Gold, and Why So Many Investors Fall for Bubbles

Gold, the asset investors bought to protect their wealth, is down 36% in the last two years. The popular SPDR Gold Trust ETF (NYSEMKT: GLD  ) is down 21% in the last three months alone. What happened?

Business Insider obtained a letter to investors from a fund manager whose fund lost almost 70% in the second quarter -- ostensibly because of heavy exposure to the metal. The manager explained why he missed the plunge:

Here is the problem. The oldest daily gold stock index started in December 1983. If you look at the older, weekly gold stock data, which starts in December 1938, there were plenty of instances when the 1-month RSI readings went lower than February 20 and gold stocks continued to go lower.

While one may think that 29 years would produce enough data to make for a robust indicator, the problem is commodities have 30 year cycles. The last major commodity top was in 1980. So the 1983 data does not even cover a full commodity cycle. While this seems obvious in retrospect, it did not become glaring obvious that something was amiss until the precious metals complex crashed in mid-April ...

In summary, there were many indicators based on 1983 data in February, March and early April that were at all-time extremes. This made the risk look negligible. However, the 1938 data does not give up "all-time" extremes so easily. The next time around the oldest available data will be utilized. 

Simple stuff, really. The manager relied on a truncated set of historical data that left out the last bear market to convince him that, historically, gold does really well. Now he's looking at a longer set of historical data and realizing otherwise.

Haven't we seen this before?

Yes. Relying on incomplete data to influence long-term views is also what took down stock investors in 2000, real estate investors in 2006, and Wall Street traders in 2008. Every bubble, basically.

Take this quote from Maggie Mahar's book "Bull!", describing stock investors' perception of market history in the 1990s: 

Sometimes a magazine would print what looked like a lengthy timeline unfolding across the bottom of two pages. But closer inspection would reveal that it tracked the market for, perhaps, three years. Occasionally, a story included a chart that looked back to the sixties, but for the most part, a timeline meant to show the market's history went no further back than 1982 -- leaving the bull market in splendid isolation.

Or this, from former Fed chairman Alan Greenspan on what took Wall Street down:

The data input into the risk-management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.

Or this explanation of why a Wall Street risk metric called value at risk (VAR) missed the financial crisis:

All the triple-A-rated mortgage-backed securities churned out by Wall Street firms and that turned out to be little more than junk? VaR didn't see the risk because it generally relied on a two-year data history.

Or this, from testimony by Deven Sharma of Standard & Poor's explaining to Congress why the rating agencies missed the housing bubble:

While we performed analysis in good faith, events have shown that the historical data we used in our analysis significantly underestimated the severity of what subsequently occurred.

During every bubble, investors truncate historical data to build a model that shows them exactly what they want to see: low risk and big returns. You can't blame them. As Nate Silver once wrote, "Human beings have an extraordinary capacity to ignore risks that threaten their livelihood, as though this will make them go away." When you want to believe something, you'll do what is necessary to convince yourself that it's true. Like ignoring historical data that gets in the way.

There's a simpler explanation for what's going on in gold. For years, we had 2% inflation and 20%-plus surges in the price of gold. Now those figures are reverting back toward each other. Which is what a long look at history tells us they were bound to do.

To paraphrase Mark Twain's saying: History doesn't repeat itself, but it rhymes.

Read/Post Comments (7) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 05, 2013, at 4:42 PM, SkepikI wrote:

    Morgan- a pretty good article, and in the interests of brevity, reasonably complete. However, its worth pointing out that numerous other signs of bubble territory have been present: 1. scads of scammers playing on "get rich with gold", more artfully framed, of course, just like "get rich flipping houses".

    2. Every Tom Dick and Harry coming out of the woodwork to sell their jewelry, old coins, silver plate, nuggets etc etc. 3. Dozens of new business predicated on no experience, unique treatment of gold and silver assets and the inevitable rising prices that YOU can capitalize on using their proprietary wining formula.

    And, I could go on. No doubt you could too. The Madness of Crowds.

    Next up Bond Flood.

  • Report this Comment On July 05, 2013, at 4:47 PM, SkepikI wrote:

    Oh, and the inevitable "This time its Different because..." (insert your favorite current event from the Fed is running the printing press to mars and Jupiter are in ascension with Polaris declining...)

