Did the Recent Silver Bubble Conform to Our Understanding of Bubbles?

Yes. Yes it did.

Let's think back to this old post of the evolution of a bubble.

As always, click on the image for a larger picture. Essentially, silver conformed to the basic tenant of a bubble that, because of rapidly rising expectations of future prices, suppliers of silver became unwilling to release supply on their old supply schedule. For instance, if I held 100 ounces of silver while it was trading at $15 an ounce, I may have been willing to put twenty of those ounces on the market once the price reached $20 in a more regular time. However, when I see prices go hyperbolic, I reassess the situation and hold on with a "wait and see" approach. My supply schedule shifts in. We saw this in the early stages of the silver rally where suppliers and buyers seemed to be having their expectations change more or less in tandem. What was the tell tale sign of this? Volume did not accelerate all that drastically until the last few weeks. Now, this can be the signs of something other than a bubble and I will discuss that in a minute.

Now, it's normal for volume to spike on one-off events like a big earnings report. For volume to increase massively, independently of major events in the context of a large rise is actually not normal. Case in point, Apple (AAPL):

Most of Apple's rally since early 2009 has happened in the context of remarkably stable volume. There hasn't been a huge surge in the number of shares traded during most of the advance. Clearly, this would provide evidence that the suppliers of Apple shares (i.e. current owners) have shifted in their supply schedules as prices have advanced. However, one key trait about Apple's advance is that it typically stalls until rejuvenated by a good earnings report. In other words, the advance is sustained by commensurate news regarding the fundamental improvements in the company's future earnings potential. To underline this point, Apple only trades at about 12x next year's earnings. If anything, one could argue that investors are discounting the possibility that the current trend in earnings might not be sustained.

To return to silver for a moment, there was no particular rationale for sustaining its rate of increase aside from the fact that it was increasing awfully quickly so one would want to buy in. Clearly, an increasing number of investors didn't buy into this idea and liquidated their positions right into the most hyperbolic portion of the increase. Volume surged in the last couple weeks of the rally, far eclipsing the daily average volume of the past several months. What was astonishing, and this is what tipped me off, was that there were enough speculative buyers to sustain the rally in the face of substantial liquidation. Clearly, speculators had become unhinged. The options markets reflected this at the end the last week of April where long-dated put options for SLV in the low 40s were trading at substantial premiums while long-dated call options above $50 were not. In other words, the options traders expected things to get ugly for silver by the end of the year. I decided, based on the frenzy, that silver was going to burst extremely quickly and decided to trade the June $42 puts. I have now liquidated two out of the three positions at large gains.

Now, let's try to piece this all together into a comprehensive picture of a bubble. You may remember from an earlier post back nearly a year ago that I laid out three criteria for spotting a bubble:

1. Is the asset or asset class in question fundamentally more attractive than other alternatives?
2. Is there either little information available or is the information corrupted in some way?
3. Are market actors incorporating available information or are they doing so in a rational way?

Silver began rallying for a real fundamental reason which is that the dollar is nearly constantly depreciating and high rates of money supply growth imply a central bank willing to devalue the currency for some time. This is usually a conventional reason to trade in precious metals as a hedge against inflation. However, the increase in silver far exceeded this fundamental reason as one will note that the dollar declined maybe around 10% depending on the measure you use in the time silver increased more than 150%. Still, there was a reason why the asset class of precious metals, broadly speaking, and silver in particular would be attractive.

On the second point, people have no idea how precious metals should be valued and economists have rarely ever been able to construct a reasonable model for how precious metals can be priced. Their industrial uses are never enough to justify their prices and their sentimental or emotional values to people are impossible to value. Further, there are a lot of people who corrupt what information is available with articles like "Silver going to $200 an ounce?"

On the third point, the answer was clearly no. The increase in volume wasn't based on any event, but on a short term frenzy where people were beating each other over the head with higher and higher bids to get into a crowded market. 

