Why Gold Can Never Be In A Bubble

TREASURY VIEW

In a Harvard Business Review blog titled What’s That You’re Calling a Bubble?, Justin Fox attempts to get to the bottom of what constitutes a bubble. He rejects Nobelist Eugene Fama’s view that bubbles cannot exist because markets are basically rational and at any given moment prices reflect the collective wisdom of the market, reviewing various academic thoughts on the issue to come up with the following:

“Bubbles arise if the price far exceeds the asset’s fundamental value, to the point that no plausible future income scenario can justify the price.”

Many would consider this a reasonable definition and wonder how one could argue gold can never be in a bubble. Well, mainstream financial commentators often attack gold by saying, as wealth manager Barry Ritholtz does in 10 Reasons the Gold Bugs Lost Their Shirts, that it “has no fundamentals. What is traditionally called fundamental analysis involves determining a company’s cash flow, revenue and earnings. Commodities have none of these things.”

Now if gold doesn’t have a fundamental value, then its price doesn’t have anything to exceed. Hence it can never be in a bubble.

OK, that is a somewhat flippant argument. So consider that both quotes from Fox and Ritholtz refer to “income” or “cash flow” from an asset. Gold is often derided as having no income, from which it follows you can’t establish its fundamentals.

However, gold does earn an income – via the gold leasing market. While this market is only accessible by those who hold gold in the thousands of ounces, individuals can also earn an income on gold by futures basis trades (see here for an explanation) or selling options against their gold.

In this respect gold is similar to a government bond, which doesn’t have “revenue and earnings” either, but it doesn’t stop people from considering it a valid asset class to include in their portfolios. Interest rates are not considered something to which fundamental analysis is applied, they are the fundamental risk-free rate against which assets are valued.

In the case of gold, I would argue along the same lines, in that many investors look at gold as the risk-free bond-like assets against which they value other assets. On that basis, you cannot have a bubble in your unit of measure.

The above statement is probably not seen as very practical to those not using gold as a unit of measure. In that case, consider Eugene Fama’s argument that

“During the dot-com era … the high prices of startups like Amazon.com and Pets.com could be justified as rational gambles in the face of great uncertainty. It wasn’t crazy to think that a couple of these companies might end up as big and as profitable as Microsoft, and since it was hard to tell which ones it would be, high prices across the board made some sense.”

Ultimately, gold is just a “rational gamble in the face of great uncertainty” about whether a country (or the world) can get itself out of its financial mess without unintended inflation or some other economic blow up.

To argue that gold is in a bubble is therefore to just argue that people are paying too much for this gamble, for the insurance against uncertainty as they see it. That, as Fox says, “is a judgment call”, and who can claim they know their judgment is right and another’s is not?