Gold, "The Ultimate Bubble," Has Burst

••• Photo: George Peters/Getty Images

In 2010, commodities trader George Soros said "Gold is the ultimate bubble." He was referring to the asset bubble that occurs when speculators bid up prices of an investment beyond its intrinsic real value. Asset bubbles occurred in housing in 2005, oil in 2008, and stocks in 2013.

Soros argued that gold is the ultimate bubble. Unlike real estate, oil, or shares of corporations, it has very little fundamental value upon which to base a realistic price.

Soros seemed like a fool when he said this at the Davos World Economic Forum. For another year, the price of gold soared. It reached its all-time record of $1,895 on September 5, 2011. Was this record just the peak of a bubble that's burst? 

Unlike other investments, most of gold's value is not based on its contribution to society. People need housing to live in. They need oil for gas to drive their car. The value of stocks is based on the contribution of the corporations represented. But the biggest use of gold is for luxury items. Jewelry uses 52 percent of the gold mined each year. Industry uses 12 percent. The remaining 34 percent is used for official government holdings and investments. 

For this reason, Soros claimed gold was the most susceptible to "the madness of crowds." He based his observation on his theory of reflexivity. It said that prices shape perceptions of an asset's value as much as fundamentals do. It creates a loop where price increases shape perceptions. As prices rise, so do the fundamentals. These feedback loops become self-sustaining. The bubble inflates until it becomes unsustainable. Spiraling prices continue longer than anyone thinks they will. The collapse is more devastating as a result.

More than any other commodity, the price of gold rises mainly because everyone thinks it will. For example, people believe that gold is a good hedge against inflation. As a result, people buy it when inflation rises. But there is no fundamental reason that gold's value should increase when the dollar falls. It's simply because everyone believes it to be true. 

Three years after gold hit its peak, it fell by more than $800 an ounce. It dropped to $1,050.60 an ounce on December 17, 2015. It rose to $1,300 an ounce by the end of 2017 because the dollar weakened. But there's no inflation and the stock market is setting new records. It was only the perception of possible inflation, due to the dollar's decline, that sent gold prices higher.

Why Gold's Bubble Peaked in 2011

Until 1973, gold prices were based on the gold standard. The Bretton Woods Agreement mandated that gold was worth $35 an ounce. When President Nixon took America off the gold standard, that relationship disappeared. Since then, investors have bought gold for one of three reasons:

  1. To hedge against inflation. Gold holds its value when the dollar declines.
  2. As a safe haven against economic uncertainty. 
  3. To hedge against stock market crashes. Research done by Trinity College show that gold prices typically rise 15 days after a crash.

All three reasons were in play when gold reached its peak in 2011. Investors were concerned that Congress would not raise the debt ceiling and the United States would default on its debt.

The gold bull market began in 2000. Investors reacted to the Y2K crisis in 1999 and the bursting of the stock market tech bubble in 2000. The economic uncertainty surrounding the 9/11 attacks spurred prices higher in 2001. The dollar decline between 2002 and 2006 raised inflation fears. Investors rushed to gold as a safe haven during the 2008 financial crisis. They bought more gold when the Federal Reserve's program of quantitative easing created inflation fears. In 2010, investors worried about the impact of Obamacare in the midst of a slow-growing recovery.

By 2012, much of this uncertainty was gone. Economic growth stabilized at the healthy rate of 2 to 2.5 percent. In 2013, the stock market beat its prior record set in 2007. By the end of 2013, Washington had reverted to a state of gridlock instead of perpetual crisis. That's because Congress passed a two-year spending resolution.

How Far Gold Prices Could Fall

Gold's price would never fall below the cost to dig it out of the ground. Depending upon how much new exploration is done, it's between $500 and $1,000 an ounce. Worst case, gold prices won't fall below $500 an ounce. If it did, exploration would stop. But historical gold prices have risen much higher than that. So, gold's value is not based on supply. 

History before 2000 reveals that, as the stock market rises, gold prices fall. There hasn't been a threat of inflation above 4 percent since 1990. In other words, investors have no compelling reason to buy gold. As the stock market hits record highs, gold prices will continue their downward descent. 

What It Means to You

From 1979 to 2004, gold prices rarely rose above $500 an ounce. The rise to record highs was a result of the worst recession since the great depression and its after-effects. Now that things have stabilized, gold prices should return to their historical level, below $1,000 an ounce.

Most planners advise that gold comprise 10 percent or less of a well-diversified portfolio. If you're holding more than that, talk to your financial adviser before gold falls again.