Take this into account with the fact that, like in all bubbles, silver followed the tradition of the trashiest asset in an asset class performing the best. Precious metals are generally in a bubble and silver is the trashiest among them and it performed the best. In fact, platinum performed the worst.

The silver bubble conformed to every basic tenant of what we understand about bubbles and the fact that several people, myself included, were able to call it should not be surprising. By the way, applying th criteria laid out here and in prior posts, you can clearly define Apple as not being in a bubble and the same applies to the overall market advance over the past two years. A large advance (50%+) does not necessarily indicate a bubble, but it does warrant examining the conditions surrounding it. 

Silver Goes Hyperbolic

What's interesting is that, despite all of the discussion about gold, it has actually slightly underperformed the S&P 500 over the past six months. Silver, meanwhile, is displaying every tell tale sign of a bubble. Look at that spike in volume that is coincident with a large and even accelerating rally. The only reason demand keeps rising is seemingly because of expectations of higher prices. Supply may be tight, but it certainly isn't tightening at the rate prices are rising except for the spike in speculative demand. 

Of course, there were approximately 20 articles today declaring that silver is not a bubble. We shall see. In any case, my large collection of silver coins I accumulated in 2006-2008 is looking pretty solid right now, though I don't ever intend to sell them.... or I didn't before silver prices nearly tripled.

Do Not Buy Coins to Accumulate Precious Metals

Frankly, I'm not a big fan of buying precious metals in any form. I can justify maybe 5% of one's portfolio being invested in commodities generally, and only a portion of that being invested in precious metals. The pricing is too arbitrary to be much larger than that, but some presence probably provides additional stability to your portfolio. However, there is the right way to do it and the wrong way to do it.

As someone who collects coins, you might expect that I would endorse this as a way to accumulate gold and silver. Nothing could be further from the truth. It is precisely because I am familiar with this market that I can tell you that you should not do this.

Now, you will see infomercials selling a lot of this:

They will emphasize it as good method to accumulate "real, physical gold you can hold in your hand". Similarly, E-Bay auctioneers will make the same pitch, and possibly pitch the historical and collectible value of the gold coin as an added extra. The difficulty is how terribly inefficient and finicky the collectible coin market is.

Case in point, is the 1909 gold Double Eagle with a Denver mint mark. If I've already lost you, you have proven my point already and you don't need to go any further. The value of this coin, with old gold values as of 2007 so you have to inflate these values, could vary between $1,850 if it was a MS-60 grade and $8,000 if it was a MS-63 grade. These grades can vary between coin rating agencies and there are a lot of phony agencies out there that provide inflated grades. If you buy at a premium grade that is incorrect, you can be getting yourself in a ton of trouble and you may already be out several grand without knowing it. Even reputable coin rating agencies like PCGS or NGC can be wrong, but you're safer if they've rated them. Generally, their word is... as good as gold. I hate myself for saying it, but there it is.

This brought up another point which is that someone selling you a collectible/historical coin may take advantage of your ignorance and not bother mentioning the mint mark. The mint mark is absolutely critical in the case of many coins as the total mintage at the various mints in this country and others varies widely as you might expect. Therefore, as a direct consequence, rarity is also highly variable. In the case of the coin mentioned above, a MS-63 1909 gold Double Eagle with a San Francisco mint mark is worth only around 12% of what the Denver mint mark is worth.

However, even assuming you are dealing with reputable dealers and not someone Glenn Beck pushed on you or some random E-Bay dealer that only has sold 6 items, you are essentially doubling down on alternative assets. You are subjecting yourself not only to the volatility of the price of gold and silver, but also to the trends in the collectibles market as a whole and specifically preferences regarding individual classes of coins. It may be that ten years from now, not only is gold down 40%, but that 1909 gold Double Eagles are out of favor in the collectibles market.

Coins that have little collectible value due to their commonality are actually better plays than the rare ones as there is less of a risk that you are bumbling into something that you don't understand and their is less of a squishy "collectible premium". However, the best bet is to buy gold/silver futures or just raw bullion if you want to make this play.

