Is Gold in a Bubble?
Short answer... Not even close!
By Chris Puplava, November 1, 2009
With gold reaching an all-time high, which by the way no other asset class can boast, some may be wondering if the bull market in gold is over as it has exceeded its prior peak. In terms of determining bubbles or significant peaks, relative valuation analysis has proven effective in identifying bubbles. As will be shown in the article below, no matter how you want to slice it, I believe gold is by no means close to a bubble, and can easily rally to higher triple-digit figures in the months and years ahead.
Technically, No Major Gold Sell Signals Flashing a Top
Over the past year I have developed two indicators that I use to help identify major gold peaks and troughs. In February of this year both my intermediate term (IT) and long term (LT) gold indicators were flashing warning signs for either a coming correction or a prolonged consolidation period, which I commented upon at the time (Gold, Is the Future Still Bright or Fading?) and warned of a correction. We did indeed correct soon after and then consolidated for several months. Periodically throughout the year I would update my indicators to look for a buying opportunity in gold, and by July both my gold indicators reached significantly oversold conditions reaching levels that have marked major buying opportunities in the past. I presented the following commentary back in July:
In contrast to the last two readings of the indicator north of 2.0, the overbought condition in February resulted in a moderate pullback with a multi-month consolidation to work off the overbought condition. A market that works off an overbought condition through a consolidation rather than a correction is a sign of strength as it indicates that the bears could never really gain the upper hand and drive prices lower. This is what was seen in gold after the February reading north of 4.0, the most overbought reading seen in 26 years, where gold simply consolidated rather than stage a significant correction. The FSO Indicator #1 is approaching -0.5, with readings in this vicinity often marking major bottoms in gold over the last decade.
For me the big key was that the last time my gold indicators reached significantly elevated readings (2006 and 2008 tops), gold corrected sharply while the severely overbought reading in February of this year only resulted in a mild correction and then a consolidation, showing the incredible strength in gold as the bears could never drive gold significantly lower. Now with gold breaking out to all-time highs I thought it timely to check in on my indicators again to see if there were any warning signs of a major top in gold. Surprisingly, neither my IT nor LT gold indicators are at frothy levels even with gold north of $1,100 an ounce. The PFS Group IT gold indicator is just slightly below neutral levels and suggests that gold would have to rally significantly further from here to present a sell signal with a reading north of 1.5.
What is perhaps even more encouraging for gold bulls is that my PFS Group LT gold technical indicator has not even breached into positive territory! It did not seem likely that gold would breach the psychological $1,000 an ounce mark on the first shot, which it attempted to in 2008. When gold was hitting nearly $1,000 an ounce back in 2008 it was doing so on extremely overbought readings in my LT indicator that suggested it unlikely for gold to rally much further. When gold next assaulted the $1,000 an ounce mark earlier this year it was doing so again at extremely overbought readings in the LT indicator, which is why I suggested a correction/consolidation back in February. However, this time around gold was attacking the $1,000 an ounce mark at extremely OVERSOLD levels as my LT indicator was nearly at -1, a level that marks major BOTTOMS, not tops! What this LT indicator suggests is that the recent move in gold may potentially be in the very early innings in terms of its recent rally. The LT indicator does not indicate whether the advance in gold will continue unabated; it simply identifies major tops and bottoms, not necessarily the path of gold. Therefore, gold may do some back and filling (two steps forward, one step back) before it reaches its ultimate peak in this advance.
Relative Ratios Suggests that this Secular Bull Market in Gold Is Far From Finished
As mentioned in the opening, it is quite helpful to measure one asset class against another to determine how out of whack a relationship is from the norm, which is useful in identifying bubbles. (Sorry Mr. Greenspan and Mr. Bernanke, bubbles are EASILY identifiable if one takes the time to do some actual homework!) As a quick example, anyone who studied the relationship of housing prices relative to key variables could clearly identify that housing prices were in an obvious bubble earlier in the decade. One key relationship in identifying bubbles in housing is to compare the median housing price to the median family income. This relationship makes sense as bubbles are identified by high home prices relative to the incomes that can sustain mortgages. As seen below, housing prices reached record levels relative to the median family incomes, marking more than a three standard deviation event, an occurrence that should happen only 0.0874% of the time (that’s 0.0874%, not 8.74%), or once every 95 years! Bubbles can’t be identified until after the fact? Please, Mr. Greenspan!
Source: U.S. Census Bureau
Moving the analysis to gold, one helpful relationship is to measure hard assets versus paper assets, or gold versus the S&P 500. One hallmark of time is a rotating cycle between secular bull markets in paper assets (stocks), and the flip side of the coin is a secular bear market in hard assets (gold, commodities), and vice versa. Over the last 100 years we have witnessed two secular bear markets in paper assets with an associated secular bull market in commodities (1929-1942, 1968-1980) and two secular bull markets in paper assets and associated secular bear market in commodities (1942-1968, 1980-2000). The two secular bear markets in paper assets last on average of 11.9 years while the secular bull markets lasted 23.4 years. In terms of duration, with the secular bear market in paper assets (stocks) and secular bull market in commodities (gold) beginning in early 2000, the average secular bear market in paper assets would suggest an eventual bottom sometime in 2012, which means the current secular bull market in gold still has some years left in it.
