Is Gold Overvalued? The Bearish Case vs. The Bullish Case

It’s an argument that seems to have no end: is gold really overvalued? There are two distinct sides to this story, and the controversy has been heating up since the precious metal made its historical run in 2011. As a number of factors combined midway through last year, gold was able to soar to its highest price in history, briefly touching the $1,900/oz. mark. The hard asset had risen so quickly, that breaking through the $2,000 barrier seemed like a certainty for many. But what goes up must come down, and gold was no exception. With prices now stuck in a rut around $1,600/oz., investors are continuing the age old argument as to whether or not this commodity is worth its salt [see also Three Reasons Why Gold Is Overvalued].

Top Three Reasons Gold Is Overvalued

1.  What Goes Up Must Come Down: Gold prices have been soaring for the past three years at a rate that seems unsustainable. In January of 2007, gold prices were sitting around $650 per ounce. That number jumped to around $1,600/oz. at the beginning of this year, an appreciation of roughly 146%. Compare that to its gains between the previous five year period of just 86%. Gold’s high rate of return has made investors a lot of money, but it has also made a number of investors weary. Many feel that its price is simply reflective of investor trends rather than its actual value. Warren Buffet famously said that gold “gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head” [see also Jim Rogers Says: Buy Commodities Now, Or You’ll Hate Yourself Later].
2. Peak as a “Safe Haven”: One of the biggest reasons that investors took flight from traditional assets and sought cover in gold was  its attraction as a safe haven security. With the U.S. dollar falling on hard times, and the Swiss franc pegged to the euro, many called this commodity the last available safe haven in the market. As such, its price was able to skyrocket as more and more people traded their oil stocks for precious metals. But with the world economy in general disarray, many feel that gold may be in a bubble. Hence the skepticism over big name products like the SPDR Gold Trust (GLD) [see also Warning: Ignore Bill Gross’ Hard Money Prediction At Your Own Risk]. When economies are rough, gold looks attractive as a store of value as it will generally offer portfolio stability. But if and when the global economy is able to get back on track, many will flee from their gold positions and into equities and fixed income that offer attractive yields and returns. If this were to happen, gold’s price would likely crater and burn a fair amount of positions. It should also be noted that gold has featured relatively high correlation to the S&P 500 in recent times, so it may be quickly losing its safe haven appeal [for more gold news subscribe to our free newsletter].
3. Limited Appeal: Few have been more vocal about their disdain for gold than Warren Buffet. Not to beat a dead horse, but as one of the world’s most successful businessmen, Buffet’s thoughts on gold tend to be quite relevant. In 2010, he was quoted as saying that “You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all —  not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?” Aside from being a store of value and a speculative instrument, gold does not have much of a glitter. It will never pay a dividend, grow earnings, expand its business, or any of the things that a traditional stock can do. While some investors may argue that these are the exact reasons why they trust the asset, others feel that these issues simply point out the fact that the precious metal is not worthy of the price levels that it is currently maintaining [see also The Ten Commandments of Commodity Investing].

Top Reasons Why Gold is Undervalued

1. The Euro Crisis: Much like the general sentiment that gold would smash through the $2,000 barrier, many feel that the euro crisis leading to a major financial collapse is only a matter of time. With a number of the world’s biggest economies faced with mountainous debt piles (the U.S. included), equity markets could be poised for major losses. Recent weeks have already shown us what bad data and troubling news can do to markets around the world, as stocks have remained volatile. If the euro were to fail along with countries like Spain, Greece, Italy, Ireland, and Portugal, a rush into this precious metal could very well follow. Multiple bailouts and rescue packages have been installed in order to avoid an all out contagion, but there seems to be no easy fix. A euro fallout will mean big days for this precious metal as its price will probably skyrocket [see also Will a Euro Collapse Wreck Your Commodities Allocation?].
2. The U.S. Fiscal Crisis/QE3: It is no secret that the U.S. has been one of the worst culprits of high debts in recent years. With those figures only set to grow in 2012, experts around the world are calling for the U.S. to slip back into another recession (while those with more colorful opinions feel that we are already in one but that government data has masked that fact). A U.S. recession would have a similar effect as a euro collapse, since investors would likely re-allocate in favor of the precious metal [see also 25 Things Every Financial Advisor Should Know About Commodities]. But should the Fed grow fearful of a recession, there is always the chance that Ben Bernanke will ride to the rescue with QE3, especially given the fact that “Operation Twist” is slated to come to an end upon June’s expiration. QE3 would mean asset purchasing from the Fed and a major boost to the yellow metal as the greenback would rapidly lose value, allowing investors to see gold as a more valuable play and subsequently shooting up the price in dollar terms.
3. Central Banks’ Continual Purchase of Gold: If there is one clue to tell you that gold is undervalued, it may just be the fact that central banks around the world are gobbling up this hard asset like hotcakes. These purchases are most likely not a temporary tactical move, but rather a powerful long term trend that will continue for years, if not decades. “Central banks increased their gold hoards by 400 metric tons—each equal to almost 2,205 pounds—in the 12 months through March 31, up from 156 tons during the prior year,” according to a Barron’s report. While central banks may not be vocally advocating the purchase of this metal, the fact that they are heavily investing in it should say something to investors. These major financial institutions believe that gold is undervalued, and they’re putting their money where their mouth is [see also 12 High-Yielding Commodities For 2012].

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Disclosure: No positions at time of writing.