Wednesday, January 18, 2006

Speculative Bubbles and Gold

First of all, that was written 40 years ago, and I was mistaken in part. I expected things that didn’t happen. And, nonetheless, my general view toward the type of gold standard effect remains to this day. My forecast of what was going to happen subsequent to that period has proved, fortunately, wrong. And as I have said to you in the past, we have tried to manage the Federal Reserve over the years, really since October 1979—because, remember, up to that point we were in some very serious inflationary trouble. Since then I think we have been remarkably successful, in my judgment. Alan Greenspan, House Financial Services Committee Q&A Feb 17, 2005, in response to a question by Ron Paul about Greenspan's views on Gold expressed in Gold and Economic Freedon

With the $ price of Gold dropping some $20 over the past few sessions the question, was Gold's recent rally a speculative bubble?, is likely to be a topic of concern. While the question cannot be definitively answered except through the passage of time, in the following paragraphs I'm going to argue that the recent rally was not a "speculative bubble", first by qualifying what the phrase, "speculative bubble" means to me and then examining what I believe to have been previous speculative bubbles in Gold.

The trading maxim of George Soros, find the trend whose premise is false and bet against it, comes to mind as a fine starting point in defining "speculative bubble." The key feature is, as both Soros' maxim and Greenspan's comment above allude, false expectations. In the case of the Nasdaq bubble, the false expectation was that un-or-marginally-profitable companies would nonetheless make money for shareholders. The second element of a speculative bubble is that the false expectation drives capital flows sufficiently to significantly influence the price. That is, there are two features of a speculative bubble, a false premise and a substantial departure from historical price relationships of the asset in question.

In the case of Gold I watch, among other relations, that with crude oil because I don't see the $ becoming a second class currency so long as it is the currency of choice for trading the world's key commodity, oil. When Gold's price in relation to crude is high and rising it seems to me that the cart, the $ collapse trade, is ahead of the horse, the $'s utility as mediator for international commodity exchange, specifically oil.

Since the price of Gold was floated in 1971 there have been a number of Gold price spikes both with respect to US$s and oil. The, in hindsight, false expectation behind some of these spikes is that the US$ would cease to be the world's reserve currency. Most followers of Gold are familiar with the Watergate inspired fears of a $ collapse in late '74 that took Gold above $200 and the now infamous, at least in Gold Bug circles, early 1980 spike that took Gold above $800.

In both of these cases, the ratio of oil to Gold rose dramatically, in late '74 exceeding 40 barrels of oil per ounce of Gold and in early '80 exceeding 23 barrels of oil per ounce of Gold. For reference purposes, the Bretton Woods era ratio was roughly 19. The lesson I take from this is that it seems a silly bet to assume that the US$ is failing as a reserve currency when oil exporters are willing to exchange oil for it. Thus when the Gold/oil ratio is high (above 20) and rising, and investors are piling into Gold as a safe haven in the event of a $ collapse, as in '74 and '80, history teaches us that this bet is riding on a false premise.

This measure also rationalizes the failed break-outs during the '87 through '90 phase when the US was unwinding the 80s equity and then real estate bubbles. During this entire period the Gold/oil ratio was well above 20, in some moths spiking to 30 barrels of oil per ounce of Gold. I remember trading during that period and fears of a US economic and by extension US$ collapse were quite real, if, in hindsight, unfounded at the time.

As Greenspan's response to Ron Paul above suggests, he and many others had assumed that the US$ would collapse and when it didn't they felt they learned something new. In Greenspan's case I think he "learned" that a fiat currency regime could work. I would argue that they were just early to the game. The US, at least with respect to external accounts was in far better financial shape in the 70s than it is now
, i.e. it could finance itself.

And it is now that concerns us here. Currently, the Gold/oil ratio is just under 10 which is quite low historically. This tells me that, unlike past periods of $ system stress, few, measured in terms of $s committed, are running for the golden exit door, despite the rise in the $ price of Gold. Yet, it is only now that one could justifiably, at least as I see things, consider the US a financial banana republic. In other words, despite the deterioration in US external account balances, Gold is still trading by my metrics as if the US$ based system was just fine.

Given the continued deterioration in external accounts, and lack of policy response, so long as oil prices remain high, suggesting stress in the US$'s role
mediator for international commodity exchange, while the ratio of Gold to oil stays under 15, I wouldn't consider Gold a speculative vehicle at all but rather a low risk investment.

I'm not arguing that Gold will rally $20 tomorrow, next week or next month, this isn't a short term trading recommendation. I'm merely arguing, to the extent I've correctly identified some of the features of previous Gold speculative bubble tops, that this doesn't qualify.


Stranger said...


A few items to consider:

Assuming 1) gold and oil are finite, 2) oil is used up whilst gold is stored, 3) oil remains the basis for the modern life which 2.3 billion new competitors would like to participate in, and 4) some day cheaply produced and easily found oil may peak globally, i.e. Peak Oil is true, then in the fullness of time, regardless of the faith in the Dollar or other fiat currencies, the gold/oil ratio will further and further deviate from its historical norm.

Also, oil has enjoyed expanding demand for over a century. During that same period, the world went from 100% of its currencies being backed by gold, to 0%. During that process, many other factors have led to a general decline in investment/monetary demand for gold by many westerners. The world is awash in paper money, and very little of it has found its way to gold, when compared to financial assets and property. There is a tidal wave of paper money that will eventually hit precious metals.

I would thus agree that gold is very cheap in real terms (and a much stronger argument could be made for silver) but I would suggest that, if the peak oil arguments are true, the gold/oil ratio may be in for a never ending deviation from the long term trend. Hence watching the gold/oil ratio may not be very helpful.

Dude said...


I won't argue against the view that the thing to be long is oil, but as I don't own a well I'll settle for Gold.

My point was not that I expect the Gold/oil ratio to rise. Indeed, if I saw a rise back above 15-20 I would begin to think, barring the death throes of a Weimar style hyper-inflationary collapse, the cart was once again getting ahead of the horse.

Within the current exchange rate paradigm, so long as the ratio is stable or falling while oil is setting new records, Gold seems a good place for me to be.

All price relations are only as good or as bad as the inference(s) one draws from them. In this case, the inference I draw is that unlike other periods of Gold price appreciation over the past 30 years, this time, oil is truly leading the way, which I believe suggests that the $'s days as mediator of international oil exchange are limited.

Yes, I also own silver.