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The Bullion Report

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May 11, 2011 in 'The Bullion Report'

Bursting a BubbleBursting a Bubble

Last week’s commodity sell-off was dramatic for many markets, harkening back to the drop in prices seen in 2008. This, of course, sparked the inevitable mention of a bubble bursting (or getting ready to). This kind of language has a strong impact on investors and prices alike, but the big question should either be “is there a gold bubble waiting to burst?” or “is the belief in a bubble the more likely thing to deflate?”

Before jumping on board with the idea that all higher priced commodities are just short opportunities waiting to happen it is prudent to consider what a bubble entails. For most of these characteristic past price plunges the whole picture offers a substantial difference to what I see in precious metals. Bubbles are often an inflating of prices with little fundamental reasoning behind them. Like their namesakes, they are large objects – or in this case, events with hollow composition. Think about some of the biggest examples of bubbles. Tech stocks, housing, and more were all fast climbers, posting gains that far exceeded their intrinsic value. The trouble is who can argue what the real value of some of these is at the time of the peak price? If there are buyers willing to pay a certain price then it can be argued that the value is just. 

In reality, some analysts suggest that a bubble appears when an asset is not being priced correctly - that a mania is taking hold without rational causes. A great example of this is the story of the mania over tulips. To oversimplify a recent bubble let’s look at the mechanics of the housing collapse. The number of participants who were buying and building more and more for the hopes of boundless profits forgot about the inherent purpose of real estate – as a place to live. Think about all of those shows about flipping homes (buying them to repair or update, and then sell for ridiculous profits) and all of the infomercials on real estate fortunes. All of this mania was built on the assumption that prices could only rise and that notion was funded by really bad loans. It was the perfect recipe for a bubble - and completely without substance. 

What about precious metals? Gold and silver, like most commodities, have a basic value supported by the dynamics of supply and demand. Then you throw the US dollar in the mix, and a whole new world of dynamics opens up. In the current environment, any weakening of the dollar has supported movements higher. This was exacerbated by moves from the Federal Reserve to stimulate an economic downturn by turning on the printing presses and increasing the money supply. This supply influx was known as quantitative easing and has come in two distinct waves. The second - QE2 - is set to expire next month, which has some critics of higher gold prices screaming sell. The trouble with this view, and a suggested catalyst for a bubble-bursting price drop, is that just because QE2 is coming to an end doesn’t mean that the money supply suddenly contracts. The Fed won’t actively be pumping funds into the system, but they aren’t scooping it all back up into their hideout either. Until they shift their policy in a way that reins in this extra cash this is a mute argument. 

The second argument against prevailing bubble theories comes from the function of gold (and to some extent silver) as possible stores of value and guards against inflation, i.e. inflation hedges. With several notable countries – the U.S., most of Europe, Brazil, China, and more – fighting to rein in inflation, there is less chance for gold to be shed from portfolios as investors hope to arm themselves against the rapid price increases. The final, and in my opinion, most important flag that waves in the face of naysayers is the fact that central banks have turned from being sellers of gold to buyers. Many notable countries like Mexico, Russia, and China have been adding to their official gold reserves rather than selling off portions. The idea that they are willing to allocate assets in this area says something. Gold is often frowned upon since it pays no interest payments meaning it isn’t earning money while it sits there. For these banks, having gold likely means protecting wealth. 

Summary

One of the most frustrating characteristics of a bubble is that you can’t identify them in advance. The markets that get one have a run up in prices and then a quick and sharp selling phase in which the asset’s price returns to “normal”. More than a few people appear eager to slap that tag on gold and silver, but I have yet to see an argument that suggests prices are anything but normal at these levels. The global economy remains poised on a precipice. Europe as a whole keeps seeing road blocks on its recovery, the latest in the form of the downgrading of Greece. The US is still struggling with housing and employment. China and India are emerging as strong points of investment demand for bullion, likely to be enhanced by China’s current struggle with inflation. Unlike bubbles that can be substantiated, I think there are good points at which gold and silver can find support and willing buyers on any price decline, and that is quite unlike a bubble in behavior. 

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Disclaimer: The prices of precious metals and physical commodities are unpredictable and volatile. There is a substantial degree of a risk of loss in all trading. Past performance is not indicative of future results.