As for myself, I generally have stayed out of the high-ticket coins and have instead focused on coins that have interesting historical values to me. For example, getting the coin of a monarch in the last year of their reign before a revolution or some other event. You can actually get this reasonably cheaply if they are silver and they make for neat additions to any collection.

Silver Blowing Away Gold (Again)

With geopolitical instability continuing to be a pressing issue, it is no surprise that the previous metals are performing well once again. As was the case a few months ago, silver continues to trounce gold.

About 90% of the time, in speculative markets you will find that the "lesser" product outperforms. 

The Out-performance of Silver and Asset Bubbles

 So, from the above chart you can see that the silver ETF (SLV) has recently had a huge run, far outperforming the gold ETF (GLD). Some have wondered why this is, but it's really no great mystery. As you can see, silver's movements are directionally the same as gold's, but are just much more exaggerated in the last three months. Arguably, they are both part of the same play as a hedge against dollar devaluation, inflation, financial instability and so on so why the disparate performance the favors arguably the less intrinsically valuable asset?

It's much the same reason in the late 1990s that the more detached a stock was from its fundamentals, the better. Just off the top of your head, if I asked you which stock would perform better in a huge bull market, a stock with a well established earnings history and reasonably reliable forward earnings projections or a fly by night enterprise with extraordinarily speculative earnings prospects, you would probably choose the former. However, that's not what happens. Instead, when the wind is at their backs in a particular asset class investors turn to the more speculative members of that asset class. Take GE (GE), Cisco (CSCO), JDS Uniphase (JDSU) and Microstrategy (MSTR) in the window of December 1998 through March of 2000. All of these stocks did well and all became quite overvalued, though to far differing degrees.

You can barely see GE's advance there, Cisco returned a very respectable 200% and the other two went nuts with JDSU setting the pace. The last three were all part of the same general play, which was speculation on the growth rate in technology company earnings, while GE was part of the broader bubble in stocks. In order, GE's earnings were the most stable and well known, followed by Cisco, followed by Microstrategy, followed by JDSU. In the earlier days of the bubble, the margin of out-performance of the two trashy stocks was not as large, but it really took off about September-October 1999.

In other words, the trashier the better when a bubble occurs and that would seem to indicate that the surge in silver might be a signal that we are at the apex of a precious metals bubble.

Milton Friedman on the Gold Standard

Since Robert Zoellick, a man of a profoundly meager intellect, decided to open his trap on the Gold Standard, I think it might be worth having a man of a far greater intellect speak on the subject. While I certainly do not endorse everything Milton Friedman stood for, he was a brilliant man who was a generous enough man to recognize the brilliance of Keynes even though he disagreed with him vehemently.

Robert Zoellick is an Idiot

http://www.ft.com/cms/s/0/213e17aa-eb5d-11df-b482-00144feab49a.html?ftcamp=rss#axzz14mw57feO

Basically, Robert Zoellick, head of the World Bank, is saying that we should entertain the return of gold-backed currency largely because markets, at the moment, are treating gold as an alternative to paper currency. Somehow, he believes, currencies backed by gold would provide more stable economies. Never mind that while global economies were on the gold standard in the 19th and early 20th centuries we had routine severe financial crises about every seven years and a very nasty tendency toward deflation.

James Hamilton over at Econbrowser has a fairly succinct post on this matter about how the gold standard actually contributed to the Great Depression (and probably made previous depressions worse as well). http://www.econbrowser.com/archives/2005/12/the_gold_standa.html

QE and the Macro Climate for Stocks, Bonds, and Commodities

Since the Fed has decided to further monetize the debt in bid to try even more monetary stimulus, a few things are clear. One is that the Federal Reserve is absolutely nowhere near tightening and won't be for many months to come. That should be no surprise considering the size of the present shortfall in employment. The other is that the dollar looks like an extremely unfavorable investment right now, meaning that foreign stocks are comparatively more attractive in the interim as the supply of dollars will increase greatly as well as the fact that US interest rates will do a poor job of attracting fixed income investments. Foreign investors holding dollar denominated investments better watch out.

