Gold is useless
This week GLD, a gold ETF, surpassed SPY, an ETF tracking the S&P 500, to become the largest Exchange Traded Fund. Gold prices also set a new all-time high. This should ring the bubble klaxon!
Gold is a useless asset. It does not produce earnings, it does not pay dividends or interest, and it has few industrial uses. The only thing it does well is look pretty.
So why is everybody buying it instead of stocks, bonds, rental properties, or anything else that does produce an income stream? There are two possible answers: Gold is undervalued even at its current price. Or herding behavior causes people to buy into a bubble.
The gold price has increased from $255 in August 1999 to well over $1800 today without serious dips or pullbacks. It is easy to see why this attracts investors, especially when compared to the turbulence in the stock market over the same period of time. It is also easy to see why people might expect that gold will continue to rise after watching it gain consistently for well over a decade.
What goes up must come downHowever, history shows that asset prices cannot continue to go up indefinitely. There are always pull backs, crashes, and bear markets. The last time this happened to gold is a distant memory, but we all remember recent examples such as the tech stocks in the '90s and home prices in the '00s.
So is gold like the tech stocks or residential housing?
As is often the case in finance, it depends on how you look at it. We recently posted about the how much S&P 500 earnings an ounce of gold can buy. By that measure gold is vastly overvalued compared to stocks.
However, there are other ways to put the price of gold in relation to the rest of the economy.
The chart above provides a few examples. We plotted the ratio of the gold price to the value of the S&P 500, to the GDP, to an index tracing industrial metals (i.e. those that are useful rather than just pretty), and to the median family income.
No matter how you look at it, gold was more overvalued in the lat '70s and early '80s. That was a time of double digit inflation and several recessions, which increased the appeal of gold. However, once the crisis was over gold fell steadily for about 20 years.
For the last decade, gold has been climbing again. In none of the categories has it surpassed its relative valuation peak from 1980, but we are getting close compared to the median family income and the price of industrial metals.
So Bubble, or no Bubble?So what does all of this tell us? Well, we have the usual mess of contradictory economic data.The size of the gold ETF screams bubble because it indicates that everybody and their dog have bet all on gold. The relationship between the price of gold and S&P 500 earnings also screams bubble. The gold price relative to industrial metals and personal incomes shouts bubble, but compared to the GDP or the S&P 500 index value it only a murmurs the question: "Bubble?"
Over long time periods, gold has been a terribly investment while stock, bonds, and income-generating real estate have produced good returns. This is likely to be the case going forward as well.Even if gold doesn't unambiguously qualify as a bubble, it is likely that price drops will be drastic when investors shift back into more sustainable investments. The sheer size of the gold ETF virtually guarantees that sellers will not be able to find buyers at current prices. Buyers will appear once gold has become cheap, but all of our ratios indicate that this would require a substantial price drop.
It is always easier to identify assets that are bubbling than to predict when the bubble will pop. Gold has much more downside than upside at this point, but this has been true for years without slowing price gains. Home prices and tech stocks also suggest that bubbles can exist for years even after objective measures (e.g. P/E ratios or rent to buy ratios) show that markets are out of equilibrium.
It is anybody's guess when gold will correct, but it is very likely that it will be ugly when it does.