3 Reasons the Gold Bubble Will Burst

Gold is neither an "investment" nor a contrarian play

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After a decade in which stocks went nowhere and the U.S. dollar lost value to every world currency except the Zimbabwean dollar, many Americans are ready to give up on the entire system.  Quite a few already have.

After watching gold more than quadruple in value in the same period, investors might be tempted to wash their hands of financial assets altogether, convert their savings to gold bars, and bury it in their backyards.  But frankly, I cannot fathom a worse idea.

Gold today is as risky as tech stock in 1999 and Miami condos in 2005, and the arguments supporting its rise are every bit as flimsy.  Let’s take a look at some of these arguments and how they stand up to a brief reality check.

Myth #1: Gold is an investment

Let’s start with the very basics.  I would define an investment as an asset that creates value and income over time.  Stocks, bonds, real estate, even livestock and some machinery for businesses would all qualify.   This is in contrast to “speculation,” which is a purchase based purely on the hope of selling at a higher price at some point in the future.

Ben Graham, the mentor of Warren Buffett and father of the investment profession as we know it today, had referred to speculation as the “greater fool” theory. The idea goes, “I know I am a fool to pay such a high price for a stock but I know that a greater fool will come along and pay me an even higher price.”

Graham was speaking of common stocks, but the same argument could be made about condos, Dutch tulip bulbs, or even baseball cards and Beanie Babies.  And it certainly applies to gold.

Gold pays no dividends or interest and produces nothing.  It’s an inert metal that you have to pay to store and insure.  And yes, your ability to profit from it depends on your being able to sell it to someone else at a higher price than what you paid, plus selling commissions and expenses. Is this a bet you’re comfortable making when it has already risen by a factor of four in a matter of years and the trade is looking increasingly crowded?

There is nothing wrong with speculating, of course, if you understand the risk.   The problem comes when you confuse it with investment.  And these days, many folks can’t tell the difference.

Myth #2: Gold is a store of value

Plenty of gold bugs concede the metal is not a traditional “investment,” per se, but argue passionately that its purpose is not speculative.  Instead, it is a store of true value in a world of paper fiat currencies and number games.

Unfortunately, the facts simply do not support this view.

That’s because gold is a great store of value—except when it’s not.   Had you become fed up with the inflation of the Jimmy Carter years and moved your savings to gold in 1980, you would have watched your “store of value” fall by 70% in the two decades that followed.  And this would have happened during a period of persistent (though falling) inflation.

Meanwhile, the raging bull market in gold since 2000 can hardly be considered “stable.”  Sure, no one complains if their purchasing power rises.  But if your stated purpose in buying gold is its role as a store of value, even volatility to the upside should be unsettling.  You can’t just create “value” out of thin air.

For an asset often touted as a “crisis hedge,” gold also performed remarkably poorly during the 2008 meltdown.  Gold went into freefall in September and October 2008 after the Lehman Brothers failure knocked the financial world off its axis.  Not a very effective insurance policy, in my opinion.

Lastly, if protection from the ravages of inflation is so crucial to investors, then why isn’t a piece of productive rental real estate an equally appealing option? Plenty of desperate owners would happily exchange their property for some of that “worthless” green paper. But somehow the idea of buying real estate at depressed prices to hedge against inflation and a plummeting dollar is seen as a fool’s errand, while buying gold at record levels is seen the only safe bet.

It’s easy to point to gold as a store of value when prices are rising. But they won’t rise forever.


Article printed from InvestorPlace Media, http://investorplace.com/2011/06/gold-prices-bubble-investing-gld-etf/.

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