Three Reasons Why Gold Is Overvalued

The past few months have put gold in the spotlight, and for good reason. The metal has shot up from below $1,000 per ounce in 2009, all the way to its current levels around $1,830. As markets around the world continue to falter, gold has seen a massive amount of inflows as it has long been the popular safe haven investment. Now that the Swiss franc is pegged to the euro, many consider gold to be the last remaining safe haven, as the once strong franc will now be dictated by the movements of the drowning euro. But with gold seeing its price nearly triple in the last three years, many investors are formulating strong opinions as to whether or not the precious metal is overvalued and due for a huge correction in the near term [see also The Ultimate Guide To Gold Investing].

In the current market environment, equities are exhibiting extreme volatility, and bonds yields are at an all time low, forcing investors to find their returns elsewhere. With so much instability, and the strong returns that gold has posted, it makes sense that it has surged in popularity over the last two years. Yet, as the commodity continue to climb, it has become clear that it is overvalued by some metrics. Below, we outline the specific reasons why gold’s price is inflated, and what makes this asset class one that investors need to keep their eye on for bubbles in the near future:

Let’s look at the facts. Gold is finite mineral that is considered a rare find, giving it such a high price per ounce. It does not pay dividends and it has no underlying benchmark, it simply sits in lumps in vaults all over the world. The past few years has not seen a massive change in the amount of gold in existence; if there were to somehow be a massive loss of gold around the world, it would certainly make sense to see its price skyrocket. Instead, the metal is just as rare today as it was 20 years ago, you could even argue that with all of the mining giants around the world that gold has become more abundant [see also Three Ways To Play $2,000 Gold].

Nothing about gold has changed in the last few years, so why the massive appreciation in price? Any other commodity, like lumber or cotton, that saw this kind of exponential jump would be under major scrutiny. And cotton, in fact, did bottom-out after seeing its highest prices in history, putting it at the top of headlines for quite some time. Investor speculation and market scares have all contributed to gold’s meteoric rise, and if equities were ever to get their act together, gold would be in for a massive sell-off. Its price is held up by flimsy markets and a cloudy future, but if skies were to ever clear for our economy, investors would pile into equities, leaving the inflated gold to plummet.

One of the most popular benchmarks for gold investment comes from the SPDR Gold Trust (GLD), an ETF that offers exposure to physical bullion. Looking at the average volumes of GLD, it is clear that the metal has been overbought as of late. In August of 2011, GLD had an average daily volume of 33.4 million, which is a huge increase compared to ADVs of 7.4 million and 9.8 million in August of ’09 and ’10, respectively. In fact, last month saw an astonishing increase in volume of over 244% from the previous year’s August and 351% compared to August ’09, leaving screaming evidence of the unnatural volumes in gold. Because markets have been so abysmal, gold has seen an extremely high amount of trading, but this is not the first time gold has seen this kind of move [see also Company Spotlight: Barrick Gold Corporation (ABX)].

In 1980, gold prices experienced a very similar pattern that we see today. In the late 70′s markets dealt with inflation and tumultuous equities, while investors piled into gold, causing its price to jump from around $200 per ounce in 1978, all the way past $800 in 1980. With an exponential rise in gold prices, increasing fourfold in fact, the metal crashed in the subsequent two years all the way back below $400 per ounce, creating painful losses for a number of investors. Gold prices are exhibiting an eerily similar pattern today, as prices have jumped threefold since 2006 in an exponential fashion. If investors were to ever consider the phrase “history repeats itself”, now may be a good time to keep a close eye on gold.

As pointed out by Simon Oates from Financial Expert, gold may be poised for a loss simply based on the portfolios of a number of individuals and institutions alike. When it comes to portfolio allocations, a well-diversified basket of holdings is key, and that means that investors will try and spread their exposure across numerous asset classes. Commodities, like gold, are typically given a small portion of a portfolio usually ranging between 5% and 10% of total assets. However, for those investors lucky enough to have held a product like GLD over the last five years, they have seen not only massive gains, but now a major increase in their commodity allocations as well [see also The Guide To The Biggest Companies In Every Major Commodity Sector].

As a result, gold, an asset that is often meant for the “buy and hold” investor, now makes up a much larger percentage of many portfolios than what was originally planned. While investors are likely very aware of this, it is difficult to sell out of an asset that has multiplied so rapidly in recent years. Soon enough, however, it will come time to scale back on the now too-large commodity allocations and prompt a healthy rebalance. This could send gold for a massive drop as a number of investors sell out to keep their portfolio reasonably diversified and avoid putting too much in the precious metal.

One of the most important things to remember is that while gold may be overvalued, that does not mean that it is a bad investment, but is rather a factor to keep an eye on. It would be absurd to call gold a bad investment given its historic gains in recent years, but that also does not mean that it is safe at its current levels. For as long as market volatility persists, gold will be able to keep its high prices afloat, but when the day comes where equities finally break ground, this shiny metal will likely suffer a massive drop. When that will happen though, could be anywhere from one year to decades depending on who you ask. Instead, investors simply need to keep a close eye on their gold holdings, and be ready to pull the trigger if and when our economy pulls itself out of its downward spiral and confidence once again returns to the markets [see also Major Countries Burn Up Crude Reserves: Big Oil In Trouble?].

[For more Commodity stories sign up for our free CHQ Newsletter.]

Disclosure: No positions at time of writing.