Gold as the “ultimate bubble”

September 30, 2010

Billionaire financier George Soros this month repeated his warning gold is locked in the “ultimate bubble”, and told investors bluntly it was “certainly not safe” in troubled times.

Soros was simply repeating a warning he issued at the World Economic Forum (WEF) back in February. At the time gold was trading at less than $1,150 per ounce. It has since risen to touch $1,300 this week, and is up more than 400 percent from its low of $252 in 1999. There is no end in sight for the bull run. Anyone who shorted gold back in February would be sitting on huge losses.

But while Soros himself warned gold was in a bubble, his hedge fund, Soros Fund Management LLC was one of the biggest gold bulls of the year, doubling its holding of shares in the SPDR Gold Trust at about the same time he was issuing his warning at the WEF in Davos.

Soros is no longer involved in the management of the fund. But the apparent disconnect between the bubble warning and the bullishness of his fund will strike many observers as strange. In reality it illustrates the fascinating investment philosophy of one of the most successful financiers of the last 50 years and is the best way to understand what is really going on in the precious metal market.

REFLEXIVITY AND BUBBLES
Soros outlined his theory of price formation, and how bubbles inflate and collapse, in a brilliant book on “The Alchemy of Finance”, first published in 1987, but updated in 2003. It remains one of the clearest, most incisive explanations of how and why bubbles occur, and shows how profiting from the “madness of crowds” has been pivotal to his success.

In particular, Soros rejected the prevailing idea that “market prices are … passive reflections of the underlying fundamentals”, a dogma he dismissed as market fundamentalism, or that there were stabilizing forces which would automatically drive prices back towards equilibrium.

Instead, Soros propounded a theory of “reflexivity”, in which fundamentals shape perceptions and prices, but prices and perceptions also shape fundamentals. Instead of a one-way, linear relationship in which causality flows from fundamentals to prices and perceptions, Soros developed the theory of a loop in which prices, fundamentals and perceptions all act on one another.

“I contend that financial markets are always wrong in the sense that they operate with a prevailing bias, but that the bias can actually validate itself by influencing not only market prices but also the fundamentals that market prices are supposed to reflect”.

Later he writes more bluntly: “[The efficient market hypothesis and theory of rational expectations] claims that the markets are always right; my proposition is that markets are almost always wrong but often they can validate themselves”.

Beyond a certain point, self-reinforcing feedback loops become unsustainable. But in the meantime positive feedback causes bubbles to inflate further and for longer than anyone could have foreseen at the outset.

“Typically, a self-reinforcing process undergoes orderly corrections in the early stages, and, if it survives them, the bias tends to be reinforced, and is less easily shaken. When the process is advanced, corrections become scarcer and the danger of a climactic reversal greater”.

RUNNING WITH THE HERD
Soros cites numerous examples of self-validating behavior — ranging from the conglomerate boom of the 1960s and real estate investment trusts (REITs) in the 1970s to the technology boom and the rise and spectacular fall of Enron and WorldCom at the end of the 1990s and start of the 2000s. Each was heralded at the time as a “new paradigm”.

But none is more fascinating than his explanation of the dynamics of the REITs bubble in the early 1970s. Because Soros recognized the potential for a bubble early and published a research note advocating investors should get aboard the trend.

In his note he sketched the entire rise and fall of the REITs in the form of a four act play, warning that eventually disappointment would affect valuation and lead to a shakeout, with fewer new entries, more regulation and more moderate growth.

But he observed “The shakeout is a long time away. Before it occurs, mortgage trusts will have grown manifold in size and mortgage trust shares will have shown tremendous gains. It is not a danger that should deter investors at the present time. The only real danger at present is that the self-reinforcing process may not get underway at all”.

In the debate about whether markets are a “weighing machine” for discovering true fundamental value or a “voting machine” which records the popularity of certain theories and the mass of the crowd, Soros came down firmly on the side of the voting machine.

Crucially, the successful speculator responds to bubbles not by shorting them and waiting for stabilizing forces to drive the market quickly back to some fundamental value, but by identifying them early and riding the wave, hoping to get out before the whole edifice finally comes crashing down.

Reading people (other investors, narratives) is as important — if not more important — as understanding the fundamentals of an asset itself. Identifying the next “new new thing” earlier than the rest of the crowd and getting aboard, and then being willing to liquidate before the deluge, is at the heart of the speculator’s success.

GOLD AS ULTIMATE BUBBLE
In this world, gold is the ultimate bubble because apart from the cost of actually digging it out of the ground it has almost no real fundamentals other than price itself. Investors have been buying it precisely because the price has been going up and is expected to carry on rising. Rising prices have created their own demand. It is the ultimately reflexive investment.

Rising gold prices have encouraged investors to add gold to their portfolios and central banks to reverse a long-standing drift towards eliminating the low-yielding asset from their reserves and start adding it instead.
In a thoughtful research note, Deutsche Bank argues that “the gold market is still some way from displaying the characteristics of a bubble” (Commodities Quarterly, Sep 28). But using the Soros idea of a bubble as a process, rather than simply a frothy end-state, gold has already been a bubble for some time as an ever larger group of investors has climbed aboard, propelling prices higher.

