Gold is a bubble - resist its charms

gold_risk_2.ju.top.jpg By Janice Revell, contributing writer


(MONEY Magazine) -- Can you tell when a boom has turned into a bubble? One clue: When pop culture starts paying attention. The housing bubble, for example, brought both the TV show Flip This House and a rival on another network, Flip That House.

So if you own a lot of gold, you might regard a recent episode of Saturday Night Live as your first warning. In the opening skit, Bill Hader as China's President Hu Jintao declares that Glenn Beck was right and that "my government should have bought gold. Unfortunately, all our assets were tied up in U.S. Treasury bills."

Back in the real world, gold is trading at about $1,400 an ounce, up from less than $500 five years ago. That's a 23% annualized return, far outstripping the gains on stocks (1.1%) or bonds (6.1%). Fear is driving a lot of the rise.

Investors have always turned to gold in times of trouble, and we have worries to spare these days: a weakening dollar, a deeply divided political climate, and a growing budget deficit.

And in the aftermath of the bursting of two historic bubbles -- dotcom stocks a decade ago and then real estate -- many investors long to hold something that seems to have a timeless, intrinsic value. (Never mind that five years ago the market thought gold was intrinsically worth 65% less.)

You may be wondering whether you should be getting a piece of this action. This time last year, MONEY argued that although gold prices could continue to climb in the short run, the case for gold as an investment no longer made sense.

And that leads to another truth about bubbles: You'll almost never look smart trying to call them, at least at the outset. The real estate bubble was six years in the making; the dotcom bubble lasted five years before bursting.

The gold bubble could stay pumped up for a while. But that doesn't make gold less speculative and risky than it was a year ago.

Three solid reasons to be wary of gold:

1. Bad economic news may not earn you much, and good news could crush you

Gold has traditionally been considered a hedge against high inflation. And gold bulls argue that the money the Federal Reserve has been pumping into the economy will eventually create runaway consumer prices, as more dollars chase too few goods.

Gold, the thinking goes, will hold its purchasing power -- after all, it can't be manufactured at the whim of a central bank. Gold enthusiasts point to a strong precedent for its vigor: During the late 1970s and early '80s, when the inflation rate surged by double digits, gold prices also soared, rewarding investors handsomely.

Right now, though, there's no sign that inflation is about to rear up anytime soon. For all the Fed's efforts to inject money into the system, the folks who have it -- banks, mostly -- have been reluctant to do much besides sit on it, leaving too few dollars chasing too many goods.

As a result, the inflation rate stands at just 1.2%, down sharply from 2.7% in December 2009. In fact, the bond market has been signaling fears of low inflation or even deflation -- a sustained weakness in prices that could hold down the economy for years. The yield on the 10-year Treasury bond is about 3%. Bond investors wouldn't accept such paltry yields if they saw high inflation.

Maybe bond investors are just wrong, and the gold traders are right. Or perhaps, says HSBC commodities analyst James Steel, investors are hedging their risks by buying bonds as a defense against the short-term threat of deflation, and gold as a store of value "in case inflation eventually takes off."

That's plausible. But the case for gold depends a lot on what you think "takes off" means. Many market observers do believe that inflation is going to rise eventually. The Fed seems to be trying to engineer at least a modest increase, and there's hardly anywhere to go but up from here.

However, a return to 3% inflation or even something a bit higher isn't what many gold investors are betting on. Many are concerned about low-probability catastrophes like the collapse of the global money system or a U.S. debt default. It's not that those things are impossible -- it's that gold owners have to worry about what happens to their investment if those things don't happen.

"Gold is already fully pricing in some very nasty scenarios, including high inflation," says Jason Hsu, chief investment officer at Research Affiliates. "The price is going to react in a very negative way to any reality that deviates from that expectation."

That reality would include a continuation of the sluggish, unemployment-ridden, but modestly growing economy we seem to be stuck in now.

And if the economy turns back to real health, watch out. From 1980 through 2005, gold earned zilch. In fact, if you had bought gold at its peak in 1980, you still wouldn't be back to even today on an inflation-adjusted basis.

"When the economy moves from recession to prosperity, there will be little reason to own gold," says Mark T. Williams, who teaches risk management at Boston University. "And speculators will learn the hard way that gold in times of financial stability is hazardous to investor health."

2. Sure, the dollar has its problems, but just look at the other guys

Related to fears of inflation is the bet that the U.S. dollar is about to tank. Part of the argument here is that the Fed's latest easing efforts will spook foreign investors. Or that fear of rising U.S. deficits will cause China and other sovereign investors to pull out of Treasuries.

When overseas investors sell Treasuries, that should mean less demand for dollars. And if the dollar falls, investors around the world tend to gravitate toward gold. Since June, in fact, the dollar has dropped about 10% against a trade-weighted basket of foreign currencies. Gold in the same period shot up 14%.

If you think the dollar is going to fall against foreign currencies, a better way to play it is to skip gold and simply own mutual funds that invest overseas. Most international funds hold stocks in their local currencies, so you get a jolt of extra returns when those currencies rise.

