Friday, October 8, 2010

Is Gold in a Bubble?

I like to think that Bob Dylan was the first to make a fetish out of the question: How does it feel? I would find that a saving grace for the amount of annoyance that this sentence has caused to so many people. MP3 download of the original here: Like A Rolling Stone.

Now that we have all learned the rather dubious skill of tuning in to our feelings, we should learn how to read the feelings of other people. Few skills will get you further in life than learning how to attune yourself to the feelings of your friends.

But, what about the feelings of the general public, or rather, the investment community? Every investor knows that doing well in the market, in any market, involves sussing out the general sentiment and then doing the opposite of what everyone is doing.

If everyone thinks the market is going up, you should sell. If everyone thinks the market is coming down, you should buy.

Clearly, irrational exuberance, of the kind that characterizes what are called market bubbles, is a sign to run for the hills.

Bull markets climb a wall of worry. Or so they say. But if everyone has stopped worrying, to the point of being carried away on a wave of market ecstasy, then you are entering into a bubble.

When everyone has invested everything they have in something-- when they have gone all-in-- they have less money remaining to make new investments. And without fresh money to keep buying the asset, its price will fall.

But, how does it feel when the market is in a bubble? If you are the proud owner of a stock that is rushing toward the moon, that is being recommended by everyone, that is making you very, very rich on paper, you are going to feel very smart indeed.

You are going to feel good about yourself. You are going to feel proud of your accomplishment.

You might even think that everyone who is touting your stock is actually singing your praises. You are going to feel that your judgment is infallible. The higher the stock goes, the more confident you become. The more confident you become, the more you decide to commit fresh capital to your position.

All of those people who were scoffing at your silliness for buying the asset before, are looking to find a way to get in to the game.

One thing is certain. If your investment is in a bubble you are not thinking that it is in a bubble. You do not feel that your exuberance is irrational. You feel that the stars have aligned themselves to give you what you so richly deserve. It is a species of happiness.

A bubble need not feel like getting caught up in an emotional wave. You are, dare I say, too smart for that. Having done your homework and worked out all of the eventualities, you have concluded that nothing can possibly go wrong. You decide to go all-in. Not only that, but you are so full of confidence that you are sleeping like a baby.

Until the bubble bursts. At which time you feel like you have been had, like you are the world's biggest fool. You have become like Icarus, he of the melted wings, and you do not feel very good about yourself or anything else.

A market bubble is the final, blow-off stage of a bull market. Bubble investors miss most of the bull market and try to make it all up in the market's final upward thrust.

Let's say that a bull market is going on out there and you are missing it. Is there anything more frustrating than thinking that you could have, should have, would have bought the stock when it was selling for pennies, only to see it ascend into the stratosphere?

It's one thing to see the price go up. Quite another to see it take off into bubble-land. The more it goes up the more you suffer the indignity of hearing about the hefty gains-- on paper, albeit-- that your dimwitted neighbor is making.

You weren't very tempted when it was just a garden-variety bull market. But once it becomes a bubble, you are going to be tempted. You will get caught up in what is called the madness of crowds, and you will starting thinking that you can catch the tail end of it. You are so smart that you will be able to get out before it crashes.

So, you commit a small percentage of your capital. The asset goes up. You feel smarter and smarter, and you celebrate your success by committing more and more of your capital. Then, you feel better and better, and start believing that there really is something behind the bubble. It really cannot come down. It will keep laying the golden eggs. It's a brave new world and the laws of economics and human nature have been repealed.

Above all else, if you are involved in a bubble, it feels good. While a bubble is going on, if you are not involved you feel like a chump.

At the extreme, in the mania stage, you sell your house and all of your possessions to buy an especially valuable tulip bulb. Link here. Houses come and go; they get built and rebuilt. A unique tulip bulb is forever; it will always have value; it is God's creation.

When a stock or a commodity is in a bubble, you feel a strange  confidence, as though you have discovered the Holy Grail and nothing bad can happen to you. You feel immune, immortal, and eternal. Otherwise why would you sell your house to buy a tulip bulb?

More than a few very savvy people believe that gold, yellow dirt, has now entered its bubble stage. They feel that gold is intrinsically worthless and that its recent bull move has been fed by fear. 

Yet, gold is and always has been a universal medium of economic exchange. Which is why some say that there's no fever like gold fever. When all is said and done, tulips are ... flowers.

Today, smart people feel fine about not being invested in yellow dirt. They are convinced that gold is intrinsically worthless and that the fools who have been collecting it are about to get their well-deserved come-uppance.

When the only people recommending an investment are people you consider to be kooks and cranks, it may be going up, but it is probably not in a bubble. When the sane and sensible folk, the great minds of our time, give in and start recommending it, then you are getting into a bubble.

If gold is in a bubble, then everyone should be going all-in on gold. The average person, the retail investor, your taxi driver and dry cleaner, would be counting out their gold coins or chasing after gold mining stocks.

When it comes to physical gold, that is clearly not the case. See Brett Arends article today in the Wall Street Journal about participation in the gold market. Link here.

Of course, when large numbers of people think a stock or a commodity is in a bubble, and when they are, in consequence, afraid to invest, by definition, it is not. When those who have not invested in it feel superior to those who have, it might be a bull market, but it is not a bubble.

The emotional valence of a bubble is designed to suck people in, not to warn them to stay out.

If you regret having missed the move, it might be a bull market. But if every fiber of your being is telling you to buy more, it's a bubble.

Thus, the real question: if gold is not in a bubble, but in the midst of an ongoing bull market, where is today's bubble? 

Is there a stock or a commodity that inspires so much praise and adulation, that has come to symbolize unstoppable future success, to the point where people believe with utmost confidence that its price will continue to rise to the heavens?

You may have your own candidate, but the first company that comes to mind, and that satisfies those predicates is: Apple Computer. Just about no one has anything bad to say about Apple or about Steve Jobs. For today's generation Apple is becoming what General Motors was for a previous generation.

Everyone feels that Apple can do no wrong, that it cannot fail, that it can print money. To my somewhat jaded emotional sensors that feels a lot like a bubble.

Most people will look askance at this suggestion, thinking that it represents an opinion that is so far outside of the mainstream that it is positively risible, then, that is another point in favor of the idea that it is in a bubble.

But that is the emotional difficulty about identifying a bubble. You cannot proclaim an asset is in a bubble phase when you believe that it is worthless. You need something that you believe to be so supremely valuable that you would never even question whether it is worth what you are paying for it.

If everyone was saying about Apple what they are saying about gold, then it would be a good time to buy some more.


Chuck Pelto said...

TO: Dr. Schneiderman, et al.
RE: The 'Golden' Rule

He who has the gold, makes the rules.

There could well be a 'bubble' for gold. However, if it's 'popped', I suspect it will be the government that holds the needle.

All they need to do is re-instate the 'gold standard' and seize the gold at whatever price they deem 'appropriate'.


P.S. Buy precious stones....

Anonymous said...

Look, the day after the Great Collapse, Mcdonalds and Walmart will be open and they will not be taking gold or precious stones for socks or Big Macs....


Stuart Schneiderman said...

Agreed, they will still be taking paper money. The question is: how much?

With the Federal Reserve trying to engineer inflation, the better to inflate our debt away, how many of those piece of paper will be required to buy a Big Mac.

And while Walmart will not be taking gold coins for patio furniture they might very well have a kiosk where you can exchange your gold for paper money.

Gold has always been a store of value. Many very smart investors are more confident that gold will retain its value than that fiat currency will.