In an implicit acknowledgment of the role self-validating forces have played driving gold prices higher, one prominent gold analyst recently pointed out that gold still has the most compelling “narrative” of any investment.

In a research note, Barclays Capital explains “For analysts … gold has traditionally been a tricky one due to its multiple roles as a commodity, currency, inflation hedge and hedge against credit risk and macroeconomic uncertainty. Gold is, in sum, more than a simple commodity, it’s a hedge against fear” (Commodity Daily Briefing, Sep 23). Barclays might have added a hedge against deflation as well, another function cited by Deutsche Bank.

But with so many apparent fundamentals, in some sense it has none at all; gold is the ultimate voting asset, which is valuable precisely because other investors believe it is valuable.

Soros was right to identify it back in February as the ultimate bubble. And his hedge fund was even more right to brush aside fundamental concerns and go long.

23 comments

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Gold is inscrutable, equities are scrutable- – earnings go up, price goes up. Earnings have increased for 9 quarters and are 40% yr over yr.

Posted by letsgetgoing | Report as abusive

Brilliant article.

Posted by yr2009 | Report as abusive

One needs to be careful, however. Isaac Newton, no less, managed to make money out of the South Sea Bubble by exploiting it in almost exactly this way. But after he’d cashed in his shares, their value kept rising for longer than he expected, so he bought some more. Just in time for the crash.

Posted by Ian_Kemmish | Report as abusive

…because he knows the “Golden Rule”: whoever has the Gold, Rules. Thats why he owns so much of it still, despite what he says about it

Posted by Dahc | Report as abusive

Great analysis, John, as usual. I would add that Soros’ theory of reflexivity inadvertently casts crowd sentimentality as a fundamental characteristic. According to his bubble theory, all trends characterized by asset price increases within a given sector are bubbles, with the only variable being time frame. A bubble that inflates and pops within a relatively short time frame represents opportunity for early investors who recognize the emerging trend and pile in, and get out in time due to an accurate assessment of the bubble life time frame.

In this regard, I think Soros’ “ultimate bubble” comment in reference to gold lacks context to convey his intended meaning, which is that gold is a secular bubble within a large time frame, and there its “pop” is a ways out, and, contrary to other asset class bubble, is driven not only by sentiment, but also by the profligate monetary policy of G8 nations for the last 100 years.

James West
MidasLetter.com

Posted by MidasLetter.com | Report as abusive

Gold may be the ultimate bubble, but it is not the ultimate manifestation of reflexivity. There needs to be a feedback process in reflexivity at the fundamental level, not just in the expectation of higher price. In the conglomerate case, a higher stock price could allow the stock to be used as currency to fund acquisitions which were accretive to earnings per share. Soros argues that currency strengthening can lead to a similar process if the country with the appreciating currency takes steps to take advantage of the situation by increasing borrowing.

In the case of gold, a higher gold price may motivate increased purchases by investors, but it’s not clear how the underlying fundamentals of the gold market change with each increase in price. The question is: how do the actual fundamentals of the gold market get better (for increasing prices) because of increasing prices. Notice the self-referential and circular logic. I don’t see that in the gold market.

Posted by jeremycjohnson | Report as abusive

Talking his position as usual like many other top callers in the last 10 years. If there is any serious risk out there or a bubble that would be the opposite and enemy of GOLD THE USD.

Posted by BRION | Report as abusive

An asset cannot simultaneously be an inflation hedge and a deflation hedge. Cash and bonds are deflation hedges. Gold is not.

Posted by hendy | Report as abusive

Its not about bubble it’s about which phase of bubble we are in.. if you see over long term everything is bubble. say in 70s Gold was bubble . If you tighten Monitory policy cash / govt bond also becomes sort of bubble :) so there can be bubble in everything.

I believe this is very early phase of Gold Bubble.

Posted by Amaresh_Gangal | Report as abusive

“Gold is money, and nothing else” – JP Morgan

Also, something that bothers the heck out of me: people calling gold worthless. you know what’s even more worthless? The paper money in your wallet. Adding a zero to a piece of paper makes it 10 times as valuable?!? THAT IS INSANE, and soon the whole world will know how insane that really is. Luckily, we’ll soon wake up and see just how dumb we have been in deciding value.

Until the early 20th century, paper money was just an easy way to break down gold. Written on cash was a note saying “I owe you x amount of gold”

The bank runs in the 1930′s had nothing to do with paper money. People were going to get their GOLD.

Posted by rarn80 | Report as abusive

on my blog I have predicted Dow to gold at atound .25.
(amareshgangal.blogspot.com/p/top-predic tions)

Posted by Amaresh_Gangal | Report as abusive

Gold has surprising drawing power but the interest amazes me.

Consider this. After peaking in 1980, it went into a 20 year slump. It bottomed around $260 in 1999-2000.

Now compare that price action with oil, uranium, copper or many of the other metals. Their percentage price increases met or far exceeded those of gold in a much shorter time, have since corrected, and now are running back up again. The world needs them.

