So farewell then…

 Recall what the agenda of this blog was: to critically analyze the theory of bubbles, and whether there might be one present in the gold market – as claimed by the experts in the video.  A blog cannot hope to cover all of the nuances and different theories of bubbles, and so the studious reader will have noted that the theory I have used comes from the realm of behavioural finance: specifically the work of Robert Shiller (for it is he).  Other theories of bubbles are surely of merit, but the work of Shiller is intuitively appealing (for a sociologist, at least).  Indeed, this blog has only scratched the surface of Shiller's work; the aim has been to have a few key premises and then scrutinize them in detail.

For it is he... (photograph permitted under the Creative
Commons Attribution Share - Alike 3.0 Unreported License)

So, as Lloyd Grossman would say, “let’s look at the evidence”.  Two things are needed to trigger a bubble (remember, there are no doubt more conditions, but for brevity we are concerned with just two key events): an exogenous environmental shock, and a positive feedback loop.  Are these factors present in gold?  It has been suggested that in the recent economic downturn, the price of gold as been justified due to its “safe haven status”.   However, the “current economic crisis”  initiated in 2007/8, yet gold had been on the rise since the year 2000.  If there was an exogenous shock present, it cannot have been the “safe haven” hypothesis.

There has been the potential for a positive feedback loop to form: investors need not invest in the physical gold, or its futures contracts.  Instead, SPDR and ETC funds allow greater access to gold, and investors are flocking to these new opportunities.  Once again, there is temporal discontinuity here: the first gold ETC was started in Australia in 2003.  The start of the rapid rise in gold occurred three years before this.

Based on this evidence, it seems difficult to conclude that a bubble has been brewing in gold as an asset class.  Granted, the “safe haven status” might have contributed to the increase in gold prices, and the formation of ETC’s might aid a positive feedback loop, but these factors are triggered after gold experiences a rapid increase: they did not initiate the price move.

Looking at inflation adjusted gold prices, the price of gold was higher in 1978 than it was in 2011.  In terms of a 30 year investment, gold hasn’t been that attractive.  Gold has been rising (admittedly, rapidly) since the year 2000; but this increase might have been predicated upon gold being at its lowest price for 20 years.  Billionaire commodities hedge fund manger Jim Rogers (2005) observes that increases in prices from their historic lows is not the sign of a bubble, rather it is the market realizing an opportunity to invest in an asset that has been undervalued for some time.  In Rogers’ opinion, this is the definition of a so called “bull run”, not a bubble.

So were the “experts” in the video correct in their appraisal of the gold market?  Or were they simply foolish?  Well, stay hungry, and decide that one for yourselves.  When listening to their rationales, just remember the saying “free advice is worth exactly what you pay for it” (and remember that applies to this blog as well!).

Blogging off.

A picture tells a thousand words

The past few posts have been building up to this moment: where I can reveal the fruits of my labour - my very own gold price charts!  There are two on show, so let’s deal with the first one.  This shows the price of gold on an annual basis from 1978 - 2011 (found here). 

Figure 1:  Average annual price of Gold (USD/troy oz.), 1978-2011

There is a definite upwards trend from around the year 2000 and a price just above $200/troy ounce, to 2011 and a price just shy of $1600/troy ounce.  In the space of a little over a decade, there as been a near eightfold increase in the value of gold.  This certainly has the hallmarks of being a positive feedback loop.  However, note that these prices are not including inflation adjustment: $100 in the 1970’s is worth considerably more in 2011.  What effect will inflation adjusted prices have to the overall trend?  Annoyingly, I only recently came across this site that will carry out the inflation adjustment for you (quite a bit quicker than having to do it in excel like I did!)  Take a look at what happens when I adjust these annual prices for inflation (the red line) and transpose it onto the original chart (blue line).  

Figure 2:  Average annual price of Gold (USD/troy oz.), inflation adjusted and nominal , 1978-2011

We see that gold reaches a peak of over $1600/troy ounce in 1980, only for it to decrease over the next two decades.  By year 2000, the price of gold is at its lowest level in two decades, and sees a near four – fold increase in value over the next decade.  Note however, that the 2011 peak price is actually lower than that of the peak in 1980.  So, in inflation adjusted terms, if you had bought gold in 1980, it would actually have decreased slightly in value by 2011 – not a great 30 year return on your investment!  There’s an extremely important lesson to be learnt from the second chart: don't be fooled by the money illusion, and always think of inflation!!!  By not having inflation adjusted prices, it might seem as if gold is reaching a 30 year high.  But when we adjust for inflation, we can see that the price of gold has not even reached its previous high – set over 30 years ago.

Mull over these charts, as next post we’ll pull together the theory mentioned in the previous posts, and see if we can apply the “bubble” label to gold.

These go to eleven...

