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The Gold Bull Market - 2 Out of 3 Ain't Bad !
The gold bull market, which started from a low of $255 an ounce in 2001, looks as strong as ever after hitting a new high price of over $1,270 an ounce last week. In the initial years, gold's rise had more to do with it being a cheap asset following a 20-year bear market. More lately, its strength reflects deep-seated investor concerns regarding the ongoing monetary instability being created by enormous global trade imbalances, quantitative easing and the intervention by central banks to weaken their own currencies, of which Japan is the most recent example. All these activities have a common theme - they add to the borrowing load of nations and to the supply of money in circulation globally. In contrast, gold mining adds circa 1-2% annually to the existing gold supplies.
Increasing national debt loads is the most significant threat and investors know only too well that central bank money printing is the age old solution to debt constraints. Using the analogy of a company - if you have a choice to invest in either Company A or Company B, and Company B is heading towards bankruptcy then there is no price too high you could pay for Company A relative to Company B in your quest to preserve capital. It is harder to think that way about currencies but it is probably the easiest way to understand this enduring gold bull market. Quite simply, investors fear for the solvency of several countries and know that money printing is the most likely answer. With that threat hanging over the dollar, sterling, yen and the Euro and the Chinese Renminbi shadowing the dollar, gold, as a hard currency that cannot be increased at will, has rightly reclaimed its 2,000 year old position as the currency of choice.
Central banks themselves have also become a source of renewed demand for gold. Traditionally, they hold gold reserves as an asset that can be liquidated at times of distress. But for years central banks the world over were selling their gold reserves, preferring instead to hold mainly US treasuries. It took the global banking crisis and solvency concerns for them to recall the difference between gold and paper money. For the first time in over twenty years, central banks are net buyers of gold.
Nonetheless, an investor should never pay too much attention to the demand / supply argument as a justification for any asset price - and gold is no different. Gold maintains its purchasing power against inflation in the long term and, in that respect, the current gold price is already some 30-40% ahead of the long term inflationary trend. In other words, gold may well already be overvalued against its long term yardstick - inflation, a fact that throws a major spanner in the gold bull market hypothesis.
That said, those who claim that gold is a bubble have a hard time justifying the enclosed chart, which shows what real bubbles in liquid assets are like and how they end. The chart depicts the 12-year gold bull market of 1968 - 1980 and the 12-year technology bull market as represented by the progress of the US Nasdaq Index from 1988 - 2000. Both bull markets experienced near parabolic price rises in their final stages before entering long term bear markets thereafter.
In comparison, this current gold bull market, which started in 2001 (in green on the chart), shows no signs of the irrational exuberance that is normally typified by rampant retail investor demand near the end. By no stretch could we argue that this gold bull market has the characteristics of a bubble.
We are, therefore, confronted with three relevant facts and interpreting them is the hard part. The first fact is that investment demand, driven by the desire to preserve capital, and central bank buying are most likely here to stay - a huge positive on the demand side. The second point is that demand for gold has been steady, quiet and patient, and not irrational. And the third is that relative to reported inflation the gold price could already be overvalued.
But as the song goes two out of three ain't bad ! My own view, for what it is worth, is that you can't price an asset (or currency) when the very solvency of the alternative asset is in doubt and I would stay aboard this gold bull market to see where it goes. But we are in dangerous territory and it would be well to recognise that a strong rise in the gold price from here is more likely to signal the end than any new beginning in this gold bull market.
17th September 2010