As Good as 

“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole and bury it gain and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head” Warren Buffet

In the current financial crises lead by a property bubble and cheap credit, the nominal price of gold has risen 159% between July 2007 and March 2012. Could gold be our next bubble? Warren Buffet seems to be talking along those lines. Many investors have significant positions in gold, including John Paulson and George Soros. But Warren Buffet does not.

I have always had an interest in bubbles, having myself traded through two bubbles, the dot com bubble in the early 2000’s and more recently through the financial crises.

Over the past 8 months, gold prices fluctuated and countless investors disregarded the long-term fundamentals sustaining this precious metal; the western world remains caught up in debt and governments are taking the easy way out by of dealing with this crisis by printing money and keeping interest rates low.

I began investing in gold when I first considered the obvious reality of the global debt crisis. I became bullish on gold very quickly, yet I could never understand why gold performs the way it does in crisis’. At the time, I made the usual assumptions that gold is a hedge against uninspiring performance in global financial markets and current financial crisis. Having being intrigued by this I dug deeper some research and from a general consensus among academic research; gold as a commodity has been described as many things, a “safe haven”, a “hedge against inflation”, a hedge against the dollar” or even a “zero beta asset”, McCown and Zimmerman (2006).

During my research I found that, despite the usual assumption, the price of gold can rise in bullish stock markets and fall during times of financial crisis and what really drives the price of gold is the value of fiat money.

I looked at three key secular time periods over the last decade:

Period 1 - January 2003 – December 2007 – Bull Market in equities

• ·         Gold increased 153%
• ·         S&P 500 increased 69%
• ·         US dollar index lost 25% of its value

Period 2 – January 2008 – March 2009 – Bear Market in equities

• ·         Gold increased 9%
• ·         S&P 500 decreased 52%
• ·         US dollar index increased 18%

Period 3 – March 2009 – April 2011 –Bull Market in equities

• ·         Gold increased 66%
• ·         S&P 500 increased 86%
• ·         US dollar index decreased 18%

It is clear from looking at trends 1 & 3 that gold tends to perform well when the US dollar doesn’t. Based on this it could be argued that, this precious metal is a hard currency and as such mirrors other currencies.

Investors should remember one thing: the bigger the financial disaster, the larger the monetary reaction by central banks. All dips in gold prices because of momentary jumps in the US dollar index are a possible buying opportunity. Real interest rates in the US will continue to be negative for the foreseeable future as the US economy remains laden with debt. Until gold’s fundamentals change, it would be my opinion that the long term bull market for gold will continue.

Thanks for reading
Rois

References
McCown, J.R. & Zimmerman J.R. 2006, "is Gold a Zero-Beta Asset? Analysis of the Investment Potential of Precious Metals",.
http://www.ecrresearch.com/famous-gold-quotes

What caused the bubbles?

The first signs the dot-com bubble was going to crash came from the companies themselves: many reported enormous losses and some even folded within months of their offering.  In 1999 there were 457 IPOs, most of which were technology and internet related. Looking at those IPOs in more detail shows, of the 457, 117 doubled in price on their first day of trading. In 2001 there were a mere 76 IPOs and none of them doubled on their first day of trading. The Nasdaq Composite lost 78% of its value during the dot com crash as it fell from 5046.86 to 1114.11.

Following the bursting of the dot-com bubble and the recession of the early 2000s, the Federal Reserve in the USA kept short-term interest rates low for an extended period. At this same time there was a global savings glut, as developing and commodity producing countries accumulated large financial reserves. Global interest rates fell to record lows as these surplus savings were invested. This, however, lead us to our next bubble, as investors became frustrated with low returns; they began to look for higher returns and therefore assuming more risky investments. For a number of years, global financial markets went through a period which became known as the “Great Moderation”, called as such because of the above-average returns and below-average volatility by a variety of asset classes.