And even if the dollar turns out to be stronger, you'll still participate in the growth of the underlying business and get some dividend income to cushion the blow.

More to the point, reports of the death of the dollar have been greatly exaggerated. As much as you may worry about the deficit, the future direction of the dollar doesn't just depend on what's going on in the U.S. In early November, for instance, the greenback shot up 3.5% in little more than a week amid fears about government debt problems in Europe. Gold plunged by about the same percentage.

In fact, many experts contend that the dollar could soon stabilize -- and might even reverse course and start rising against currencies like the euro and the Japanese yen if the Fed's moves actually work at spurring the U.S. economy.

"The U.S. dollar is the best-looking horse in the glue factory," says Nariman Behravesh, chief economist for the information and forecasting group IHS. "Many economies around the world are in far worse shape."

What about China dumping Treasuries?

Props to the writers at SNL for catching the zeitgeist, but it's unlikely that President Hu regrets China's having invested so much in the U.S. By financing U.S. debt China has kept its exports to our shores humming. That can't last forever, and there's always a risk that this trade pattern will unwind too fast. But at the moment, the Chinese seem to need us as much as we need them.

3. The gold boom has the earmarks of a speculators' rally

Scientists sometimes call a bad idea "not even wrong" -- meaning that it's so groundless it can't even be tested. In the same vein, you could say that gold isn't even overvalued. Because how would you value the stuff in the first place?

Unlike a bond, gold doesn't promise to pay you back with interest; unlike a stock, it doesn't have any hope of generating earnings over time. If gold were a house, it would be one you couldn't live in or collect rent from.

Unless you want to flash some bling, buying gold today is just a bet that someone else will want to pay you more for it tomorrow. That's why even advocates of diversified portfolios, like Vanguard founder Jack Bogle, often rule out gold investing as speculation. "The 'greater fool' theory is not a convincing argument for buying gold," says adviser William Bernstein, author of The Investor's Manifesto.

This actually makes the argument that gold is a "bubble" a little bit tricky. Since it produces no earnings in the first place, you can't say gold's price/earnings ratio is too high to justify the risk. But you can tease out some indicators that demand for gold is overinflated right now.

An oft-cited argument in favor of high prices is that gold is in limited supply -- new mines take up to a decade to come online. But as the chart above shows, the demand side of the equation has changed a lot.

In 2005 only 16% of the demand for gold came from investors most went to industrial users and jewelers. Now investors reflect almost 40% of the demand. As a result, gold prices are more exposed to speculators' whims.

Meir Statman, finance professor at Santa Clara University and author of What Investors Really Want, points out that investors buy assets for "expressive" and emotional as well as economic benefits -- and owning gold expresses a lot right now.

"It gives you the opportunity to convey to others that you're a 'player' like the hedge fund managers, or that you're a 'patriot' opposed to the country's growing debt," says Statman.

True, some investors refuse gold for expressive reasons too. Charlie Munger, longtime right-hand man of Warren Buffett, recently dismissed "hoarding" gold, telling an audience, "Even if it works, you're a jerk." But right now, gold bugs have the buzz. Are you comfortable betting this mood won't change -- or that you'll sense when to get out in time?

Gold fans often lean hard on history. Although gold may have hit new highs in nominal terms, the bulls note that it hasn't come close to hitting its peak price after accounting for inflation.

Figure that into the 1980 high of $850 and you get a price of around $2,300 an ounce -- some 63% higher than where gold is trading today. But that is just the greater fool theory dressed up with charts: If people paid $2,300 once, maybe they'll repeat that mistake. Well, in 2000 investors were willing to pay 45 times earnings for stocks. Want to bet they'll do that again?

Still can't resist the luster?

There's always that sneaking suspicion that maybe the doomsayers are right. In an economy where nothing grows and paper currency goes for kindling, yes, you'll be glad to own gold. Plus, you're only human. When people around you seem to be getting rich on gold, it's hard to sit idly by.

That's why Harold Evensky, a Coral Gables, Fla., financial planner, doesn't think it's crazy to indulge in a little preventive speculation. Use no more than 1% of your total portfolio to play your gold hunches.

"If that prevents you from putting 15% or 20% of your portfolio into gold, it can be effective," says Evensky.

If you want to take a flier on unlikely events, consider a high-octane wager. You could plunk down a small -- emphasis on small -- amount of money to buy call options on the SPDR Gold Trust, an exchange-traded fund that invests in the metal.

The ETF cost around $138 a share in December. But for $3 you can buy the right to snap up GLD at $200 anytime until January 2012. If gold doesn't rise, your small investment is wiped out. But if it actually hits its $2,300 peak, the GLD will go for around $230, earning you $30.

That's a 10-bagger on your $3 investment, way better than you'll get buying the coins hawked by talk-radio yakkers. And if you sleep better knowing you have a Plan Z on the off chance those guys and the SNL writers are right, all the better.  To top of page

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