Gold: A Boombustology Perspective
by Vikram Mansharamani, PhD
As gold has been one of the most volatile assets in the past several weeks, with some analysts arguing for a $10,000/ounce fair value, many in the media and investment communities have asked me if gold is a bubble. To answer this very difficult question, I have chosen to apply the five-lens framework from my book Boombustology to gold today.
Let’s begin with my first lens, micro-economics. Most mainstream economic theories utilize a supply and demand driven price determination model that generally results in prices tending towards equilibrium. I say “tending” because most serious scholars admit that behavioral and informational issues can distort the price at any one point in time, but there exists an overarching philosophical belief that such distortions are rapidly ironed out. Markets are, according to this view, efficient. Higher prices dampen demand, and lower prices dis-incentivize supply.
Let us suppose for a minute, however, that higher prices increase demand. Such a dynamic might arise for many reasons, but one eloquent explanation for such an outcome in asset markets is the Theory of Reflexivity, as proposed by George Soros. Although the theory has many subtleties beyond the simplified “self-fulfilling” logic that many ascribe to it, the underlying implication of this perspective is that prices can and do tend away from equilibrium. In this case, boom and bust dynamics appear highly likely.
Turning to gold, it appears higher prices are indeed generating more demand. Might his indicate that a reflexive dynamic is underway? Are prices tending towards or away from an equilibrium level? Evidence from the Gold ETF (GLD) indicates that higher prices have correlated with higher demand for gold. The chart below shows the number of shares outstanding (i.e. a reasonable proxy for “demand”) and the price per share of GLD. The fact that these two metrics correlate indicates that both price and demand are aligning, a classic sign of bubbly conditions. Lens 1: check.
FIGURE: Gold ETF price per share vs. Gold ETF shares outstanding
My second lens is macroeconomics, with special attention to credit. In Chapter 11 of my book, I state that financial innovation that embeds or enables leverage can often provide fuel to a bubble. Indeed, rapidly rising leverage of any sort (direct or indirect) is cause for concern.
Consider the above-mentioned GLD, the gold ETF that enables individuals to purchase Gold directly in a brokerage account. Unfortunately, however, because I do not have access to aggregated brokerage account information, it’s hard to determine if GLD has been purchased on margin or financed with equity. Combine this with the double, triple and other leveraged ETFs that promise multiples of daily price moves. For good measure, add on a bit of small margin, high effective-leverage futures…and what you get is evidence of a credit fueled asset price dynamic. Consider the fact that I can today (as an individual) buy 100 ounces of gold exposure (>$150,000 at the time of this writing) through futures market by putting down less than $10,000. This enables me to have more than 15x financial leverage! Clearly, embedded and indirect leverage are clearly supporting the gold market. Lens 2: check.
Overconfidence and new era thinking are the hallmarks of my third lens, psychology. Whenever individuals develop a devout belief that “its different this time,” buyers beware. It is rarely different and asset prices generally go up and down and in this regard, gold prices too go both up and down.
So, is there a belief that gold is a “store of value” like no other? Absolutely. Is it deemed a commodity that is different than others? Perhaps it is considered protection against inflation…but others insist it is the only thing to own when facing deflation. The reality is that gold is a risk-asset like any other. Its price rises and falls. In fact, the fall is generally more frequent followed by an occasional but spectacular rise. For a concise analysis of historical gold price dynamics, read Ken Fisher’s Debunkery Bunk 35: “With Gold You’re Golden” which ends with an eloquent recommendation: “Feel free to buy gold – for earrings, necklaces, and electrical wires. But for your portfolio, gold has less luster unless you’re a super-duper timer.” Lens 3: Check.
The fourth lens of my bubble-spotting framework is politics. I tend to focus on government intervention and the distortions such actions have on market prices. This a complicated topic when it comes to gold, and one I will revisit after addressing my fifth lens.
An application of epidemic thinking to the study of financial bubbles has proven very useful in gauging the relative maturity of manias. Let us analogize an investment hysteria to a fever or flu spreading through a population. To an epidemiologist, the variables of concern include the infection rate, the removal rate, and perhaps most importantly, the percentage of the population not (yet) affected. The population of “yet to be infected” participants can be thought of as fuel that is available to keep the fire burning. Once we run out of fuel, the party’s over. Prices will fall. The investing implications of this logic can be illustrated with a simple piece of advice: Don’t buy whatever your taxicab driver is talking about. It’s too late. Widespread amateur investor participation is tell-tale sign that a bubble is in its last innings.
One way to gauge amateur participation in a financial bubble is observe media targeting everyday audiences. In this regard, gold is very concerning. While walking through the streets of NYC one recent afternoon, I saw no fewer than 14 signs offering to buy my gold, 18 signs indicated there was a willingness to sell me gold…and if I veered several blocks in the wrong direction, I’m sure there are eager individuals that would simply take my gold. Other confirmatory indicators include TV commercials, billboards, dinner party conversations, and the fact that everyone under the sun now has an opinion about gold. Gold is, in many ways, the ultimate greater fool asset. To make money investing in gold, you need someone with a belief more money is to be made to take it off your hands. Lens 5: Check.
Before concluding that gold is bubble (which I tend to believe is more likely than not), let’s revisit lens #4. While I generally do not subscribe to the many conspiracy theories arguing that governments are manipulating gold markets, the primary linkage with politics over long periods of time has been through the currency. Thus, we can ask if today’s policies are affecting currencies in a way that might be affecting gold. Given that gold is effectively an “anti-asset,” by which I mean it is the flip-side of fiat currencies, we need to evaluate what is happening in the market for fiat currencies…and in this regard, the upside pressure on gold remains. In many senses, I am therefore agreeing with Jim Grant’s point that gold’s price is an inverse indicator of investor confidence in central banks. Lens 4: half-check.
Thus, given that four and a half of my five indicators are flashing “bubble,” it is my view that gold is very bubbly. But as many bubble-watchers know all too well, the final innings of a bubble can be extremely profitable. Combine this potentially lucrative opportunity with a bit of career risk (from not-participating) and you get a very volatile situation. The gold game is not in the first innings, and in fact may be well beyond the seventh-inning stretch. When one considers the fat that gold does not generate any cash flow, costs money to protect, and is generally not consumed (i.e. 99%+ of the gold taken out of the ground in the history of the world is still around today), one must use extreme caution when dabbling in this market today.
Miss the last gains, but avoid potentially devastating losses? Or capture potentially very dramatic gains rapidly, with a known and elevated risk of big losses? Given investors are all prone to making errors, it may be more prudent at this juncture to make the error of omission (miss gains, avoid losses) than to make the error of commission (ride gains, capture losses).
Vikram Mansharamani, a Lecturer at Yale University, is the author of Boombustology: Spotting Financial Bubble Before They Burst, published by John Wiley & Sons. The book presents a multi-disciplinary method for identifying unsustainable booms in financial markets.