Are gold bubble fears overblown?

Ashutosh Shukla | September 08,2011 04:52 pm IST

Let me start by saying that gold is a metal of almost no use. It does not product any cash flow, dividend, interest income etc and it has very limited or no industrial use.

Only thing it is of any use is that women love it. In the recent market scenario, we have observed that there is capital flight from stocks, bonds, rental properties or any other asset that produces income stream to the Gold or Gold ETFs. There can be two prominent reasons for that: Either gold is undervalued at the current price or there is a herd behavior prevalent in the market that is pushing the gold prices up into the bubble.


In this article, I will discuss the relatively contradicting statistical inferences to learn about the bubble fears in gold market. Let me start by looking into the serial correlation in the gold return – that is, rises followed by the rises. The chart shown below shows the correlation between the price changes one week and the price changes the next week over the 26-week period.

 

          
                                                               Figure 1
In case of bubble the correlation is strongly positive. But here the correlation is slightly negative. By contrast, the same measure showed the strong correlation between the tech stocks during their bubble. Thus, this test does not support the argument that gold is into the bubble. But the argument can’t be refuted only on the basis of this test as there may be other tests suggesting the presence of bubble.


In case of second test, the price of gold is put in relation to the rest of the economy. In the chart below, the ratio of the gold prices to that of S&P500, to that of GDP, to that of index tracing industrial metals and to that of median family income is plotted. If we look at late 70s, the gold looks more overvalued as compared to the 2011. After late 70s, the gold price relative to other economic variable has come down as has started climbing again in the last decade, but is far away from its peak of late 70s. Digging further into the chart, the gold prices relative to the industrial metal index and family income indicates bubble but the gold prices relative to other economic indicators does not suggest the bubble strongly. Thus the second test gives us the contradictory results.

 

                             
                                                                  Figure 2
In case of third test, the chart below shows the gold price movement in last four decades. We can see that in late 70s, there is the sharp rise followed by an immediate fall in the price of the gold. Now the gold prices are up over $1500 per ounce and if we adjust the 1980 peak for inflation. In term of dollar purchasing power parity of 2010, that peak would come out to be around $1892 per ounce. We are still far away from that peak. This analysis further reinforces that analysis of first test that gold may not be in the bubble as of now.

 

                              
                                                                Figure 3

Looking at the results from all the three tests it is rather difficult to arrive at the conclusion about the gold prices but the second test do indicates to us that there is a probability of the bubble being there. The relative flight of capital from stocks, bonds etc to the safe heavens has fueled the rise in the gold prices and it is pretty much possible that, at some point, there may be drastic fall in gold price as the sentiment improves in the world markets and that point is often difficult to identify.

 

Gold price may continue to rise further but one thing is clear that the upside is limited at this point and the downside is huge. Thus there is need to have some measures in place to avoid the type of devastations caused by earlier bubbles of housing and technology stocks.


We will now look into what is driving the gold prices up and what should be the measures taken by the regulator to avoid any kind of market debacle. It is clear that the speculations have been driving the gold prices up. People are buying gold to hedge against inflation, in anticipation of economic calamity or simply to profit out of rising prices. The recent data of world gold council reveals that the demand for gold has almost doubled since 2009. This speculation is fueled by the technology and financial engineering innovations where one can click and buy gold via internet and gold ETFs. Moreover, the advances in Media and communication technologies have made the markets and people more prone to financial infections across the globe thereby facilitating the creation of bubbles. At this point, the regulators must act proactively because it may be possible to identify the bubble but it is very difficult, if not impossible, to identify the timing of the bubble bust.

 

And if the bubble does bust, then the aftereffects on the banks and other institutions can be very devastating. The regulators can raise the margin requirement for gold to reduce the leverage and thus curbing the speculation activity. These types of policies have to be implemented on the globally coordinated basis. Limiting the media barrage can be one of the options subject to the local laws of the countries.


After all, Alan Greenspan, the former Federal Reserve chairman, once said that stock market might be “irrationally exuberant” in 1996, well before the actual bubble took hold. As with the technology and real estate bubble, we will know if a bubble truly existed only if and when gold falls.


Concluded...


References and image sources -:-
1. www.investorschronicle.co.uk, what gold bubble?, Christ Dillow.
2. www.dealbook.nytimes.com, How to deflate a gold bubble, Steven M. Davidoff.
3. www.forbes.com, Gold: bubble or not?, Marc Schindler.
4. www.wallstreetpit.com, Is Gold a bubble, Bill Conerly.

 

 

 

 

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Ashutosh Shukla is 2nd year PGDM participant at IIM Indore class of 2012. He has done B.Tech in Electronics & Communication Engineering, with honors, from GND University, Amritsar. He has close to 45 month of work experience in SAP Labs India and Cognizant Technology Solutions....

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Comments


sachin dabhade on 09/28/11 at 04:13 pm

Hi,

an excellent article...the facts are presented in a crisp manner and alomost all the aspects of the gold price dynamics have been touched upon. The metal has indeed witnessed an ugly drop, testing near $1500 and as mentioned rightly in the article "Gold price may continue to rise further but one thing is clear that the upside is limited at this point and the downside is huge". Being a commodity analyst myself, I would give a biiiig thumbs up to your analysis and say keep it up!


Ashutosh on 10/05/11 at 10:49 pm

Dear Sachin,

Thanks for your commendation.

Regards,
Ashutosh Shukla