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Gold Isn't the Big Trend

Alex Dumortier
August 3, 2011

In a December 2009 interview, with gold around $1,150 per ounce, the Bank of Korea's Lee Eung Baek said to Bloomberg:

There's an illusion in gold. We follow the big trend. Gold isn't the trend. Out of more than 200 nations, how many countries have bought bullion? ... [Gold] offers little value.

Since then, the metal has appreciated over 40% against the dollar, and Mr. Lee is no longer responsible for reserve management at the Bank of Korea (in fairness, I don't have any evidence the two are tied). Meanwhile, the central bank's new head of reserve management is singing a different tune, as the bank announced yesterday its first gold purchase since the Asian crisis of 1997 and 1998.

A powerful and long-lasting trend
At 25 tonnes (rough worth: $1.3 billion), the purchase isn't huge for a central bank -- hedge fund Paulson & Co.'s position in the SPDR Gold Shares ETF (NYSE: GLD  ) at the end of March was over three times that size. However, it's indicative of a phenomenon that I highlighted 13 months ago, when I wrote that, "we may be witnessing an important shift in the way central bankers perceive gold, which could become a powerful and long-lasting trend."

In 2009, the "official sector" (banks, sovereign wealth funds, and other government investment vehicles) became a net buyer of gold in for the first time in two decades. Among the buyers that year were Russia, India, and China (the largest manager of foreign exchange reserves in the world). In 2010, European central banks all but halted gold sales, while their counterparts in the emerging markets continued buying the yellow metal.

Goodbye dollar, hello gold!
This year, with Mexico, Russia, and Thailand among gold buyers in the first half, official sector purchases are on target to achieve the largest annual total since 1971, the year in which gold was allowed to float against the dollar.

Is gold attractive here?
With increasing demand from emerging economies that are managing growing pools of reserves, is gold an attractive purchase at these levels? Certainly not, if you're looking for an investment. As I wrote last week, based on a careful analysis of monthly gold prices going back to 1971:

Jeremy Grantham, the chief investment strategist for asset manager GMO and an experienced bubble watcher, defines a bubble as asset prices two standard deviations above the long-term trend (for a normal distribution, that represents roughly the top 2% of values). On that basis, gold is in a bubble in terms of American and Canadian dollars and the South African rand, and is getting close in terms of the Australian dollar.

Even against the Swiss franc -- long considered a safe haven currency -- gold is overpriced by almost 60%.

Anytime you hold an asset that is overpriced, you run the risk of suffering a permanent loss of capital.

For the speculator
Speculating is an entirely different matter. I believe that gold is a bubble, but I also think the bubble hasn't run its course yet. The yellow metal's rise has been pretty orderly to date; there has been no euphoric, frenzied buying that creates a sharp acceleration in prices. During the last gold bubble, the metal rose by two thirds during the first three weeks of January 1980, peaking at an inflation-adjusted price of $2,467.

Spike or stagnation?
I don't know that the current bubble will end with a massive spike in prices followed by a collapse; instead, it could deflate slowly through stagnating prices as inflation catches up. However, given the exceptionally uncertain landscape investors must now navigate and the trend of central bank buying, betting on robust gold price increases looks like a pretty good speculation.

However, let me be clear about my assessment of the risk inherent in buying gold today: I'll define a speculation as an operation in which the adverse outcome could produce a permanent capital loss of at least 50% and stretching until total loss. Gold is a speculation (but if it's any comfort, it'll never