The question of ‘Is gold is overpriced and overvalued‘ is a question often asked by beginner investors who are new to investing in commodities and want to gauge whether 2011 or 2012 will be a good time to invest in gold. It’s a simple question, but you may be surprised at my simple answer: Yes. In my humble opinion, gold is overvalued. For my view on the wider group of commodities, see ‘Are Commodities Overpriced?‘.
I will present 4 reasons why I believe gold is overpriced. If you disagree, and believe that gold is not overpriced – leave a comment!
Is Gold Overvalued?
Reason #1 – Gold is difficult to value, so we should err on the side of caution
My readers will know that I have a fairly moderate risk tolerance. However when the markets give me reason to be concerned, I show signs of conservatism. This is one of those times. Gold bullion is a lump of refined ore that sits in the vault of a bank. Gold does not buy and sell goods at a profit, and pay out dividends. Commodities are indeed completely different from stocks.
Reason #2 – Gold overvaluation has occurred in the past – do not trust gold ‘experts’
In 1980 investors were getting very excited. Extraordinary gains were being posted in the commodities markets and they wanted a piece of it. Short term inflation concerns were contributing to unrest, and bears were taking sanctuary in gold. Gold experts cited the current conditions as ample justification for future capital gains, and traders were seeing record prices. 2 years later, the price of gold had halved and retail investors who had decided to play ‘hedge fund’ were nursing considerable losses. We could draw innumerable parallels between todays market and that of 1979, or indeed 1980, so why take the risk that this time is magically different?
Reason #3 – Prudent portfolio re-balancing rules are giving sell signal
Asset allocation is the tool behind the simple science of diversification, and means the way that investors divide their funds across different asset classes such as bonds, stocks, cash and real estate. Portfolio ‘rebalancing’ is the act of taking a hacksaw to your portfolio and making a series of trades in order to re-adjust the different class such that your strategy (e.g. 40% bonds, 50 stocks, 5% commodities, 5% real estate) still holds.
Any investor that has held gold for the past 5 years will have seen its value multiply within their portfolio, meaning that gold would now represent a much larger chunk than they originally planned. Sensible and prudent investment strategy would dictate that these investors should sell their gold and buy other asset classes to re-balance the percentages and bring risk back down to where it is desired. Re-balancing has worked so effectively over the past century because it naturally instructs investors to sell assets when they are valued fairly highly, and buy other assets which are priced lower. So if the prudent long term investor is currently selling a big chunk of their gold holdings, does it really sound like an ideal time to buy?
Reason #4 – The smart money is leaving gold
As reported by BullionVault, the number of professional investors (traders, investment banks) holding a ‘short’ position i.e. betting against the price of gold, has increased substantially. The author ties this to a similar build up of such contracts in October 2009 which occurred before a $183 fall in the gold price. It is common knowledge that professional investors generate superior returns (before fees) over armchair investors, due to their informational advantages and execution speed. When the tone of professional investors begins to silently swing in the opposite direction, everyone should begin to feel nervous.
Notably, George Soros, the investor who infamously ‘broke the Bank of England’ on Black Wednesday, has recently shelved most of the gold holdings under his management, eliminating 99% of his holdings in the famous physical gold etf, ‘SPDR Gold Shares’. Soros does not have a perfect investing record, but his headstrong calls in the past have earned him a fearsome reputation, and it may do us well to take head that he has publicly called the top of the gold market.
To learn more about gold, continue to ‘What is the Best Way to Hold Gold?‘