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Debunking the Gold Bubble Myth - Eric Sprott

March 14, 2011 | About:

Gold’s continuous ten-year rise hasn’t sheltered it from controversy. Despite producing consistent returns in virtually all currencies year after year, some market pundits still question its validity as an asset class. It’s true that gold doesn’t pay any interest, and it’s also true that much of the gold produced throughout history still exists in some form today. But these characteristics shouldn’t inhibit it from performing as a monetary asset. Cash, after all, doesn’t pay real interest either, and there is more fiat money in existence today than ever before. So why does gold still receive such harsh criticism?

We believe much of it stems from a widely held misconception that gold is forming a financial bubble. It’s a fairly straightforward view – that gold buyers are merely foolhardy speculators buying on a whim with no rationale other than to sell to the ‘greater fool’ at higher prices in the future. It’s a view that assumes that gold has no intrinsic value and is simply a speculative asset that has captured investors’ imaginations.

We don’t take these views on gold lightly. We’ve seen bubbles before and fully know how they end. We have no interest whatsoever in participating in some sort of speculative frenzy – that’s a recipe for disaster in the investment business. Thankfully, however, our gold investments present no such risk. As our analysis has revealed, gold is actually a surprisingly under-owned asset class – and one that has generated far more attention in the media than it probably deserves. While its exemplary performance since 2000 is certainly worthy of discussion, gold simply hasn’t commanded enough investment to warrant the bubble fears it seems to have aroused among market pundits and business commentators. The truth about gold is that most people simply don’t own it…yet.

To be clear, a speculative bubble forms when prices for an asset class rise above a level justified by its fundamentals. For this to happen, increasing amounts of capital must flow into the asset class, bidding it up to irrational levels. Gold may be trading at all-time nominal highs, but a look at investment flows proves that it isn’t anywhere close to being overbought.

In their Gold Yearbook 2010, CPM Group noted that in 1968, gold held by individuals for investment purposes represented approximately 5% of global financial assets. By 1980 that amount had fallen to roughly 3%. By 1990 it had dropped significantly to 0.6%, and by the year 2000 represented a mere 0.2% of global assets. By the end of 2009, nine years into the gold bull market that began in 2000, they estimate that gold had increased to represent a mere 0.6% of global financial assets – hardly much of an increase. Gold ownership didn’t change much last year either, as we estimate that this percentage increased to 0.7% of global financial assets in 2010.1 So despite gold reaching record nominal highs, the world holds about the same portion of its wealth in gold as it did over two decades ago. While this probably says more about the proliferation of financial assets over the past decade than it does about gold investment, it is surprising to note how trivial gold ownership is when compared to the size of global financial assets.

The increase in gold ownership from 0.2% in 2000 to 0.7% in 2010 is also misleading. If you consider the approximate $227 billion that was invested in gold bullion in 2000, that level of investment would have grown to $1.18 trillion, or 0.6% of financial assets, by the end of 2010 - based purely on gold appreciation alone.2 In other words, the actual amount of new investment into gold since 2000 represents only 0.1% of current global financial assets, or about $250 billion. Although this number may seem large, consider that roughly $98 trillion of new capital flowed into global financial assets over the same period, so gold’s approximate 0.3% share of global investment flows is essentially trivial.3

The 0.7% ownership data point also has interesting implications for global gold ownership going forward. Consider that to return to a meaningful level of gold investment, say to the 5% level of 1968, it would require over $9 trillion of gold investment today, or about 6.5 billion ounces of gold at the current gold price. This would represent well over 1.3 times the amount of gold ever produced throughout history and four times the amount of known gold reserves.4,5 So not only is the public relatively underinvested in gold, but at current prices it isn’t even possible to increase our gold holdings back to a meaningful level.

Gold’s apparent underinvestment also applies to gold equity financings since 2000. According to our sources, gold companies raised approximately $78 billion of equity capital in new financings over the past 11 years.6 To put this amount in perspective, this is equivalent to the total amount of equity raised by technology companies in the first three months of 2000.7

To further illustrate the lack of activity in the gold equity capital markets, we compare last year’s gold company financings with the technology company financings in the year 2000 (Chart 1). Once again, looking at the relative amount of capital market activity in the gold equity markets, we find no indication of a bubble whatsoever.

Furthermore, we compiled information on mutual fund flows to get a sense for the average retail investor’s appetite for gold equity investments (Chart 2). We found very familiar results in this area as well: compared to the $2.5 trillion dollars that was invested in US mutual funds since 2000, precious metal equity funds have seen a mere $12 billion in inflows. If there is a bubble in gold investments, the average retail investor hasn’t participated in it.

To truly gauge the level of exuberance (or lack thereof) in today’s gold market, it’s beneficial to review equity valuations, since they provide an excellent lens into investor sentiment for an asset class. Certainly if a bubble was forming in gold, it would likely rear its head in the stock market, where speculative manias have been fleecing ‘greater fools’ for centuries. The best gold index to review for valuation is the Amex Gold Bugs Index (HUI), which has returned a stunning 674% since 2000. It is certainly an index that could be mistaken for a bubble based on its incredible performance… until one considers its relative valuation. In Chart 3 we present a time series chart comparing the price-to-EBITDA of the HUI vs. that of the Nasdaq Composite since 1998. Price-to-EBITDA is a valuation metric that compares a company’s stock price to its profits before accounting for taxes, interest payments, and non-cash charges like depreciation and amortization. It is similar to the ubiquitous price-to-earnings (P/E) multiple but allows for a comparison across periods where net earnings are negative and P/E ratio’s incalculable.