One thing that is abundantly clear is that financial markets have interpreted this Fed action as an all clear signal and everything from gold to Goldman Sachs (GS) has joined in. We are not in bubble territory in the stock market, though we are almost there in some, though not all, commodities markets. Those who are using commodities as a substitute for investing in financial assets in times of loose monetary policy continue to push those assets further and further from their fundamental values. There is no need to be worried about a bubble being fueled in the real estate markets. Those are so far deflated that no amount of monetary or fiscal stimulus could re-inflate them because investor expectations of returns have been so brutally throttled.

In the short run, meaning the next few weeks, I would not be stunned to see some retracement of recent gains on the order of as much as 5% in domestic stock markets. However, the next 12 months or so should be quite good. Earnings growth for the time being is strong and interest rates will not be a headwind. Commodities markets are probably a better than even shot to outperform in this environment as this global distrust of "paper" currencies seems to really be hitting a frenzy. However, once this current period of extremely loose policy relents those investments will crack much worse than the equity markets in the aggregate because there is much less of a link to fundamental value.

Stocks are supported by extraordinary levels of corporate profitability that make overall valuations quite reasonable. This is due in no small part to the current levels of slack in the labor markets that allow corporations to enjoy a larger share of productivity gains without passing them along as wage increases. However, lack of investment in both human and physical capital means, to a large extent, that corporations are cannibalizing future earnings for current earnings. Invariably this means that future earnings growth will be relatively muted as corporations need to hire and expand plant and equipment to grow sales as conditions normalize. That will prove to have a dampening effect on the later stages of the present rally.

Bonds, on the other hand, are currently being supported by Fed purchases, but this obviously will wear off, particularly as investors in long term bonds become frustrated by their low rates of return compared to high rates of return elsewhere. As such, prices will fall and yields will rise, possibly considerably. Long term treasuries are thus not a particularly good place to be.

Now, all of this is just my own opinion, which in no way constitutes professional advice, and I could certainly be wrong as I have been in the past. Still, it seems to me that this represents a fair summary of where we are right now.

Mr. T Pities the Fool Who Doesn't Buy Gold

http://www.bloomberg.com/video/63695708/

I think this, and the ever shifting series of justifications for gold (including arguments that it is your hedge against inflation, deflation and prosperity all at once) are beginning to flash big warning signs that gold is about to top out and possibly top out for some time to come.

Blogger Barry Ritholtz, who is a far more esteemed observer of financial markets than I, argues for maybe having 5% of your total liquid assets in gold or precious metals more broadly. I can't say that I'm entirely opposed to that proposition, but I think the issue here is the entry point. While no one has ever developed either a good empirical or theoretical framework for valuing gold, the odds are that gold has seen its best days for some time to come.

Opposing Views on Gold and GOOG

I have recently been critical of both gold and Google (GOOG). In the interest of presenting multiple views, here are a couple of articles disagreeing with what I have been saying lately.

Gold: http://money.uk.msn.com/investing/articles.aspx?cp-documentid=154762364

The basic premise here is that since we are still at a time when central banks seem to be focused on devaluing their currencies in order to boost exports. I would agree that in the short run this provides some support to gold. Still, I don't buy the win-win scenario for gold because if gold is truly an asset class for all seasons, even a marginally efficient market would have already priced it as such. The risk to gold is that if stable economic growth is restored without an major outbreak of inflation it will suffer horribly. A restoration of 2-3% inflation is not bullish for gold. However, this author makes his case and it helps to have opposing views.

Google: http://blogs.marketwatch.com/cody/2010/09/23/googles-headed-to-2000-heres-why/

Now, there the author says that Google is going to $2000 a share by 2020, which would be about a 4x increase. I actually don't doubt that as a possibility, but I would be inclined to take the under on that one. There is plenty of upside for Google and it is true that the major trends are with them, but a decade is a long time in information technology and Google seems somewhat undisciplined in terms of achieving good operating results. I do think that Google makes a great deal of sense as a long term holding as I have a hard time figuring how it doesn't outperform the overall market over the next several years. Google just frustrates me because they could be more profitable than they are if it was a more professionally managed company.