  • Report this Comment On July 06, 2013, at 12:48 PM, xetn wrote:

    Sorry Morgan, but citing info about paper gold (GLD etc.) is totally different that physical gold. The assault on gold (and other pms) have been of the paper variety.

    However, the physical side has seen massive increases in purchases to the extent that there are instances where demand is far outstripping supply. That has resulted in increases in premiums.

    By the way, there is very little evidence of a bubble in gold as detailed in:

  • Report this Comment On July 06, 2013, at 3:03 PM, ershler wrote:


    It appears to me your chart shows gold is as bad as buying stocks in 1929.

  • Report this Comment On July 06, 2013, at 3:33 PM, johndog19 wrote:

    I don't know how to read that bubble chart. A lot of those in the chart are companies that crashed in value because their fundamentals broke, not (just) because they were overvalued, and I have no idea if the percentages take that into account... or inflation, or anything else, like the value of physical vs paper gold.

    I also don't get the paper vs physical gold thing. Anyone who is arguing that we should back currency with physical gold should see that all of these securities that are essentially backed by gold appear to be much less stable in value than fiat currency. Or at least these same people should make a cogent argument why currency backed in gold with is different than so-called paper gold. What happens to our gold-backed currency when people's/nation's interests whimsically flock to/from gold? You either have unstable currency, or you have a fed agency that uses monetary policy to manage the value of the currency, which I thought was the supposed problem with fiat to begin with.

    Apart from the gold standard issue, I don't hear anyone arguing we should carry gold minted coins on our person. I suppose there is potential value in keeping some gold nuggets on your person in case the dollar completely collapses... you can trade it for a few months of gasoline, maybe. I wouldn't keep it at the bank, though, you may never get it back, or actually even have it. And the rules that govern the way banks need to manage their gold inventory might change, which could pop a "bubble" in the physical medium, too.

    Being the case, I'm not sure that the distinction between paper and physical gold is of much practical use, except to say that gold is not a great fiscal investment, but it *is* a great thing to stock in your personal fallout shelter next to guns, canned food and lots of water.

  • Report this Comment On July 06, 2013, at 7:57 PM, Shawnerz wrote:

    Usually Morgan, I agree with you, but on this one I don't. To me, saying that there is some cosmic multi-decade cycle that influences gold prices is small 'f' foolish. From what I've seen, the changes are much more shorter and the variables are influenced my shorter term events.

    I believe you quoted Mr. Buffett in saying that gold is only worth what someone else is willing to pay for it. My opinion is that this decline is due to everybody buying, holding for 2 or 5 years, seeing that there wasn't much of a return, then selling.

    My $.02.

  • Report this Comment On July 07, 2013, at 11:45 AM, gkirkmf wrote:

    My thought is that the price of gold has a lot to do with three things... resource scarcity, cost of production and demand. On the cost side, I have seen cost of production figures of around $700 per oz for gold currently. On the demand side, India and China continue to buy gold despite the hedge funds and banks clearing their positions. On the scarcity side, it's relative abundance to other metals is low. For these reasons gold is higher than $700 per oz.

    Compare it to another metal... Aluminum... It is abundant over the entire earth, it's cost of production have remained relatively constant, as had demand for the the metal. This is reflected in the price of a ton now vs. a ton 30 years ago. If you figure an inflation rate of 1%, you have the difference between now and then.

    What does this say about gold? Well, for those who own gold for the long term as a hedge, who bought it when inflation was the main driver of it's cost, the price of gold currently is just fine. For those who bought during the irrational demand period, they may have a looser if sold now. If you remember that gold and other commodities a good place to stash your LONG term cash and you buy at "reasonable" prices you will accomplish your goal.

    If you have room in a storage shed or barn, take delivery on a few tons of aluminum or nickle. Either are good inflation hedges, and are relatively stable price wise compared with gold... For the rest of us, storing gold, or better yet... buying GLD is probably more convenient.

Add your comment.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2522730, ~/Articles/ArticleHandler.aspx, 9/26/2016 7:04:34 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 2 days ago Sponsored by:
DOW 18,261.45 -131.01 -0.71%
S&P 500 2,164.69 -12.49 -0.57%
NASD 5,305.75 -33.78 -0.63%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

9/23/2016 4:00 PM
GLD $127.65 Up +0.08 +0.06%
SPDR Gold Trust CAPS Rating: **