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The Bubble in Gold Still Lies Ahead

There are many reasons why sensible columnists prefer to steer clear of writing about gold. One is that you get the weirdest responses. Twenty years ago they would arrive in funny shaped envelopes, often in green ink, often from individuals with extraordinarily peculiar views about the world. These days the risk is that anything you say will be instantly picked up, recycled and commented on in a thousand online blogs. Not all of that community, shall we say, are interested in constructive dialogue. Gold retains its capacity to excite the most extreme polarised views.

A second reason for thinking better of writing about gold is what one might call the Warren Buffett problem. When asked for his views about gold, he typically replies with the same answer, along the lines that gold has never been a good store of value and is unlikely ever to interest him as a home for his money. Gold, he says, ” gets dug out of the ground in Africa or some place. Then we melt it down, dig another hole, transport it halfway round the world, then bury it again and pay people to stand around guarding it”. It has, he argues, “no utility”. There will always be other things that he would rather own.

Although doing back-flips when circumstances change is one of Buffett’s greatest strengths, he appears to have been true to his word in never having made a significant investment in gold or gold shares. In the late 1990s, he did briefly place a large bet on the price of silver, based on a personal analysis of the supply and demand equation for the metal which turned out to be quite flawed. He has been known also to recycle Mark Twain’s famous description of a gold mine as a “hole in the ground with a liar at the top”.

If the world’s greatest investor doesn’t think gold deserves consideration, has he got a point? A serious criticism of gold is that it may not in the strictest sense be an investment, in the Ben Graham sense of generating returns that can be analysed and valued. It can be lent out, for sure, albeit for meagre returns, but that has to be set against storage and insurance costs. While physical supply and demand clearly play a part in determining the price of gold, its performance is increasingly influenced by fluctuations in demand from investors (which a Grahamite purist might label as speculative interest).

The arrival of liquid, freely tradeable exchange traded funds in precious metals, some but not all of which are backed by physical collateral, is further encouraging this trend. With the sharp run up in the dollar price of gold this year, coupled with a notable recovery in equity markets, new gold funds are emerging by the week. John Paulson, the hedge fund manager who did so well out of the credit crunch, is the latest to launch a gold fund. Such high profile launches can only heighten interest in gold and more highly geared gold shares, and might in normal times be seen as early evidence that gold is entering a speculative bubble and must therefore be heading for a nasty fall.

However these are far from normal times. While the seeds of a future bubble in gold are being sown, and the gold price will remain volatile, if only to relieve momentum-chasers of some of their money, on most measures we are a long way away from any kind of climax. Despite growing media attention, gold remains surprisingly underowned by private investors. More people talk about it than actually own it in volume. Every trend-following speculator who is buying gold today for bandwagon reasons is, I suspect, comfortably matched by seasoned wealthy and professional investors accumulating gold for traditional defensive reasons, not to mention central banks desperate to reduce their dollar dependency.

Whether or not you care to define it as an investment, gold offers protection against the devaluation of the dollar and the eventual re-emergence of inflation that Buffett himself has identified as the inevitable consequences of the financial crisis and governments’ response to it. While he may be right that buying the Burlington Northern railroad is a better way to profit from eventual recovery in the global economy, the rest of us mere mortals will not be easily convinced to dump our gold and other commodities for some while yet.

Putting your head above the parapet and admitting to owning the barbarous relic and inviting all the unwanted attention that comes with such a public confession of unorthodoxy is one of the costs of ownership. The point about gold is not to own it for some ineffable or intrinsic reason, as gold bugs do, but because today’s unprecedented economic conditions make it a sound and defensible two way bet on the future. If gold’s time is ever going to come, we are living through just such a time now. The real gold bubble still lies ahead.

Written by Jonathan Davis

November 22, 2009 at 10:35 PM

Posted in FT Columns, Gold