Thursday, April 28, 2011

How To Spot Gold Mania Cracking Apart

The author of this piece is far from being a gold skeptic: he's been in gold for about ten years. He reassures us that gold is far from being in a bubble right now, because it's underowned relative to housing in 2005 and tech stocks in 1999. But, gold's heading that way. Here's what to watch for:
Try starting up a conversation with your neighbor about the best silver stocks in the world... or why the geology of Nevada has made it such a prolific gold producer. Ask your personal trainer what the best places to store physical gold are. Chances are excellent you'll get a bunch of odd looks. They'll want to turn the conversation to baseball or the weather.

We'll know we're in the midst of a real gold and silver bubble when we can have those conversations at will. Or when, as my colleague Jeff Clark of Casey Research has pointed out, Silver Wheaton is a market darling... instead of a stock you occasionally hear about from "fringe" publications like DailyWealth.

In the gold bubble, we'll be able to ask any cab driver which gold stock he likes and get a quick reply. "Goldcorp," one will say. "It has the lowest cash costs and great growth prospects."
Or, even more alarmingly, a cab driver says "XYZ Exploration. Its drill results were so hot, it's guaranteed to build a mine!"

Pre-bubble investments are tricky except for those who like to hold on out of faith. To be frank, faith pays off when an investment's about to move into a bubble. The blockage to full bubble status comes from the investment's nosebleed level when compared to historical norms. That makes the ones who were there from the early days nervous. I remember a fellow who bought a lot of gold, from 2000 on up, selling in early 2009, when gold was around $900, because he thought gold wouldn't crack four digits. It's easy to smile in retrospect, but this guy was used to gold being much lower. $300 was a bargain. So was $500. $700? Not so much. The bulk of his accumulation was undertaken when forecats of $1,000 gold were mostly seen as absurd.

The tip-off towards a bubble approaches when an investment stays at nosebleed values long enough to assure people that there's not much risk at those high prices. Typically, these people are late entrants who hadn't heard about the investment until late in the bull market. For gold, this would be the new goldbug that got in because George Soros and John Paulson did. For the first crop of these people, $900 didn't seem that high. They didn't remember gold scraping along at $250-$300.

Those new goldbugs, if they held on, are sitting on substantial and fairly quick profits. They're also in a minority. The average Joe has heard about gold, but hasn't pulled the trigger - perhaps because gold looks so high and inflation isn't much of a problem right now.

It's those people that turn a third-stage bull market into a mania once they pile in: the cabdriver and personal trainer.

Faith comes into play when a bull market transitions from its first to second stages, not just from second to third. The first-stage investor gets in because the investment's a bargain, and gets jittery when the investment rises above fair value. The second-stage investor gets in for growth reasons, and gets jittery when the investment becomes overvalued even by generous growth metrics. The third-stage investor gets in when the investment looks like a sure thing, largely becasue even rational skeptics have been throughly discredited as boys who've cried wolf too many times.

With respect to gold, the first stage covers the time when it was undervalued as a commodity. The second-stage growth story is rooted in global inflation, Asian demand and central-bank buying. Transitions between stages can be seen when the air is thick with cries of "bubble," as was the case when gold was at $650 in '06. The third stage is usually an exaggeration of the second-stage growth story with a kicker. The kicker in this case would be developed-world inflation taking off, with a plausible rationale explaining why central banks won't do anything about it.

Right now, gold's transitioning to the third-stage blow-off. I wouldn't be surprised to see second-stage goldbugs get jittery right now, except for the ones waiting for the blow-off. In this kind of transition time, faith helps. Needless to say, the first-stage goldbugs who've held on are getting jittery.

The trouble with faith is, it hurts terribly once the blow-off is complete. One of the lethal side effects of faith, which enables people to shrug off false alarm bells, is it encourages people to shrug off real alarms that were obvious in retrospect. An example would be the Fed finally raising rates enough to make for a 3% real return, or the U.S. Congress implementing a real budget-trimming plan. In mania times, these turning points are laughed off as insincere or politically unsustainable. Mainstream goldbugs didn't realize that Volcker was serious until 1982, when it was too late for gold.

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