Gold Bubble – Thin end of a Wedge

August 26, 2011   ·   0 Comments

Rising prices of Gold has enslaved the markets today. Without having a clue on the World economy & where stock markets are headed , everyone seems to have a conviction that Gold has a unidirectional way of moving which is up. Is it the beginning of the Gold bubble or is it gold really worth buying at these levels?

www.stockssavvy.comStock markets were never considered such picayune in the last 3 years as of today. Brokerage houses are feeling the heat with the lowest turnovers in this period. Everyone seems gung-ho on the commodities especially Gold. After reporting consistent gains for the past 10 years, gold continues to be the best performing asset this year as well. The year-to-date return is a whopping 35% as the price of gold touched an all-time high of Rs 27,840 per 10 gm. While new investors and speculators are rushing to benefit from this ‘golden harvest’, seasoned players have already started raising an alarm.

Last Bull Run in the Gold

www.stockssavvy.comGold Bull Run started in 1970 climbing to $835 in 1980, completing a bull cycle that started at $34.95 in 1970. Now if we go back in the history, in the year 1976-81, gold had a dream bull run. From $100 per ounce in 1976, it had gone as high as $850 per ounce. That rise took place as people feared that US economy would collapse and $ would have no value. That time, US was in war with Vietnam & then came Iranian Revolution – inflation in US was at very high levels and in a way, there was hyper-inflation.

Once the war was over and inflation eased out, Gold came crashing down. Gold had crashed to $260 an ounce (nearly 69%) after hitting a peak of $850 in 1980.  In the year 1990, it was $400 per ounce and in the year 2000, it was close to $250 per ounce. That means the effect of bubble was so big that even in 20 years, the gold could not recover its original price and was languishing at less than 1/3 of its peak price.

Bull cycle of Gold is of around 64 years. Price of gold in 1865 is same as that was in 1930. As the cycle is long, the corrections are deep & are time corrective rather than price correction.

What is triggering the gold rally this time?

Here’s a look at some crises that are driving the gold market now.

  • Currency crisis:

As two major economic blocks (US & Europe) suffer problems, central bankers of several countries have started losing faith in their reserve currencies and have decided to buy gold as an alternative. For instance, in July, Thailand, South Korea and Kazakhstan added gold valued at $2.56 billion to their reserves.

  • No Stable alternative Paper Currency

Gold is a recognized international currency and currently Dollar is the most recognized Paper Currency. With Euro & Pound are also dubious, investors are finding it safe to invest in Gold.

  • US crisis:

One of the causes has been the downgrading of the US sovereign debt to AA+ from AAA, a rating it had held for the past 70 years. The effort by the US government to support the faltering economy is another reason. For instance, rising interest rates usually lead investors away from gold. However, the decision by the US Federal Reserve to leave interest rates close to zero for two more years will boost the gold market.

  • Euro crisis:

Several European countries, such as Portugal, Ireland, Greece, Spain and Italy, may be forced to default in the short to medium term. Their efforts to reduce spending and increase taxes are being hampered by a faltering Eurozone economy, which grew by just 0.2% in the second quarter, its worst performance after emerging from the recession in 2009. There are also concerns about the ability and willingness of relatively stronger countries, such as Germany and France, to support the troubled ones.

  • Falling consumption demand

While the investment demand is shooting up (holdings in exchange-traded products backed by gold rose to a new record of 2,217 tonnes on 8 August), the consumption (jewellery) demand is on the wane. According to the recently released World Gold Council report, the global gold demand in the second quarter of 2011 came down by 17% y-o-y to 919.8 tonnes still fall in consumption is not enough to cool of the Gold price.

Gold in terms of Currency (Dollar & Rupee)

www.stockssavvy.comIn terms of Dollar, Gold has risen from 850 $ in 1980 to 1900 $ in 2011 giving a rise of only 2.2 times. In this time, dollar value has depreciated due to inflation. Adjusting dollar value from 1980 to 2011, 850$ is projected around 2400 $ which means if one has invested in Dollar in this perios rather than investing in Gold, he would have yielded much better return.