So why all the interest in gold? If we didn’t mine another ounce for the next 20 or 100 years, the world not not be in trouble. Now do the same with oils and metals. Can you spell “disaster.”

Posted by Robebrum | Report as abusive

The term “bubble” conjures up emotional images of something that is likely to pop and dissolve suddenly and rapidly. Soros is implying that the price of Gold is likely to pop and suddenly be priced a lot lower in terms of US dollars. During Q2 2010, the markets accommodated a $2.0 Trillion annualized pace of federal debt growth. In just eight quarters, federal government debt expanded $3.610 trillion, or 54%, to $10.308 trillion. In a short 24 months, federal debt has jumped from 46% to 71% of GDP. With this monetary debasement, the likelihood that Gold will deflate in price is very remote.

Posted by caryc | Report as abusive

Gold has every bodys confidence as valuable commodity without reservation. It is ultimate power for all values behind worthless paper notes and hedge against loss of values of fibnancials. It has therefore massive appeal, as such a big winner.

Posted by merchanthyder | Report as abusive

No one can pretend to understand gold valuation. Stock is tied to earnings, which have increased for 9 quarters, right through the Recession. Global growth is robust . We have reports of same coming in daily. The S&P500 earn half their revenues abroad. This may already be approaching 60%. Domestic indicators grow increasingly favorable. We should start October with a bang in the Market. Hard times are drawing to a close, my homies. Construction and employment have nowhere to go but up.We have answered the big question on everyone’s mind. Would the recovery continue post stimulus. Nota bene, my homies, earnings increased right through the Recession. And global growth is much stronger now than then and our large caps are benefitting more from it. Eg, WMT ‘s Q2 was made by its Mexican and overseas stores. It will dominate in South Africa in 2011. We’re on the comeback trail, my homies. Everything’s coming up roses. Forget gold.

Posted by letsgetgoing | Report as abusive

I get so tired of hearing “gold has no real value”.

Gold is critical in the building of a fissionable nuke.

It keeps the “pit” of plutonium from oxidizing and ensures a successful “blast”.

Posted by Joblo1 | Report as abusive

Great stuff! I think I will get Soros’ book and do some homework.

Posted by Kenmeister | Report as abusive

Why Soros made that comment, he may never explain, and he could easily. His deeds and words clearly don’t match. The thing to learn is that nobody knows for sure anything about markets. If they did, they would own the market soon. However the percentage of their personal wealth that they gamble is more telling than their words.
Better buy gold after the next 12% dip. jmmy owns 10% of his wealth in gold.

Posted by jmmy | Report as abusive

What happens in a massive inflation is the majority of the middle and upper classes are wiped out. The privileged few with foreknowledge will make it through OK, everyone else will lose all their property and face starvation. Given that knowledge, does it seem reasonable to make a few adjustments in the nature of your assets when those assets need never leave your person? We’re not talking about YIELD here, we’re talking about begin able to eat, and being able to keep up your taxes so you retain ownership of the things you’ve already paid for. Talking heads like to claim that it’s unreasonable to take these simple precautions – do you believe them? Have they spoken for your benefit and not for their own?

Posted by nardozi | Report as abusive

jeremycjohnson comments that “..it’s not clear how the underlying fundamentals of the gold market change with each increase in price..”. He is mistaken. For example, I would refer him to a stock that is rocketing on the Mumbai SE: Manappuram Finance. The company operates in the lucrative gold loan market–a very direct link between gold and fundamentals in this emerging market. And other markets? Simply put: any asset price or income stream can be collateralized, securitized, and utlimately monetized (as we found out with devastating consequences in the US housing markets–classic reflexivity at work). As Gordon Gecko said in the 1987 Movie “Wall Street” at some point “the illusion becomes real”. Charles Kindlebger, in his classic book on “Manias..etc”(and other authors)explains clearly how bubbles have real effects through credit markets. The questions for Jeremy then: do gold prices correlate with other assets; and what happens when credit markets are broken? Please share, and we’ll all be rich.

Posted by secularview | Report as abusive

Gold didn’t go up, the dollar just got more worthless. Gold is steadily gaining value because the Fed continues to print and promise by the trillions. Ask yourself, if in 10 years the Fed continues to do what it has for the last 10, would you rather have a pocket full of gold or dollars. Read Alan Greenspan’s essay “Gold and Economic Freedom.”

Posted by joshbot | Report as abusive

Gold is the ultimate bubble, and for all but the final tranche of investors, this is therefore a one-in-a-lifetime opportunity. When the global fiat system collapses, trillions will have nowhere to go but gold – it will become the first “global bubble” in human history (on the basis that fiat currencies as separate bubbles, not one). The result is that the bubble will grow for far longer than most bulls anticipate because there is nowhere else for money to go.

Posted by Sabremesh | Report as abusive

Ok

For all you Gold Bugs out there I have a fill in the blank for you for you.

Buy ___________ now before there is no more left.

The supply of ___________ is always going to be less than the Demand

Is the blank real estate or gold?

http://www.bleifeldcpa.com

Posted by BrianBleifeld | Report as abusive