Why Investing In Gold Can Be Profitable, And When The Gold Bubble Will Burst

 

The trend in gold is expected to increase for a number of years, and is considered an asset bubble.  But that does not mean the bubble will burst anytime soon, which means there is opportunity to profit from investing in gold. Given such a rapid rise in recent months and many different views in the media about the direction of gold, many investors are asking is it too late to invest in gold? What is the long term trend for gold?  Will gold continue to rise? Is gold a bubble that is waiting to burst? These questions will be answered in this article.

Its been a little over 2 years when I first posted a small article regarding gold while it was temporarily out of favor (How The Financial Crisis Will Affect The US Dollar, Inflation, Gold, and Oil Prices).  Since that time gold has steadily risen, and continued to reach record levels along the way.  When the financial crisis hit, gold’s ascent paused for a bit around the $800/oz level, before continuing to shoot past $1000/oz.  In the past 6 months, gold has climbed very quickly reaching record prices on a weekly basis.  It has surpassed $1370/oz and has lately experienced a slight pullback.

We can expect the trend for gold to increase for a number of years. Although the price of gold may experience some short term pull backs, as can be expected with anything that rises so quickly or over a prolonged period. How large the pull backs will be is anyone’s guess, and no one can know for sure.  That being said, gold is definitely a bubble and will eventually burst. Investors should understand and acknowledge these two facts.   We will begin by discussing  the factors that are affecting the price of gold so far, and then move on to when the trend in gold will end, and why it is a bubble.  We will also discuss the economic and common sense factors affecting gold in the long term (next few years), and under what conditions the gold trend will end causing the bubble to burst.

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THE FACTORS AFFECTING THE PRICE OF GOLD SO FAR:

There are a few factors that have influenced the price of the metal and other precious metals, that have caused them to increase so dramatically within the recent 6 months. We have seen investors pile into gold and commodities in general, and pull out of equities.  We can also see that investors have poured money into bonds, as yields are at very low levels.  There are a few reasons behind this recent activity:

Economic uncertainty and a weak global recovery have created much uncertainty, and gold is seen as a safe haven, as are bonds.  The problems in the US have not gone away, and more stimulus (monetary/quantitative easing, low rates, other programs, etc) is needed to prevent the recovery from stalling.  Manufacturing, housing, and employment data have not been good.  European nations are facing very difficult times with austerity measures in place to reduce debt, which at the same time is restricting investment & expansion.  UK, Iceland, Ireland, Japan, Portugal, and Greece (to name a few), still have very serious financial problems.

The US dollar used to be seen as the world’s most stable and strongest reserve currency.  However, since its first bank bailout package in 2007/2008 it has slowly fallen out of favor.  With much more quantitative easing since then, and an enormous debt burden, the US currency is no longer the favorite for investors.  The growing global currency battle and deliberate competitive devaluation of currencies have made what used to be investment alternatives to the US dollar (euro, etc.) unattractive as well.  Protectionist measures and trade wars are a growing concern.  It has increased significantly as nations implement efforts to resist capital inflows.  Many emerging nations are seeing inflows of foreign capital from investors seeking higher returns than the near-zero interest rates offered in the developed world.  As a result, their currencies are rising, which threaten exports and undercut the competitiveness of such exporting countries.  Many nations have started to intervene in foreign exchange markets or invoke policies to curb capital inflows in order to decrease the effects.
Many nations are acting on expectations that the US Federal Reserve will continue to spend more stimulus money to buoy its faltering economy (printing money it doesn’t actually have).  [read the old article How The Financial Crisis Will Affect The US Dollar, Inflation, Gold, and Oil Prices for explanation and background regarding money supply and its affect on gold]

Demand, primarily from investors have been increasing (individuals, banks & financial institutions, governments, etc).  The increase in the price of the metal has also attracted even more individual and institutional investors.

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IS GOLD A BUBBLE THAT IS GOING TO BURST?   WHEN WILL THE TREND IN GOLD END?

Gold is definitely a bubble that will eventually burst. All asset classes that rise experience investor euphoria, eventually peak, and then burst.  We’ve seen this with stocks in general, mortgage related securities, real estate, technology, etc.  We expect this with bonds in the next few years as well, due to investors buying at record prices with very low yields, despite extremely high national debt levels. Bonds now make up a very large portion of portfolios.  Gold is no different, and it will eventually burst.  Unfortunate, no asset continues to rise forever, and such a scenario does not make any sense.  This does not mean we expect the gold bubble to burst any time soon.

• George Soros had this to say:

“I called gold the ultimate bubble which means it may go higher but it’s certainly not safe and it’s not going to last forever.”

Some investors, economists, and analysts predict that the price of gold will reach $1500 by the end of the year, while others predict $2500.  Some have predicted $4000 or $5000 at the peak or end of the trend.  There are no right or wrong answers until it either reaches it, or doesn’t.  How can one predict with any accuracy?  The answer is simple, you can’t. The exact price, and especially the time frame is anyone’s guess.  Given the economic conditions, supply & demand factors, etc, all an investor can do is determine and predict conditions (not a specific price & time).  The price can be expected to increase from this point until conditions become present that would likely stop its rise.   No one can determine with any accuracy before hand, exactly when those conditions will occur, and what the price of gold will be at that time.  Nor is that information necessary, in order to successfully invest in it.  All that an investor needs to determine is under what conditions they can expect the trend to end, and then plan how they will exit from gold related investments.  This is true actually for any investment.  Investors too often focus on timing, and not on identifying the conditions. To understand what those conditions are for gold, we first need to understand why the trend will continue.