What does a quote from the excellent This is Spinal Tap have to do with bubbles?  In the film, Nigel gives Marty a lesson on amplifiers: that’s what this post is all about.  What if an amplification process leads to asset prices rising rapidly?  Sticking to the musical theme, Shiller (2000) describes this as a “positive feedback loop”. 

These don't go to 11. (photograph permitted under the Creative Commons
Attribution Share - Alike 3.0 Unreported License)

Let’s break this down into an abstract representation.  Suppose person A buys x at a price of 10.  This then increases in value to 11 (these go to eleven…).  Person B sees this (maybe person A has been boasting about how much money they have made), and buys x at 11.  Then x increases to 13.  Seeing this, person C buys x at 13; x increases to 16.  During each stage, people are drawn into buying the asset as the price increases from its previous level.  This in turn leads to further increases in the price of x.

Mackay (1841) notes how this manifests itself in real life.  As people start to make money, confidence in the asset grows, leading more people to invest and make money.  In turn, confidence in the asset increases still further.  Increasing levels of confidence in an asset – based on the past increases in price - lead to these increased price of the asset in question.  Galbraith (1954) noted how this confidence multiplier was present in the Florida real estate bubble of the early twentieth century.  Liebenstein (1950) used the “bandwagon effect” to describe similar activity. 

Initial price increases in gold can lead to increased confidence in the value of the asset, in turn leading to an increased price of the asset, and so on.  A positive feedback loop is born, and the price of gold increases to dizzier new heights.  Has this been happening?  The next post will look at this in more detail (and I have a few of my own home made charts to show off!).

It's the environment, stupid.

Jack Nicholson’s character in The Departed has a brilliant (albeit flawed) quote: “I don't want to be a product of my environment. I want my environment to be a product of me”.  The environment (as in the state of affairs of the world -not in a Greenpeace sense) is a critical component in understanding asset price bubbles: a shock to the environment might have a repercussion in the markets.  Let’s get a bit more technical and call this environmental shock “exogenous”.

An exogenous shock might be something like an epidemic sweeping through society; the bubonic plague appears to have been an important factor that contributed to the tulip mania in the Netherlands (Garber, 2000).  The exogenous shock of technological innovation – whether in the form of railways (Campbell and Turner, 2012) or the advent of the world wide web (Shiller, 2000) - has been identified as a critical factor in stock market bubbles of certain industries over the centuries.

Not this environment! (photograph permitted under the Creative
Commons Attribution Share - Alike 3.0 Unreported License)

What’s been happening in the world of gold then?  Take two rather basic but fundamental assumptions. First, recall that there is only a finite amount of gold on the planet, and this has to be mined.  We therefore have limited supply of this asset – Forbes notes the amount of gold could be filled into a couple of Olympic sized swimming pools (yes, that's right - just a couple of swimming pools!).  Gold is therefore seen as a nice hedge against inflation, given its supply is fixed (Ghosh, Levin, MacMilan, and Wright, 2004). 

Second, Gold has had the moniker of being a “safe haven” for when times are stormy in the global economy (Rogers, 2005, for example).  People flock to gold as a shelter from market turmoil or downturns.  Given today’s Eurozone GDP figures, it looks pretty bleak out in the real world.  Linked with these two points, in an attempt to trade their way out of recession, many countries appear to be embarking on a currency war to devalue their currency to aid the increase of exports (Stephanie Flanders from the BBC has a good introduction to this).

Might the fact that there is only a finite amount of gold, and the persistent global economic downturn be the requisite environmental exogenous shock that indicates a bubble is present in gold?  Hold that thought, as the next post considers what mechanism might translate this environmental exogenous shock into price movements of an asset.

Stay hungry, not foolish.

As Steve Jobs once recalled to Stanford’s graduating class, “stay hungry, stay foolish”.   Well, ever listened to the so - called “experts” in the world of finance being interviewed and thought “what a fool”?  No?  Maybe it’s just me then.  Maybe being foolish in this sense isn’t so good.  Perhaps we should let these people stay foolish, and for us to stay hungry.  Hungry for understanding: analyzing a problem and deriving some sort of conclusion.

Thanks to the popularization of the term “bubble”, these ever so clever “experts” are using this phrase left, right, and centre (and maybe up and down too).  But what does a bubble mean?  What’s the difference between a “bubble” and a “bull run”?  Or is there one?  This blog sets out to try and set the record straight, by taking time to stop and think (not very popular nowadays!) what the term “bubble” actually means.  Then it will look at the price of gold and try to assess whether the term “bubble” can be accurately applied to its price movements.

And just to keep the juices flowing, this is an interview with the "experts" in 2010 discussing a possible gold bubble (I’ve slummed it by watching CNBC, I know).  Note how the word “bubble” rolls so easily off the presenter’s tongue…   Who  is right?  By the end of this blog we’ll come back to these assessments and see if they really are foolish!