In 2010, commodities trader George Soros famously 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 value.
Unlike real estate, oil, or shares of corporations, gold has very little fundamental value upon which to base a realistic price. Soros seemed like a fool when he called gold a bubble at the Davos World Economic Forum. For another year, the price of gold soared, reaching a record of $1,895 on September 5, 2011.
Soros's words have a new relevance: On August 7, 2020, gold hit a new record of $2,061.50 in response to fears of economic uncertainty caused by the COVID-19 pandemic.
- Unlike real estate, oil, or shares of corporations, gold has very little fundamental value upon which to base a realistic price.
- The biggest use of gold is in making luxury items, with most of the yearly gold supply being made into jewelry (78%).
- People believe that gold is a good hedge against inflation, but there is no fundamental reason that its value should increase when the dollar falls.
- Most financial planners advise that gold comprise 10% or less of a well-diversified portfolio.
Calculating Gold's Value
Unlike other investments, most of gold's value is not based on its contribution to society. People need housing to live in and oil for gas to drive their car, and the value of stocks is based on the profitability of the corporations represented.
The biggest use of gold is for luxury items. Most of the yearly gold supply is made into jewelry (78%). Other industries, including electronics, medical, and dental, require about 12% of the year's supply. The rest is used for financial transactions (10%).
Soros claimed gold was the most susceptible to "the madness of crowds." He based his observation on his theory of reflexivity, which says 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-perpetuating, and the bubble inflates until it becomes unsustainable. Spiraling prices continue longer than anyone thinks they will, and the collapse is more devastating as a result.
The Role of Perception
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, and as a result, they buy it when inflation rises. 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 2011 peak, it fell by more than $800 per ounce. It dropped to $1,050.60 per ounce on December 17, 2015, and rose to $1,300 an ounce by the end of 2017 because the dollar weakened. There was no inflation, and the stock market was setting new records. These are both historic drivers of rising gold prices. 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 per ounce. When President Nixon took the United States off the gold standard, that relationship disappeared. Since then, investors have bought gold for one of three reasons:
- To hedge against inflation. Gold holds its value when the dollar declines.
- As a safe haven against economic uncertainty.
- To hedge against stock market crashes. A study done by researchers at Trinity College shows that gold prices typically rise 15 days after a crash.
All three reasons were in play when gold reached its 2011 peak. Investors were concerned that Congress would not raise the debt ceiling, and that the United States would default on its debt.
By 2012, much of this uncertainty was gone. Economic growth stabilized at a healthy rate of 2% to 2.5%, and 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, because Congress had 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 and bring it to market. Depending on a variety of factors and inputs, that cost is between $500 and $1,000 per ounce. (For 2018, the "all-in-sustaining cost" for the industry was $837 per ounce.)
Even in the worst-case scenario, gold prices will never fall below $500 per ounce. If it did, exploration and mining would stop.
What It Means to You
Between 1979 and 2004, gold prices rarely rose above $500 per ounce. The rise to record highs in 2011 was a result of the worst recession since the Great Depression, and the 2020 records were due to the COVID-19 pandemic.
Most financial planners advise that gold comprise 10% or less of a well-diversified portfolio. If you're holding more than that, talk to your financial advisor before gold falls again.