Is Gold in a Bubble?

Over the past five years, gold as represented by the SPDR Gold Trust (GLD 0.31%) is up over 75% on the type of steady march higher that investors dream about, including the roughly 4% sell-off that has occurred over the last three months. I have made no secret of my bullish position on gold, but I have received many questions as to whether gold is, in fact, in a bubble and should be avoided. While there are many typical hallmarks of a bubble scenario, most are not present in the gold market – I hesitate to say none for fear of a barrage of examples. Suffice it to say that I believe the gold market's extended rally remains intact. Below are four classic characteristics of a bubble that are missing when considering gold.

1. A parabolic move higher: If you go back and examine some of the previously celebrated bubbles, one common characteristic of each is that before the end, buying became so frenzied that the asset in question climbed in a nearly vertical path. The flip side of this is that when bubbles burst, particularly in precious metals, the fall tends to be fast and violent. As noted above, gold has cooled over the last three months, meaning it is neither going straight up nor disastrously lower. A reasonable argument can be made that the really dangerous move higher has yet to come – thus excusing this argument from the discussion – but if that is the case, an investment at current levels should still have plenty of upside potential.

2. Disconnect from reality: Perhaps the greatest hallmark of a bubble is the separation that exists between investor sentiment and reality. In the housing market, for example, banks continued to lend because "housing prices cannot go down." From 2007 to 2009, the Case-Shiller Home Price Index imploded from 225 down to 150. The recent decline in the price of gold has been orderly and based on significant data. Last week, the Bureau of Labor Statistics released data that showed jobless claims had hit a five-year low. This is dually negative for gold. On the one hand, it may suggest that the economy is strengthening, meaning that the safety of gold may be less attractive. On the other hand, the Federal Reserve, as a part of the current round of quantitative easing, has made clear that its current actions and policy initiatives are tied to the labor market – the Fed said it would keep rates near zero until unemployment dips below 6.5%. Quantitative easing drives inflation, which in turn is bullish for gold which protects against inflation; if it ends, gold will get hit.

3. Structural breakdown: In the midst of a bubble, any asset even loosely tied to the hysteria begins to trade as if it were the same thing. In the case of gold, you might expect gold miners like Barrick Gold (GOLD 0.71%) to trade in lock-step with GLD. Over the past three months, Barrick is down over 20% relative to the slide of roughly 4% of GLD. Part of the reason for this disconnect is that the recessionary forces of the fiscal cliff and the European debt crisis have been weighing on the economy. The miners are treated with a harsher hand because as operating companies they face these recessionary pressures in ways that the commodities do not. This is a reasonable response by the market that has also taken Goldcorp (GG) and Newmont Mining (NEM 1.22%) down by roughly 20% in the same period. Trading the miners can be tricky because they often behave like stocks yet still have significant sensitivity to commodity prices. As some of these recessionary forces are alleviated, if the upward pressure on gold remains, the miners may outperform in the immediate term.

4. Group think: As you would expect, during a bubble, everyone begins to think alike, including the press and the denizens of the blogosphere. The good news for gold bulls using this metric is that the current news and coverage is fairly balanced, with many questioning if gold's rise has finally run its course. Even some of the large investment houses like Morgan Stanley have lowered their price targets but remain bullish. Joel Crane and Peter Richardson of Morgan Stanley said in a report: "We remain bullish on the gold price outlook in 2013 despite recent selling pressure triggered by market concerns of an earlier-than-previously anticipated tightening in U.S. monetary policy." In terms of the ramifications for a bubble, the diversity of opinion and well-reasoned basis for them suggests gold's rise is not a bubble.

The verdict
While this is not a definitive list of the characteristics of bubbles, it includes many of the most important signs and reasons why gold does not currently qualify. While it is always advised to be prudent when investing in an asset well into a positive run, gold still has plenty of upside. Even with improving stats, the labor market has a long way to go until the Fed lets up on bond buying or releases its stranglehold on rates. These factors should combine to keep inflationary forces in place, which will ultimately drive gold higher.