Commodities, Gold and Bubbles

I've been getting increasingly annoyed with the mindless drivel that passes for market commentary whenever gold and market bubbles are discussed. It seems that commentators and other market pundits gleefully declare that gold, housing, or whatever is in a bubble, ready to explode higher or ready to crash. You can usually find this in nearly any random set of articles on gold. The only thing consistent across all these pronouncements is their unwavering (and often pugnacious) certainty in their position. Whether they truly believe what they're saying is another matter.

Despite all the noise, the question does matter: what is gold, or any commodity for that matter, going to do, and how should one invest for maximum benefit and lowest risk? I don't claim to know the answer although I do invest in commodities, including the gold sector, and I won't promote any particular view. Instead I think it is useful to review just what it means to talk about bubbles in the context of the commodities market.

Many investors like investing in commodities since they are generally less subject to the intricacies of business and consumer dynamics. These include: fads, competitive offerings, mismanagement and turnaround artists, pricing uncertainties and so forth. In other words, unless you have your hand on the pulse of a specific industry there is a perception of additional risk when investing in typical businesses that produce goods and services. I doubt whether this is true, but that's another story.

Accepting this assumption, we can talk about the three general classes of price movements: cyclic, secular and bubble (a crash is nothing more than an inverse bubble). Commodities are generally seen to be a cyclic, where the cycle time can be a decade or more and mirrors the cycle of recession and growth phases in the broader economy. In other words, if the economy is expanding, commodity prices tend to ascend, and decline during recessions.

In the adjacent fictional cyclic and secular charts I show lines for the (long-term) median and price bounds within which the price can be found 95% of the time. When a cyclic commodity makes a secular change, it simply moves to a different median; it's shown as going higher, but it could also go lower, and not necessarily outside the old cycle's 95% bounds. A bubble is very different, in that it's a one-shot affair with no cyclical behaviour, and the final median after the bubble could end up anywhere, including below the pre-bubble median.

Now take a look at the US$-denominated gold ETF for the past 5 years. Which of the three charts does it most resemble? Can you tell? No? Well, neither can I. The lesson is that textbook charts are best left in textbooks and are not to be trusted. However, beyond that simple retort, there are a few things to consider in how a real commodity chart differs from the ideal, due to, in part: time-frame, price bias, and cycle time.

Commodity cycles of more than a few years mean little to me since I don't hold anything that long. There are other cycles of shorter duration that are more important to my investing. This is possible since there is more than one cycle superposed on any one chart, and so it can be helpful to distinguish among them. If you do have a longer time-frame in mind, go ahead and ignore the shorter cycles, including those of several hours duration! Outside factors such as currency exchange rates and inflation give the median and bounds of a cycle a bias in an up or down direction, and they too vary over time, although their cumulative effect is usually upward.

Ultimately, what we see in these charts is more noise than signal, and that is true of pretty much any price chart of interest to investors. The larger trends are only visible in retrospect and by smoothing out the fluctuations within which, in most cases, we buy and sell.

To finish off this article, let's look at what happens when price approaches the upper 95% line. In a cycle you expect that the price will soon drop -- not necessarily soon -- since the price excursion is extreme and there will be a reversion to the mean. However, if it is a secular move, or even a bubble, betting on the cycle continuing is a mistake. Except you cannot know which it will be -- that's the dilemma. Look at the smaller fluctuations shown in the highlighted area. If you are buying or selling at that time, what are you and every other market participant thinking? Everyone has their own projection of what will happen, perhaps very strong convictions, except that you cannot possibly which way the price will break.

None of this tells us which way gold will go, and that is as it must be. Those price quotes are nothing more than the measure of the psychology and outlook among millions of people, including you and me. They include long-term investors, sector funds, speculators and professionals using gold as a hedging instrument. Amateur or professional, none of us can predict the future with certainty, therefore be skeptical of pundits and headlines and proceed with caution.