Gold, "The Ultimate Bubble," Has Burst

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Has the gold bubble burst?. Photo: George Peters/Getty Images

Was commodities trader George Soros right when he said "Gold is the ultimate bubble"?  An asset bubble is when speculators bid up prices of anything--housing, oil, and gold--beyond an intrinsic real value. Soros argued that gold is the ultimate bubble. Unlike real estate or oil, it has very little fundamental value upon which to base a realistic price.

For example, the cost to dig gold out of the ground is between $500-$1,000 an ounce That depends on how much new exploration is done.

But historical gold prices have varied much more wildly than that. It doesn't seem that gold's value is based on supply. Instead, the commodities market is the real driver of gold prices.

Soros seemed like a fool in 2010, when he said this at the Davos World Economic Forum. For another year, the price of gold kept soaring. 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? If so, how far could gold prices fall?

President Nixon took America off the gold standard in 1973. Since then, investors have bought gold for one of three reasons:

  1. To hedge against inflation. It holds its value when the dollar declines.
  2. As a safe haven against economic uncertainty. 
  3. To hedge against stock market crashes. Historically, gold prices have risen 15% immediately following a crash.

All three reasons were in play in 2011. Investors were concerned that Congress would not raise the debt ceiling, and the U.S. would default on its debt.

The gold bull market began in 2000, as investors reacted to the Y2K crisis (1999) and the bursting of the stock market tech bubble (2000). The economic uncertainty surrounding the 9/11 attacks spurred prices higher in 2001, while the dollar decline between 2002 to 2006 raised inflation fears. Investors rushed to gold as a safe haven during the 2008 financial crisis, then bought more gold when the Fed's Quantitative Easing program created more fears of inflation.

In 2010, there was uncertainty surrounding 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 health rate of 2% - 2.5%. In 2013, the stock market beat its prior record in 2007. By the end of 2013, Washington reverted to a state of gridlock instead of perpetual crisis. That's because Congress passed a two-year spending resolution.

History before 2000 reveals that, as the stock market rises, gold prices fall. There hasn't been a threat of inflation above 4% 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 - 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% or less of a well-diversified portfolio. If you're holding more than that, talk to your financial adviser before gold falls again. For more on what the research shows, see Why Invest in Gold.

 

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