on frightened investors' 401k’s, infomercials about gold coins, and the Internet sensation CASH4GOLD.
  3. Gold serves no useful purpose, to my knowledge, outside of a minor uses in electronics / dentistry and major uses (at lower prices) in jewelry. I say "at lower prices" because gold is already to being replaced by cheaper metals in jewelry (the demand for gold jewelry was down 35% in the fourth quarter) and the existence of CASH4GOLD means people may be net sellers of gold in jewelry (I personally like to picture a frightened investor selling all their prized jewelry out of fear, only to take that cash and invest it in gold out of fear of inflation).
  4. The wildest thing to me is that in most cases this investment is not in bars you can actually see (the value in gold is supposedly its beauty), but in an ETF where you see its value in your account statement. (In addition: if you think the financial system is melting... don't put your money into an ETF).

After all that you’d think I’m shorting gold? Well, I actually am in the short-run (The Financial Ninja read my mind with his post regarding that opportunity), but I am ready and waiting for gold to make new highs to reverse my positioning with expectations that this bubble train is far from over. I've learned my lesson with the Internet Bubble (and recent housing bubble) that most people are illogical and invest based on fear (sometimes fearing loss, sometimes fearing they will miss out on the next big thing) and money can be made even if the premise makes absolutely no sense in the long run. As long as fear reigns supreme and equity markets remain volatile, there will be plenty of people convinced gold is the only "safe" investment.

My expectation is that eventually the golden bubble will run its course and come crashing back down to earth. If the economy gets worse, people will realize you can't eat the stuff and investors will sell their stakes to pay for necessities. On the other hand, if the economy recovers, investors will have much better opportunities with their capital… as I mentioned Tuesday, asset inflation, especially in precious metals, serves no economic purpose in the long run.