Looking at the price-to-EBITDA multiple for the HUI Index we see absolutely no evidence of a frothy market for gold stocks. At the current level of 13 times EBITDA, the HUI is actually trading below its 15-year average of 14 times. Moreover, valuations for gold stocks are currently one-third of the levels reached by the Nasdaq in late 1999. There simply isn’t any evidence of excessive valuations in gold stocks, which is most certainly where we would expect the excesses to be most apparent.

Based on our findings, this notion of a gold bubble is patently false. The current investment interest in gold relative to other financial assets remains surprisingly low - about where it was two decades ago. Moreover, the modest valuations of gold equities highlight the absence of unbridled investor enthusiasm for gold investments. The fact is, despite all this talk about the gold bubble, the capital flows into gold vis-à-vis other financial assets have simply not been large enough to indicate any speculative mania. Investors can rest assured that they are not participating in any speculative bubble by owning gold. They are merely protecting their wealth.

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Bertens - 6 years ago    Report SPAM
excellent article by one of the best investors around. Somehow part of the value investing crowd just follows Buffet without thinking for themselves. The very best like Einhorn know the function of gold as money. As long as real interest rates stay negative gold will rise.
LwC - 6 years ago    Report SPAM
Sprott writes:

"We believe much of it stems from a widely held misconception that gold is forming a financial bubble. It’s a fairly straightforward view – that gold buyers are merely foolhardy speculators buying on a whim with no rationale other than to sell to the ‘greater fool’ at higher prices in the future. It’s a view that assumes that gold has no intrinsic value and is simply a speculative asset that has captured investors’ imaginations."

It appears to me that after making that statement, he goes on to argue that the reason he thinks that gold is not forming a "financial bubble" is that it is an under owned "asset class", and that more and more investors speculators will buy gold because… well, just because. IMO he contradicts his own argument, and is in fact stating that one should invest in gold today because others will pay more for it in the future. In fact, while asserting that it's a misconception that gold has no intrinsic value he does not even try to show how one might calculate gold's intrinsic value or what he thinks the intrinsic value of gold might be.

CanadianValue posted a similar screed by Sprott a month or two ago, and Batbeer2 pointed out in a reply that in his/her opinion gold is just another form of fiat money. No one challenged that assumption by showing that gold has an readily discernible intrinsic value against which an investor can measure the market price. I can't see that the current infatuation with gold is anything other than a momentum play in the price action of gold. Certainly one can make profits in a momentum play, as long as he's out when the momentum stops, or goes into reverse. That is what has happened in the past, and we have seen similar arguments in the past for why one must buy gold. Is this time different?

As for arguments that the gold trade has attracted investment greats like Einhorn and Paulson so it must be right, well I haven't followed them into other well publicized trades in the past because I don't believe that I can invest like them. AFAIK we don't know the details of their gold trades and hedges, and IMO it is foolish to buy gold just because of those well publicized trades.

If any reader is willing to show how to discern the intrinsic value of gold, I for one would be happy to see it.

FWIW the following excerpts are from an article by Alexander Green at Investment U:

"Don’t Be Blinded by the Gold Light

Gold badly underperformed inflation – not to mention stocks, bonds, real estate and burying your money in a hole – for 20 years after 1980. Why is it suddenly destined to catch up now?

Or look at it another way: On August 25, 1999, gold traded at $252.55 an ounce. Adjusting for inflation, gold should be trading at $339.65 an ounce today.

Granted, my starting point is the 30-year-low. But then, a calculation based on the 1980 high is just as arbitrary.

It’s understandable that gold spiked during the 2007-2009 financial crisis. Gold is an excellent barometer of investor anxiety. But that crisis is over. The recession – defined as two straight quarters of negative GDP growth – ended in June 2009. And inflation is running at just 1.2%."


"But if you’re counting on gold to dash higher, note that the last time investors bought into a gold mania it took more than 25 years for them to break even – not counting inflation."


(thanks to Jacob Wolinsky of ValueWalk.com for that link)

I don't know if the price of gold will go higher, significantly higher, lower, or stay about the same. But that may be the point. If an investor can't estimate the intrinsic value of gold, how does one know if gold is currently priced low, high, or about right? Under that assumption IMO what's left is just a play on the price action of gold.

Rgosalia - 6 years ago    Report SPAM
James Grant, the author of the famous publication Grant's Interest Rate Observer, commented in his Dec 2010 letter the following on gold:

"Concerning gold, is it just us or does the yellow metal look more and more like Angelina Jolie? The higher it goes, the more bewitching it becomes. This publication retains its hopes for the gold bull market, but it does not forget that the operative word is "hopes." You can't value a non-earning asset, even though you can pretend to. Our own contribution to the meager literature of gold valuation takes the form of fraction: 1/n where "n" is the world's confidence in paper currencies and the mandarins who manipulate them. Regrettably, "n" is unknown; the formula is therefore nebulous."

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