Gold has been the universal symbol of wealth since the dawn of civilization and there's no reason to believe this will ever change. It was also used to back up the earliest monetary and banking systems. (For more on gold, check out The Gold Standard Revisited.)

TUTORIAL: Commodities

The purpose of this article is to explore the allure of gold and what has been pushing prices higher. In the interest of full disclosure, I own physical gold. I bought it several years ago when I began to fear the consequences of the giant asset and debt bubbles that were building in the U.S. As a result, I follow the news and price movements of gold every day. Do your own research and consult with financial experts before making any investments.

Recent bubbles
As gold has risen in value, there have been the inevitable comparisons to past asset bubbles that eventually imploded. Here are a few recent examples:

  • During the Great Depression, the Dow Jones Industrial Average dropped almost 90% during the period September 1929 to July 1932.
  • During the Japan economic bubble in the 1980s, easy credit and soaring leverage fueled speculation in real estate and the stock market. During the "lost decade" of the 1990s, the Nikkei sank 80% and real estate values plummeted over 90%.
  • The "dot-com" implosion of 2000-2002 caused the technology-laden NASDAQ stock index to lose almost 80% of its value.
  • The U.S. housing collapse started in 2006 in most parts of the country, resulting in a 30% overall decline to date.

Gold bubble?
Most bubbles start completely unnoticed, but pick up steam under what is known as the "greater fool" theory. This occurs when new buyers jump in only because prices are rising, not because they think the asset is actually worth more than it was yesterday. They are willing to pay higher and higher prices because they believe they will always be able to sell later on to someone willing to pay an even higher price - the greater fool. Real estate flippers depended on a never-ending supply of such fools. So did the investors who bought Internet stocks in 1999.

While it's easy to conclude that gold is now in bubble mode, the real question is whether or not the recent price action is based on more than pure speculation. Here are some possible considerations:

  • Gold is still well below its January 1980 inflation-adjusted high of about $2,400, making some believe it still has plenty of room to run.
  • The Federal Reserve is printing money (aka quantitative easing) to cause inflation (or avoid deflation). If this monetary policy continues, the long-term effect is likely to be high inflation and rising commodity prices.
  • The supply of gold is limited and more can't be created out of thin air.
  • Several European countries are in severe financial stress, and there are few signs that enough structural changes are in place to put them on a sound footing. The U.S. is heading down the same path.
  • The U.S. economy is currently being propped up by $1.5 trillion of annual debt, accounting for 10% of GDP. Subtract that debt, and there has been no GDP growth in the past four years. That debt is paying for about 7,000,000 jobs that would disappear overnight if the budget had to be balanced.
  • Twice in the last 100 years (1933 and 1980), the ratio of the Dow to the price of gold approached 1/1. Some believe we are on a path to parity once again, with gold rising and the Dow falling until they meet somewhere in between. (For more reasons to add gold to your portfolio, see 8 Reasons To Own Gold.)

While gold is used in jewelry, ornamentation and limited industrial purposes, most of the current demand is being driven by governments, central banks, mutual funds and individual investors. These investors don't really need gold, but rather see it as a hedge against inflation, famines, wars and natural disasters. Some think of gold as insurance rather than an investment, as it provides no income stream and requires secure storage.

While bubbles are often driven by emotion, the rise in gold may be tied to a rational assessment of the world economy. Growth has stalled, debts are rising, and many western nations have promised far more government services than they can now deliver. Without significant structural changes and spending cuts, the only way the U.S. can continue to provide those services is to borrow and print more money. That spells higher inflation, a weakening of the dollar and more attraction to hard assets.

If gold is in a bubble, could it be different this time? The term "bubble" implies there is no logical or defendable reason why prices have risen, and that buyers are piling on simply because they are afraid the train is about to leave the station. People have a reason to fear fiat currencies that are backed by nothing other than faith, and many view gold as a safe haven. It's not so much that they are betting in favor of gold as they are betting against other asset classes. In addition, there is no shortage of uncertainty about the future economic health of Europe and the U.S.

Bottom line
What would the world look like with gold at $5,000? Most likely it would mean that we are in a period of extreme economic upheaval and possibly world chaos. So hoping for gold to rise is really a two-edged sword.

On August 24, 2011, gold was trading around $150 below its recent high. The last time gold had a pullback of that magnitude, it was a buying opportunity. Is another buying opportunity unfolding now, or is this just the start of the crash that many have predicted?

To buy or not to buy. To sell or not to sell. Unless you are a day- or swing-trader, the advice I hear most often is to think long-term and diversify. Hard assets should be a part of every portfolio depending on your risk tolerance and stage of life. Nothing goes straight up, so I view any substantial pullbacks as buying opportunities. I will probably continue to think that way until we start closing in on $2,400, or a miracle happens and financial discipline becomes a reality. (To learn more, check out 5 Signs Gold Has Peaked.)

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