The Peculiar Allure of Gold: Part 1.1

Some time recently, we discussed here some of what seems to drive the price of gold.While all of the other arguments for owning gold are generally a pile of crap, I had noted that over time there did seem to be an inverse relationship with the value of the dollar under most circumstances. However, I would note of late that it seems that even this relationship has broken down.

This is a simple picture (click on it to enlarge):

What you are seeing there is a 3-month chart of the ProShares US Dollar Bullish Fund (UUP), which has leveraged bullish bets on the US dollar vs the SPDR Gold Trust (GLD) which tracks the price of gold. You might note that there is a positive correlation between the dollar and the price of gold. Wait... what?

Well, maybe for the past three months gold has been a bet against the Euro while over the long run it is a bet against the dollar while also being an inflation hedge while also being a crisis hedge while not doing a particularly good job reflecting any of those relationships! I think there is a simpler reason for the decline of gold recently and that is that as it is clear that there is no risk of accelerating inflation, probably the number one reason scared little Glenn Beck listeners have been hoarding gold has been undercut severely. By the way, bashing on Glenn Beck is not in violation of this blog's no political discussions rule since Glenn Beck's insanity transcends ideology. He gives investment advice and it is damn bad advice at that.

For instance, while things have gotten rough over the past few months and U.S. deficits are in the stratosphere, surely you wouldn't want to invest in worthless pieces of paper like U.S. Treasuries and instead would want the safety of gold, right? Wrong. Very wrong. Stupidly wrong.

TLT, our long term treasury proxy, kicked the hell out of GLD over the past three months while stocks, represented by SPY here, suffered as we all know. It is interesting to note that some gold bulls had maintained that stocks and gold must necessarily rise together because... um... well because they said so, that's why. Never mind that this is a relationship that has never really held except for brief periods when it seems to out of pure coincidence. Recently stocks have rebounded more sharply than many give them credit for while gold has been in a trudging decline.

Gold currently is trading in such a peculiar way that it is helpful to think about the following. Currently, gold is not trading in accordance with any clear rational relationship to, well, anything. If the rationale for investing in an asset is not clear, then you should not invest in it. I can easily spell out why equities are good buys at present levels based on well accepted empirically derived relationships. Gold, it is not so easy unless you truly believe that we are about to undergo a period of 10%+ inflation, which I do not and the markets do not either except for the gold bugs who are always and everywhere trapped in a particularly pernicious insanity.

It may well be that gold gets foisted to new highs by irrational markets, but I would wager that in the next five years gold will be beaten by just about everything, including housing.

The Peculiar Allure of Gold

Anyone who knows me knows that I have a pathological hatred of precious metals so take that into account when I delve into a brief discussion of gold. Let me first get something out of my system by saying that, in my view, metals should only be valued by their relative rarity and usefulness in industrial purposes. At an emotional level, to me, not much else makes sense, but I digress.


In any event, gold has been the investment of the last decade, unless of course you invested in overseas stock markets. Brazil from the lows of 2002 kicked the hell out of gold. "Kicking the hell out of" something is a technical investment term used to discuss relative performance. Yes, it is true that gold blew away stocks in a bad way in the 2000s. Its proponents point to a few attributes that gold has that explain this performance. These are, namely:

1. Gold is the ultimate inflation hedge. Your money will not lose value if it is invested in gold.
2. Gold is the ultimate crisis hedge. When people get scared, they buy gold.
3. Gold is the ultimate hedge against a falling dollar. When people lose faith in "fiat" money, they will turn to gold.

Proponents argue that these are all absolutely immutable laws of the market and that these relationships always hold. In fact, some argue that there is a strict mathematical relationship.

Of these arguments, only the third really holds any water for me, and even that I am slightly skeptical of. Let me address these in order.

More after the page break.