old prices have had a spectacular run up from their historic lows in the early years of the last decade. In April 2001 gold prices were hovering around 220 – 250 USD/ounce. With the slowing of central bank selling of their gold reserves and the forward delivery costs of gold changing dramatically, the pressures that had been weighing on gold for almost 10 years were lifted and a 10 year run up in prices started. Some gold analysts are now claiming that the long secular bear market has ended and a bull market has returned. Others are wondering if gold prices have the wherewithal to rise further and if not, is the current stage of gold prices signaling a bubble?
According to my analysis of Thomson Reuters commodities futures data, it’s probable that gold prices will continue to climb this year and the next, supported by good fundamentals, bullish sentiment and an overall environment supportive of gold. However, it’s likely that sometime in 2013 a critical point will be reached for gold prices, more than likely because herding or crowd behavior will have overtaken such basic fundamentals as mining and purchases and uses of gold. This speculative market will bring with it the potential for prices to decline sharply.
As seen in Figure 1, gold has seen an almost 8 fold run-up in price since its low in April 2001.
Source: Thomson Reuters’ Datascope
Note that from late August to early September 2008, gold prices started to accelerate in a new pattern – faster and steeper than they had before. For example, prices more than doubled in the last 3 years, with most of that increase coming in the last 2 years.
This sort of acceleration in price is a sign of the beginning of a bubble – a rapid increase in price, or what maybe be called a change in trend. A change to something that is much steeper than that which has been seen before. This rapid increase is signaled by something called a power law, which indicates that the price of gold is increasing in a manner that is greater than a smoother, linear increase and even faster than something that is growing exponentially.
The birth of a bubble in price for any financial security does not suggest price increases have gone from benign to mad. At the start of most financial bubbles, the price increase starts smoothly, supported by both fundamentals and sentiment in an otherwise relatively optimistic market. All these statements are true for gold today. For example, good fundamentals exist in the form of a surge in net official gold purchases to over 200 tons in the first half, from just 77 tons in all of 2010 and mining production rose by 4.9% in the first half. In a recent report, Thomas Reuters GFMS expects these supporting fundamentals to continue growing for the next year or two. Furthermore there is increasing positive market sentiment as measured by such methods as technical analysis which is showing steady upwardly titling trend lines, a sign of increasing sentiment or belief that prices will go higher. And there is an optimistic market for gold due to the uncertainty about the U.S. dollar and the Euro.
In the next stage of bubble activity, the attraction of an investment with good potential gains brings in institutional investors who may begin using leverage to make purchases. As levered purchases increase and/or small investors begin to enter, with some amount of leverage as well, prices start to rise faster than the amount of real money entering the market.
If the above occurs, the market begins to separate or completely decouples from fundamentals. Real wealth – industrial and service production – weakens as a driver of prices.
In the final stage herding takes over as investors bring about a speculative market driven almost entirely by sentiment. At this time we also see fewer new investors entering the market. Then, at some stage in a speculative market, a critical point is reached at which price instability is revealed via the increasing oscillations about the trend. What these oscillations portend for prices will be discussed next.
We defined above the recent trend of gold prices but spoke nothing about the actual movement of prices about that trend. In Figure 2, we plot the trend as well as movement of gold prices about it.
Source: Thomson Reuters’ Datascope
As can be seen, the price series is indeed oscillating about the trend. If we were near the aforementioned critical point, the oscillations would be occurring more frequently and would have less of a distance between their up and down movements. This behavior, which has been observed in every market, metals and options crash since 1929, is due to the aforementioned increasing nervousness in the market and as well as the impact of fewer new investors entering. And this increasing oscillatory activity is not what we are seeing now.
So what does our analysis say about gold prices? On reviewing the data available, such as the patterns in the oscillatory swings and our ability to predict the time to criticality within certain limits, it looks as though over the next 12 – 15 months fundamentals, sentiment and an optimistic market for gold will continue to support gold prices. This prediction is in-line with that recently made by GFMS. But 2013 is a concern, in particular its latter half. In no more than 2 years time there is a good chance that the critical point mentioned above will be reached and it will be a matter of “buyer beware,” as the gold market enters a phase of greater nervousness and possible bubble-bursting.
If gold does go through all the steps above, what will the effect be on gold miners? That we will cover in a subsequent article.
Andrew Clark is Chief Index Strategist at Thomson Reuters in London