Is There a Gold Bubble?

By Daniel Indiviglio

Gold hit yet another record high today, closing at $1,298 per ounce. As the economy continues to look gloomy, central banks print more money, and uncertainty clouds the future, buying gold seems like a pretty good idea. It's also up around 75% over the past three years, which breaks down to about a 25% annual return over that time. Usually, when an asset's price rises like that, it's the sure sign of a bubble. Is that the case with gold?

This question has a lot to do with government policy. If inflation goes crazy, then the gold prices are justified. Inflation has risen by less than 5% over the past three years, which doesn't nearly justify the 75% rise in gold prices. But if you look back further, 30 years, then you find that inflation has risen by 162%, which is actually more than the 107% increase in the price of gold over that period. Money supply has also grown very aggressively over that time period. M2* has increased from $1.56 trillion in August 1980 to $8.66 billion in August 2010. That's a 454% increase.

The question, really, is whether gold should be tracking the dollar and/or money supply at all. At the end of the day it's just a precious metal that's only worth what people are willing to pay for it. And you can be almost guaranteed that eventually some investors will leave gold and move to equities and other investment alternatives when the economy returns to normal. So the decline in demand on the investor side will have to be made up somewhere else to keep the price steady or rising.

So are we in a gold bubble? If investors continue to be wary of currency, inflation picks up, and the desire to hold gold persists indefinitely, then maybe not. But if investors start favoring productive assets again, then the price may fall. It's just really hard to believe that there isn't some irrational exuberance in an asset that's experienced the sort of return gold has over the past few years. 

* M2 is a measure of money supply consisting of currency, traveler's checks, demand deposits, other checkable deposits, retail money market mutual funds, savings, and small time deposits.

This article available online at:

http://www.theatlantic.com/business/archive/2010/09/is-there-a-gold-bubble/63548/