In terms of Rupees, In the year 1980, $1 was equal to Rs.8 and today as we are writing this article, $1 = Rs.46. Dollar has appreciated more than 5½ times in last 30 years. In the year 1991, there was a time, when Indian government was literally bankrupt and they had to devalue INR more than 25% in just a single day, just to repay the debt we had. That was the time, India was liberalized and government opened their economy and allowed foreign companies to do businesses. Since then, India has grown dramatically. The fact of the matter is that in the year 1991, sensex was close to 1000 and today it is at 16000 after hitting a top of 22,000

Gold was Rs.1450/- in the year 1980 and today it is Rs.27,000/- after hitting a high of 29,000. The rise of 18.5 times in last 30 years @ 10.5 % p.a. But 5½ times of such rise is on account for Rupee depreciation in terms of dollar. So if we were to analyses the rise in gold price in relation to rupee alone without taking dollar factor, it is shocking only 3.37 times. Just in comparison with Sensex, Sensex has given more than 17% p.a. returns since inception & the Mutual Funds has given a return of more than 25% p.a. which started around 14 years back.

Way Ahead for Gold:

In 1980, gold climbed to $835, completing a bull cycle that started at $34.95 in 1970. According to Wang, analyst of Reuters told that that cycle was corrective, made of three small waves labeled as “a-b-c”, and the wave “c” traveled 4.618 times the length of the wave “a”.

“That ratio may repeat under the present scenario, indicating gold could hit about $4,000 over the next few years”. But he cautioned that it was too aggressive to target $4,000 right now, saying he would rather target $2,345 by the end of this year, which is the 261.8 percent Fibonacci projection level of the current wave “C”, based on his wave count and a Fibonacci projection analysis.
The wave “C” is composed of five small waves, with the current rally labeled as a wave “V”, the final stage of a five-wave cycle

The final stage is often the fiercest rally in a commodities market, as seen in the sharp rise over the past several weeks, he said. Spot gold prices could rise further towards the 1980’s inflation-adjusted record price of just below $2,400.

But can Indian investor investing in gold benefit tracking gold price in terms of Dollar?

  1. If dollar in comparison to INR were to stay at the same level of 45-46, then there is a likelihood that gold may rise further.
  2. If Rupee Strengthens i.e. dollar flows to India by way of FDI, FII etc continues, rupee would strengthen and that would mean that even if gold were to rise in dollar terms, it will still decline in rupee terms. In fact, as it happened from 1980 to 2000 that gold kept going down in dollar terms but since the rupee was depreciating in dollar terms, the gold kept rising in Rupee terms. The reverse can happen now and gold may decline in rupee terms.
  3. If Dollar weakens which it can as FED is printing dollars in the form of QE1 then QE2 & now QE3 to pay their debts & even if gold keep rising in term of Dollar, it will not rise in terms of Rupees. In the year 2007, dollar had depreciated to as low as Rs.37 after QE1.

Correlation will be

Gold price (In Rs.) is directly proportional to Dollar Strengthening, Gold price(in $)  & inversely proportional to Indian Rupee Strengthening.

It is believed that a bubble formation can be only formed if the assets breaks its previous lows which for gold is believed to be around 2400 $ (dollar adjusted price from 1980) which still gives a belief that there could be some steam left in the bubble formation. The only thing we will urge readers to keep in mind nothing in this world is unidirectional. Bull markets are bound to have correction may it be Equity or Gold.

People believed in 2007-08 that real estate prices can only go up which led to massive recession due to failure of real estate companies & Banks. It is hard to imagine the catastrophe of a recession formed due to gold which will be much more severe than recession before as Gold price are directly related to printing money for any sovereign.

Rajesh Singla

Rajesh is the founder & CEO of Stockssavvy, Stocks analyst,financial advisor by choice,software engineer by fate,biker,gamer,cricket lover n enthusiastic person. He believes in doing things not just to get by but to get Ahead...

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