What is often typical of the final stages of secular bull market in either paper assets or commodities is a parabolic blow off top. We saw this in 1980 when gold reached its former record highs north of $800 an ounce and we are likely to see another parabolic blow off top in gold before gold’s secular bull market is over. Using ratio analysis in terms of measuring gold relative to the S&P 500, it appears that the S&P 500 would have to decline by 77.68% in real terms (gold deflated) to reach its levels seen during the Great Depression, and an 86.58% decline to reach the levels last seen in 1980 when the last secular bull market in gold ended. Thus, while we may be in the later innings of gold’s secular bull market, the final innings ahead may be the most spectacular yet!
Flipping the ratio around, we can see that gold would have to rally 351.75% relative to the S&P 500 to reach its Great Depression highs and a monstrous 682.22% to reach its 1980 highs. Clearly the best may be yet ahead for gold bulls.
Using ratio analysis even further we can measure gold relative to long term US Treasury bonds. The high in the gold to 30-Yr UST ratio was roughly around 13 and we are just breaching nine currently, meaning that gold would have to rally 44% relative to bonds to match its 1980 highs. The fact that gold is still in an uptrend relative to long term treasury bonds signals that we are still in a secular inflationary period that began in 2000, and what we have witnessed over the last year was a cyclical deflationary period within the confines of a secular inflationary period. The relationship below is perhaps the best judge of who is winning between the ongoing fight between inflationists and deflationists, and clearly with gold’s breakout relative to bonds the inflationists are carrying the day.
One other side note, bubbles are often characterized by excess supply such as excess technology IPOs in the dot.com bust and excess technology capacity, or excess housing this decade. As shown below, what appears to be in excess supply are USD’s while world gold reserves are a far cry from showing bubble-like supply.
As the number of USD’s has expanded exponentionally over the last few decades, the purchasing power of the dollars has eroded and while gold may have reached a new all-time high, a clearer picture is to use the consumer price index (CPI) index to measure gold currently to what it’s inflation adjusted price was back in 1980. Using the government’s CPI shows that the 1980 inflation adjusted high in gold was about $1,807 an ounce while using John Williams Shadow Government Statistics (that measures CPI BEFORE all the government manipulations) showing the inflation-adjusted gold peak at $5,513 an ounce. Just to get back to the real inflation-adjusted high in gold, gold would have to rally 64% to reach the government's CPI adjusted peak and 401% to reach the true inflation-adjusted high in gold. Thus, gold’s recent high is in no way close to the bubble peaks seen during the last secular bull market in gold.
Source: BLS, John Williams Shadow Government Statistics
What is interesting in this cycle is how gold is acting in a post recessionary environment, that is if the recession is indeed over as Mr. Bernanke and most economists are saying. After recessions the flight to safety associated with gold tends to unwind with the 2001 experience being the only exception in post war history until now. As shown below, the path of gold appears to be following the path of 2001 rather than following its typical script of falling in the early part of an expansion.
What Could Derail the Gold Rally Currently?
Perhaps the greatest obstacle that could short circuit the rally in gold in the short term to intermediate picture would be a USD rally. While the trend is still down in the USD Index as evidenced by the 50 day moving average (red) below the 200d moving average (green), there is still a good likelihood for a USD rally as the greenback is oversold, which can lead to a correction in gold and gold stocks.
An oversold condition is a sign of weakness while an overbought condition is a sign of strength, and a prolonged period in oversold territory is something associated with a weak market that fails to rally, which certainly characterizes the USD. While the USD is overdue for a short term rally, we may in fact continue to see the USD slide for the remainder of the year as was the case in 2002 and 2003. Below you can see a chart of the average path of the USD in 2002 and 2003 normalized to 100 at the start of the year. So far the 2009 path of the USD appears to be following quite closely the script seen during the reflationary years of 2002-2003 when the Fed engineered an ultra low interest rate environment and an expanding balance sheet, the same set of circumstances that we see currently.
As the USD remained weak into the later part of 2002 and 2003, gold remained strong and had a sizable year end rally, with gold’s path in 2009 matching closely the average of 2002-2003, with its recent action more accelerated than in 2002-2003, and the same goes for the AMEX Gold Bugs Index.
In summary, the gold bull market could hardly be described as a bubble when one values gold relative to the S&P 500 or even the 30-Yr UST bond, with both indicating that gold could gather anywhere from 44% (relative to bonds) up to 682% (relative to 1980 peak in gold) just to reach prior secular bull market peaks. Moreover, gold is still well below its inflation-adjusted highs and with my PFS Group Intermediate Term and Long Term Gold Indicators at either neutral and or even negative levels, I feel a sizable correction in gold is a small probability. That being said, the USD could easily undergo a small oversold bounce with gold perhaps testing the $1,000 mark before heading higher. But as the 2002-2003 experience shows, we may simply witness the USD slide into the end of the year with gold and precious metals stocks continuing to advance. Given the wealth of bullish information concerning gold, those speculating for a sizable correction in gold and precious metals should tread softly as gold may indeed have a dramatic end of year rally.
© 2009 Chris Puplava