11/12/2009: For a true goldbug, gold is not expensive yet

According to Warren Buffet, “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” Gold’s main role is as a store value, so it needs to be scarce. And it is: all the gold produced throughout history could fit into a cube 25 meters a side, which is roughly a third the volume of the Arc de Triomphe or the Washington Monument.

Demand ultimately sets the price for gold and market sentiment is the principal driver—the darker the economic mood, the higher gold price. And once in a while, gold can embark on a sentimental journey that truly has a life of its own, untethered from fundamentals and common sense. Yes, even one of nature’s heaviest substances can form a bubble.

The last time a real gold bubble inflated was in January 1980, when it hit 850 US dollars per ounce and delivered a 100% annual return for 1978 and 1979. Despite setting a new all-time record recently at 1,064 US dollars an ounce, gold is still far away from matching that thirty-year-old bubble. Considering the purchasing power of 850 US dollars in January 1980, an ounce of gold would have to sell for roughly 2,360 US dollars to equal 1980’s punch, another 120% from its current levels.

While this comparison is certainly a useful one, we can even dig deeper by looking at an equilibrium value for gold. A word of caution first: unfortunately, unlike dividend discount models for equities, or purchasing power parity models for currencies, there is no universally accepted equilibrium model for gold.

But several economists have come up with an intriguing approach to modeling gold’s value: consider, they propose, the price gold would carry if US gold reserves were to cover completely America’s monetary base, i.e. all the dollars in public circulation and in commercial banks’ deposits with the Fed. The US possesses some 261.5 million ounces of gold and its monetary base is about 1.78 trillion US dollars. To back this base completely, the price of gold would have to reach 6,790 US dollar per ounce. Interestingly, at the time of the last bubble, at 850 US dollar an ounce in 1980, gold actually covered the US monetary base one–and-a-half times! To reach that dimension of coverage today, gold would have to ascend to a whopping 10,185 US dollar an ounce.

There is one caveat to this approach, of course: it is simply too US-centric. In the late 1970s, even in the aftermath of the Bretton Woods breakup, the old model still applied: every currency was backed by the US dollar and the dollar backed by gold. Today, the US monetary base is dwarfed by the size of foreign exchange reserves worldwide, so it might make more sense to take a global view in assessing gold’s fair value.

But first fasten you seatbelts because if global FX reserves were to be backed by gold, gold’s price would have to reach 8,830 US dollars an ounce. Shifting up a gear, in January 1980, at the peak of the gold bubble, global gold reserves covered the global exchange reserves two and a half times. Duplicating this today would lead to a gold price at a staggering 22,075 US dollars an ounce!

Needless to say, these numbers are neither forecasts nor price targets. However, we think they do put the current gold price in a useful context. If we are in a gold bubble, then we are still in an early stage.

10/12/2009: Crisis' tipping point

Pop sociologist and bestselling author Malcolm Gladwell coined the phrase "tipping point," referring to that instant when momentum for change becomes unstoppable. With the publication of the surprisingly positive US labor market report for November, on 4 December, we just might have reached such a moment.

A first interpretation might consider the report a business-cycle tipping point. The cheering labor data at least hints at a definitive end to the US recession, although cautious economists would need to see confirmation of such a judgment in December’s data.

However, the real tipping point wasn’t the labor market report at all, but the market’s reaction to it. One of the most striking features of the financial crisis was the high correlation among all kinds of assets. With the exception of government bonds and cash, supposedly unrelated performers behaved like synchronized swimmers as they headed for the bottom in 2008. In 2009 this high correlation continued, especially after March, as every investment, including even government bonds, delivered decent to outstanding returns.

This unusual collective behavior did not reflect portfolio shifts. Rather, it was surely due to the immense amount of liquidity that central banks worldwide injected into the economy to counter the credit crunch. This money flowed into almost every asset class, lifting the prices for bonds, commodities and equities. The only real loser this year has been the US dollar, which, given the negligible US interest rates, has taken over from the Japanese yen as the darling funding currency for carry trades.

But after US labor market report, we think the market is finally differentiating again, for the first time since March: equities increased in sync with a strengthening US dollar, while both bonds and gold lost some ground. This is, historically, a normal market reaction when participants start to believe in a recovery.

While it is too early for an all-clear signal, both the US labor statistics for November and the market’s reaction can be seen as the first signs since the crisis hit that the economy is truly mending. This would obviously be a solid basis for 2010.

03/12/2009: Skyscrapers' omen

There’s an old adage that only a fool builds a house upon sand. We could modernize this by saying it’s foolish to build a skyscraper upon a bubble of credit. Indeed, looking at the history of financial crises over the past hundred and fifty years, building heights offer a rather good indicator of economic excess.

Let’s look at the record. The first skyscraper to rise above 100 meters, the now demolished Manhattan Life Insurance Building in New York, was built in the middle of the 1890s depression. The first to surpass 200 meters, the Met Life Building in New York, was completed just a year after the banking panic of 1907. The Chrysler and the Empire State Buildings (respectively 282 and 381 meters) were completed in the early 1930s. The World Trade Center (417 meters) was built in 1972 and the Sears Tower in Chicago (442 meters) in 1974, in the middle of the first oil shock. The Petronas Towers in Kuala Lumpur (451 meters) was completed in 1998, a year after the Asian financial crisis. There’s plenty of evidence for what economists would call a positive correlation between tall buildings and bubbles.

Thus, Dubai’s recent race to skies should have warned us of a possible crisis. The Burj Dubai, topped out in January 2009, soars to 818 meters (2684 feet), by far the tallest structure ever built. But even this giant would have been dwarfed by another planned super-tall building in Dubai, over a kilometer in height, the Nakheel Tower. This dream has been put on hold for the time being.

After triggering an initial wave of panic throughout financial markets worldwide last week, things have returned to normal and equity markets continue to rally. So we can say that the liquidity-induced market pickup this year may have withstood its first real test. But the Dubai incident also shows how frayed the nerves of market participants still are.

While the default of the government-backed investment company Dubai World does not equate to a default by the government of Dubai, it does serve as a chilling reminder that debt has its limits. Even with no tall building as an emblem, we must acknowledge that the skyrocketing amounts government debt worldwide are also built upon the sands of credit and are simply not sustainable over the long haul.

And if we take the skyscraper indicator seriously, there is good reason to remain rather cautious and alert. According to skyscraperpage.com, sixteen buildings over 400 meters in height are currently under construction worldwide, fifteen of them in emerging markets and almost half of those in China alone.