Gold as the “ultimate bubble”

Billionaire financier George Soros this month repeated his warning gold is locked in the “ultimate bubble”, and told investors bluntly it was “certainly not safe” in troubled times. But while Soros himself warned gold was in a bubble, his hedge fund, Soros Fund Management LLC was one of the biggest gold bulls of the year, doubling its holding of shares in the SPDR Gold Trust at about the same time he was issuing his warning at the WEF in Davos.

Soros is no longer involved in the management of the fund. But the apparent disconnect between the bubble warning and the bullishness of his fund will strike many observers as strange. In reality it illustrates the fascinating investment philosophy of one of the most successful financiers of the last 50 years and is the best way to understand what is really going on in the precious metal market.

Soros outlined his theory of price formation, and how bubbles inflate and collapse, in a brilliant book on “The Alchemy of Finance”, first published in 1987, but updated in 2003. It remains one of the clearest, most incisive explanations of how and why bubbles occur, and shows how profiting from the “madness of crowds” has been pivotal to his success.

“I contend that financial markets are always wrong in the sense that they operate with a prevailing bias, but that the bias can actually validate itself by influencing not only market prices but also the fundamentals that market prices are supposed to reflect”. Later he writes more bluntly: “[The efficient market hypothesis and theory of rational expectations] claims that the markets are always right; my proposition is that markets are almost always wrong but often they can validate themselves”.

Rising gold prices have encouraged investors to add gold to their portfolios and central banks to reverse a long-standing drift towards eliminating the low-yielding asset from their reserves and start adding it instead. In a thoughtful research note, Deutsche Bank argues that “the gold market is still some way from displaying the characteristics of a bubble” (Commodities Quarterly, Sep 28). But using the Soros idea of a bubble as a process, rather than simply a frothy end-state, gold has already been a bubble for some time as an ever larger group of investors has climbed aboard, propelling prices higher.

Link...