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02 _11_Debunking the Gold Bubble Myth

02 _11_Debunking the Gold Bubble Myth

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Published by: rmullis on Mar 15, 2011
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Gold’s continuous ten-year rise hasn’tsheltered it from controversy. Despiteproducing consistent returns in virtuallyall currencies year after year, somemarket pundits still question its validity asan asset class. It’s true that gold doesn’tpay any interest, and it’s also true thatmuch of the gold produced throughouthistory still exists in some form today.But these characteristics shouldn’t inhibitit from performing as a monetary asset.Cash, after all, doesn’t pay real interesteither, and there is more at money inexistence today than ever before. Sowhy does gold still receive such harshcriticism?We believe much of it stems from awidely held misconception that gold isforming a nancial bubble. It’s a fairlystraightforward view – that gold buyersare merely foolhardy speculators buyingon a whim with no rationale other than tosell to the ‘greater fool’ at higher prices inthe future. It’s a view that assumes thatgold has no intrinsic value and is simplya speculative asset that has capturedinvestors’ imaginations.We don’t take these views on gold lightly.We’ve seen bubbles before and fullyknow how they end. We have no interestwhatsoever in participating in some sortof speculative frenzy – that’s a recipefor disaster in the investment business.Thankfully, however, our gold investmentspresent no such risk. As our analysis hasrevealed, gold is actually a surprisinglyunder-owned asset class – and onethat has generated far more attentionin the media than it probably deserves.While its exemplary performance since2000 is certainly worthy of discussion,gold simply hasn’t commanded enoughinvestment to warrant the bubble fears itseems to have aroused among marketpundits and business commentators.The truth about gold is that most peoplesimply
don’t own it 
By: Eric Sprott & Andrew Morris
Contributing Editor: David Baker
Debunking theGold Bubble Myth
February 2011
To be clear, a speculative bubble forms when prices for an asset class rise above a level justied by itsfundamentals. For this to happen, increasing amounts of capital must ow into the asset class, bidding it upto irrational levels. Gold may be trading at all-time nominal highs, but a look at investment ows proves thatit isn’t anywhere close to being overbought.In their 
Gold Yearbook 2010 
, CPM Group noted that in 1968, gold held by individuals for investmentpurposes represented approximately 5% of global nancial assets. By 1980 that amount had fallen toroughly 3%. By 1990 it had dropped signicantly to 0.6%, and by the year 2000 represented a mere 0.2%of global assets. By the end of 2009, nine years into the gold bull market that began in 2000, they estimatethat gold had increased to represent a mere 0.6% of global nancial assets – hardly much of an increase.Gold ownership didn’t change much last year either, as we estimate that this percentage increased to 0.7%of global nancial assets in 2010.
So despite gold reaching record nominal highs, the world holds aboutthe same portion of its wealth in gold as it did over two decades ago. While this probably says more aboutthe proliferation of nancial assets over the past decade than it does about gold investment, it is surprisingto note how trivial gold ownership is when compared to the size of global nancial assets.The increase in gold ownership from 0.2% in 2000 to 0.7% in 2010 is also misleading. If you consider theapproximate $227 billion that was invested in gold bullion in 2000, that level of investment would havegrown to $1.18 trillion, or 0.6% of nancial assets, by the end of 2010 -
based purely on gold appreciationalone
In other words, the actual amount of new investment into gold since 2000 represents only 0.1%of current global nancial assets, or about $250 billion. Although this number may seem large, consider that roughly $98
of new capital owed into global nancial assets over the same period, so gold’sapproximate 0.3% share of global investment ows is essentially trivial.
The 0.7% ownership data point also has interesting implications for global gold ownership going forward.Consider that to return to a meaningful level of gold investment, say to the 5% level of 1968, it would requireover $9 trillion of gold investment today, or about 6.5 billion ounces of gold at the current gold price. Thiswould represent well over 1.3 times the amount of gold ever produced throughout history and four times theamount of known gold reserves.
So not only is the public relatively underinvested in gold, but at currentprices it isn’t even possible to increase our gold holdings back to a meaningful level.Gold’s apparent underinvestment also applies to gold equity nancings since 2000. According to our sources, gold companies raised approximately $78 billion of equity capital in new nancings over the past11 years.
To put this amount in perspective, this is equivalent to the total amount of equity raised bytechnology companies in the rst
three months
of 2000.
 To further illustrate the lack of activity in the gold equity capital markets, we compare last year’s goldcompany nancings with the technology company nancings in the year 2000 (Chart 1). Once again,looking at the relative amount of capital market activity in the gold equity markets, we nd no indication of a bubble whatsoever.Furthermore, we compiled information on mutual fund ows to get a sense for the average retail investor’sappetite for gold equity investments (Chart 2). We found very familiar results in this area as well: comparedto the $2.5
dollars that was invested in US mutual funds since 2000, precious metal equity funds haveseen a mere $12 billion in inows. If there is a bubble in gold investments, the average retail investor hasn’tparticipated in it.
SAM estimate based on data obtained from McKinsey & Co., IMF, CPM Group, Thomson Reuters, BIS
“CPM Gold Yearbook 2010” CPM Group (March 2010)
SAM estimate based on data obtained from McKinsey & Co., IMF, CPM Group, Thomson Reuters, BIS
Larmer, Brook. “The Real Price of Gold” National Geographic Magazine. (January 2009) Retrieved on March 7, 2011 from: http://ngm.nationalgeographic.com/print/2009/01/gold/larmer-text
“Mineral Commodity Summaries 2011” US Geological Survey (January 2011). Retrieved March 7, 2011 from: http://minerals.usgs.gov/minerals/pubs/mcs/2011/mcs2011.pdf
RBC Capital Markets, Dealogic
Source: Bloomberg, Sprott Asset Management LP
Price-to- EBITDA (TTM)
Source: Morningstar, Sprott Asset Management LP
$US billions
To truly gauge the level of exuberance(or lack thereof) in today’s gold market,it’s benecial to review equity valuations,since they provide an excellent lens intoinvestor sentiment for an asset class.Certainly if a bubble was forming in gold,it would likely rear its head in the stockmarket, where speculative manias havebeen eecing ‘greater fools’ for centuries.The best gold index to review for valuationis the Amex Gold Bugs Index (HUI),which has returned a stunning 674%since 2000. It is certainly an index thatcould be mistaken for a bubble basedon its incredible performance… until oneconsiders its relative valuation. In Chart 3we present a time series chart comparingthe price-to-EBITDA of the HUI vs. thatof the Nasdaq Composite since 1998.Price-to-EBITDA is a valuation metricthat compares a company’s stock priceto its prots before accounting for taxes,interest payments, and non-cash chargeslike depreciation and amortization. It issimilar to the ubiquitous price-to-earnings(P/E) multiple but allows for a comparisonacross periods where net earnings arenegative and P/E ratio’s incalculable.Looking at the price-to-EBITDA multiplefor the HUI Index we see absolutelyno evidence of a frothy market for goldstocks. At the current level of 13 timesEBITDA, the HUI is actually trading belowits 15-year average of 14 times. Moreover,valuations for gold stocks are currentlyone-third of the levels reached by theNasdaq in late 1999. There simply isn’tany evidence of excessive valuations ingold stocks, which is most certainly wherewe would expect the excesses to be mostapparent.Based on our ndings, this notion of agold bubble is patently false. The currentinvestment interest in gold relative to other nancial assets remains surprisingly low- about where it was two decades ago.Moreover, the modest valuations of goldequities highlight the absence of unbridledinvestor enthusiasm for gold investments.
Source: RBC Capital Markets, Deal Logic, Sprott Asset Management LP
$US billions

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