What Is a Gold Bubble?

Woman looking at golden jewelry in a shop window
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Asset bubbles occur when the price of an asset, such as stocks or housing, increases rapidly without any strong reason to suggest a higher value. When the price of gold goes up dramatically over a short period, typically because speculators bid up prices beyond its intrinsic value, a gold bubble takes shape.

Unlike real estate, oil, or shares of corporations that yield income or dividends, gold has very little fundamental value upon which to base a realistic price. This makes it easier for gold prices to get swayed by speculation.

Learn more about the factors that impact gold prices, what makes gold susceptible to bubbles, and historical instances of gold bubbles.

Key Takeaways

  • 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 as a commodity for the production of 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%).

Famed investor George Soros said in his theory of reflexivity that sometimes asset prices shape perceptions of an asset's value as much as fundamentals do. That can create a loop where an increase in price influences perceptions about the fundamentals. As prices go higher, so does the investor confidence in fundamentals.

These feedback loops can 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.

Perception and Its Impact on Gold Prices

More than any other commodity, the price of gold rises mainly because people think it will. For example, people may 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 people believe it to be true.

Three years after gold hit a 2011 high of $1,896.50 per ounce, it fell by more than $800 per ounce to $1,050.60 per ounce on Dec. 17, 2015. Over the next two years, by the end of 2017, gold prices had climbed to $1,300 an ounce 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.

In 2020, the economy came to a standstill due to the COVID-19 pandemic and by August gold prices had crossed $2,000 an ounce. By 2021, gold prices hovered between $1,600 and $2,000 per ounce.

Gold Prices Before and After 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 Richard Nixon took the U.S. off the gold standard, that relationship disappeared. Since then, investors have generally 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. A study done by researchers at Trinity College shows that gold prices typically rise 15 days after a crash.

Note

All three reasons were in play when gold reached a high price in 2011. Investors were concerned that Congress would not raise the debt ceiling, and that the U.S. 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, the government had reverted to a state of gridlock instead of perpetual crisis, because Congress had passed a two-year spending resolution.

Can Gold Prices Fall?

Gold's price would likely 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. (As of the second quarter of 2021, the "all-in-sustaining cost" for the gold industry was $1,067 per ounce.)

Important

Even in the worst-case scenario, the price of gold would likely never fall below $500 per ounce. If the price did fall below that, exploration and mining would stop. That would reduce supply, increase scarcity, and push prices back up again.

What It Means for You

Between 1979 and 2004, gold prices rarely rose above $500 per ounce. The rise to a then-record high in 2011 was a result of the worst recession since the Great Depression, and the 2020 highs 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.