Rising house prices led to extensive property speculation, and also fuelled excessive consumer spending as people started to see their homes as “piggy banks” that they could take cash out from at any time to fuel discretionary spending. As house prices rocketed many home-owners “stretched” to make their mortgage payments and the possibility of a collapse grew.

When the long held idea that house prices do not decline turned out to be incorrect, prices on mortgage-backed securities plunged, creating a domino effect with large losses for banks and other financial institutions. We reached the climax of our housing bubble in September 2008 with the bankruptcy and ultimate collapse of Lehman Brothers Bank in the United States.  This housing bubble caused markets to crash, the S&P 500 fell 57% from its high in October 2007 of 1576 to a low in March 2009 of 676.

However we shouldn’t feel too bad, the Oracle of Omaha has this bubble “the granddaddy of all bubbles”. Yet the question remains, where does the global economy go from here? Do we need to just accept bubbles and be willing to ride the rollercoaster? What do we need to look out of to prepare ourselves for the next bubble? And most importantly what is our next bubble? 

Lessons from the Dot-Com Bubble!

Between 1995 and 2001, a speculative bubble known as the “dot-com bubble” occurred, during which time the stock market soared significantly from the growth of the technology and internet sector, IPO’s were all the rage and the sky was the limit for stock prices. Bubbles like this have occurred right through history: in the 1840s, for example, frenzied buying in the field of railway building lead to a stock market bubble which burst devastatingly in the 1850s. The result in 2001 after the dot-com bubble burst was a mild but long-term recession in the Western world.


Most people believed that we had entered a new world and the internet was going to become the future of business. However, reality set in and all the hype didn’t live up to its promise and the inevitable occurred, the stock market crashed.


If you look deeper into stock market crashes you will find an abundance of timeless lessons that in my opinion every investor should learn. The three main lessons that we learned from the dot-com bubble are: Fundamentals don’t lie; trading the stock market momentum in fun, but we need to remember it is just momentum; life-altering changes, such as new worlds, don’t happen overnight.


After the bubble burst, many dot-com’s were either acquired by other companies or they liquidated. A few larger dot-com companies survived: Google and Amazon are good examples. According to a number of sources, about 50% of dot-com’s survived. Unfortunately, there were still thousands of technical experts such as programmers and web designers who were laid off and found themselves in a highly competitive job market.


Following in the footprints of the then US central bank chairman Alan Greenspan, Mr. Buffett said that the “irrational exuberance” which occupied the stock market between 1995 and 2001 left investors expecting unrealistic returns. Mr. Buffett famously said “The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them.”


There has been extensive academic research into the dot-com bubble and after looking at the dot-com bubble from an investor’s perspective I am now going to undertake an examination of it from the academic viewpoint.

Over the past decade investors were burned by three bubbles, dot-com stocks, housing prices and financial services. The question remains, will the coming decade be any different, it would be my opinion that this is not likely. Despite the many academic theories that state markets to be efficient and claim assets are given the price they deserve, Wall Street has a habit of inflating investment values until the bubble pops. The big question for long term investors is what potential bubbles to steer clear off over the next decade?

The Oracle of Omaha. Billionaire. The most successful investor in the world, Berkshire Hathaway chairman, Warren Buffett has recently dismissed gold as a “valueless asset”. Buffett has warned that gold was a self-inflating bubble, which was created by investors looking for a possible alternative to property and shares. Alex Zumpfe, a trader at Heraeus precious metals house said “Gold is facing some selling pressure after support levels didn’t trigger sufficient buying interest.” Could it be the case that the Oracle of Omaha has called it right once again? Gold rose over 400% since 2000, if this were to continue gold would be trading at over $8000/oz, looking at this would indicate signs of a bubble.

In the coming weeks I am going to investigate historical bubbles and what we have learned from them, if anything! I am going to look at the research behind bubbles; what defines them; what causes them; and how we can protect ourselves again them. Finally I will look at potential bubbles that it would be best for us to avoid.