My hesitancy to hop on the gold train is based on the limited use of gold as a productive asset. Unlike other precious metals, gold has little real use in a modern society apart from as jewelry. Since determining the fair value of gold is impossible, it is likely that once the inflow into the market dies down, prices will plunge with little downside support.
It seems to me gold is driven by the "greater fool theory" -- there is always a greater fool who will buy at a higher price. In that sense, gold is a classic asset bubble. However, unlike asset bubbles based on productive assets, there are few so called "reality checks." In equity bubbles, there are valuation ratios that show the absurdity of stock prices. There are economic statistics and inventory figures that will do the same for commodities. Bubbles in these markets are obviously possible, but it is easier to tell when these assets are historically over-valued.
With gold, its not that simple. Gold is generally seen as a protector of value and used to hedge against currency depreciation and inflation. Gold tends to increase after indications of a weakening US economy, lower dollar, and more government spending. However, unlike other assets, gold does not move the same way it did 10 years ago. When earnings come in worse than expected, stocks still drop. The same is not true for gold, which is now driven by an ideology more than anything else.
The price of gold is driven by the pervasiveness of the idea that quantitative easing, low rates, and high government debt will devalue the dollar and incite devastating inflation. This ideology has become a political issue in the US, with conservative commentators on Fox News and the radio using this ideology to attack the Democratic leadership in the White House and Congress. As Michael Smerconish, a right-wing radio host, told Politico recently, "There's a natural synergy between conservative talk radio listeners and gold." The loudest voice on this issue has been Glenn Beck, who uses his radio program and Fox News show to promote this idea. Glenn Beck's show (as well as Bill O'Reilly's) is filled with advertisements for gold, especially after many traditional advertisers have removed their ads due to the controversial nature of the show.
Beck's popularity has surged in the last few months. He said recently: "the three scenarios that we could be facing: recession, depression or collapse." In the case of a total collapse of the economic system, he recommended that his viewers construct "fruit cellars" and rely on what he called "the three G system. It’s God, gold and guns." Beck's program has dominated the competition recently:
During the same period that gold rallied and Beck's popularity surged, confidence in the Fed has markedly decreased. Rasumusen polls show that in July 2009, 26% of Americans were in favor of reappointing Bernanke while 33% wanted a new chairman. In November, only 21% favor reappointment and 41% favor a new chairman. A current poll online on Politico show 56% of respondents think Bernanke should not be reappointed. The ideology that the Fed is secretly destroying America with its easy money policies used to be a fringe movement but has become center stage in the new GOP, mostly due to the strong grassroots support for people like Beck, Palin, and Ron Paul. The strength of this ideology, reflected in the price of gold, is a real issue Democrats will have to address in 2010. With the dollar low and unemployment high, this might become a key issue.
The rising popularity of Beck underscores the rising popularity of the hyperinflation/devalued dollar/buy gold ideology. Interestingly, when Beck's viewership really took off was during September 2009, when gold started its incredible rally past $1,000/oz. for the first time in six months. It has since exceeded $1,200/oz.
I firmly believe gold is in a bubble. For one, it has a great story. SocGen strategist Dylan Grimes recently said in an FT Money Show podcast that China faces the "mother of all asset bubbles" partially because the "story" of China is so pervasive. Everyone knows and understands the idea that China, with more than 1B people, has enormous economic potential, even though in reality China's growth is much more complex than that. The simplicity of this story and ease of buying into it is a strong indicator of a coming bubble in China. The same is true for gold. It is plausible to look at government deficits and monetary policy and conclude gold is a good way to protect oneself against spiraling inflation and a falling dollar.
But like China, the current macroeconomic situation is much more complex than that. I personally doubt we will see much inflation over the next five years. I also believe that Obama will show fiscal restraint in the next few budgets. Though our debt is sure to rise, I think it will stabilize around 40% of GDP--a high number to be sure, but no Armageddon.
To be clear, I think gold holds a legitimate role as an alternative asset class that can be a valuable addition to a portfolio since it is historically uncorrelated with other assets. As Dylan Grimes said in that podcast I referred to earlier, history shows that stuff goes wrong faster than people think. Though I think there are better ways to hedge against currency or inflation risk, I would hold gold to protect against geopolitical threats.
My point in this post is to point out the extent to which the weak dollar/inflation/government spending ideology is driving the value of gold. In doing so, I hope to point out the risks of investing on this basis. Gold does not have a calculable fair value, meaning its price is completely dependent on sentiment which can change much faster than fundamentals. Good news about government debt could completely derail the ideology driving gold. This drop was evident in the most recent, better-than-expected jobs report, after which gold dropped 3%. Gold could go higher than $2,000/oz, but I doubt it. There are strong reasons to believe that once Gold starts to fall, it won't stop till it hits bottom.