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WHY THE TREND FOR GOLD IS SET TO CONTINUE FOR A NUMBER OF YEARS

We will now look at why the trend will continue for a number of years:

• No matter how illogical or irrational it is, the fact is that around the world people (and governments) have in the past, and still identify gold as a universal currency & safe haven that holds some lasting value.  The markets are illogical, irrational, and highly behavioral.  This is because the market is made up of the combined actions/decisions of people.  Although making decisions without emotion is key to successful investing, the majority of people often behave illogically, irrationally, and emotionally, especially when money is involved. However, this creates opportunities for investors that can identify and capitalize on  such behavior.

• There is a lot of new institutional money being invested into developing financial products related to gold in order to profit from its rise in price, and product demand by individual investors (new mutual funds, ETFs / index funds, gold bars, etc). Many have newly introduced products to related existing investment lineups, while others have made new forays into the sector  (i.e. they are still just beginning). As a result, gold makes up a very small portion of investment portfolios.  Many individuals, as well as institutional investors do not have a large chunk of their money invested into gold related investments yet.

Investment by the industry is still relatively low, but is beginning to pick up again.  The key word is beginning.  Activity pertaining to exploration & production are ramping up.  Junior miners have been outlining plans to start exploration programs again or small production operations (many have been on hold for the last few 2-3 years).  There is currently no shortage of related labour (qualified geologists & mining engineers), capital equipment, consumables, and drilling equipment.  This shows the relatively low level of activity in the industry, with costs still at low levels.  Companies would not invest hundreds of millions dollars into ramping up exploration and production now, only to curtail and reduce it within a year or two before prior to having new or existing projects reap any financial benefits.  It simply does not make any dollars or sense.  Companies would only invest such large sums of money knowing that they can benefit from such investments for at least a few years.

The global currency battle has really just begun.  When it stops, it will still take a good number of years to reverse all the monetary policies and quantitative easing that have (and will have) taken place in nations around the world.  Until that even begins to happen, currencies will still be devalued.

• Once economies begin to grow again, taxes will increase along with a decrease in government stimulus.  Prices and interest rates will rise and a high inflationary environment is likely to take hold.  In high inflationary environments, the purchasing power of currencies are eroded.

We are still at the beginning of a gold trend that will continue for a good number of years.

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WHAT ARE THE CONDITIONS FOR THE GOLD TREND TO END?

There isn’t just one condition, and not all need to be present either. Likely, a subset of the conditions will be enough to send the trend in the opposite direction. The conditions are basically the inverse of those that give rise to the current situation, which are the conditions that will increase investor demand/interest for equities, rather than gold:
– Economic certainty, and sustained global recovery.
– No longer a need for economic stimulus policies.
– Easing of global debt levels
– Strength in global currencies (especially those of developed nations), cooling of the global currency battle and protectionism policies.  A few reserve currencies (not gold) seen as a strong/definite alternative to US dollar.

• When economies become more stable, and currencies regain some of their value.

• Global investment & expansion by the mining industry peaking.

• There will be more demand on all of the services used by the gold & mining industry. When costs sky-rocket, making it less profitable, there will be a shortage of labour & equipment.  Things will become expensive for the miners, and an industry slowdown will begin.

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WHAT AN INVESTOR NEEDS TO KNOW TO SUCCESSFULLY INVEST IN GOLD

An investor cannot know exactly when (what year) the trend in gold will end.  An investor needs to be knowledgeable about economics, monetary policy, and the mining industry, in order to identify the conditions when they do appear.  Nothing happens overnight, but indicators will become present.  That is why investors also need to be aware of what is happening in the global economy and the mining industry, so that they will notice the indicators as they become present and then act accordingly. Reading news articles related to the economy, as well as those related to a few mining companies, should be a minimum.

Investors can plan ahead, by projecting specific conditions that may take hold after a certain period of time.  However, investors must remember the limitations, that the projected scenarios may never actually occur, or occur earlier/ later.   The projections are only meant to help investors become aware of a range of possibilities that can be expected, and not be caught off guard.  They can then capitalize on expected opportunities, or be defensive against expected dangers.

This article presents some important aspects to consider about investing in gold related investments.  There are also other general aspects to consider as well.  This article should investors to get started, or at least provide more specific areas to research. Now that we’ve covered some of the principles & economics that affect gold, the next article will breifly discuss some practical gold related investments.

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Update:
How To Invest In Gold Related Investments
How To Pick Great Junior Mining Stocks [How to pick and evaluate junior mining stocks]

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Thanks and Happy Investing!  –

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2 thoughts on “Why Investing In Gold Can Be Profitable, And When The Gold Bubble Will Burst

  1. I¡¦ll immediately snatch your rss as I can’t find your e-mail subscription hyperlink or newsletter service. Do you have any? Please let me recognize so that I could subscribe. Thanks.

  2. Another great article that can now be viewed with the benefit of hindsight. Since the time of writing gold values continued to increase, and as more investors look to reduce their exposure to financial markets and seek out alternative investments instead, I think the price support is definitely still there for the mid-term – what with all of the global economic uncertainty.

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