There are a number of ways to define a price bubble (also referred to as a speculative bubble, economic bubble, asset bubble or financial bubble). The simplest definition says that a price bubble is an upward deviation of the market price from the asset's fundamental value. In other words, the bubble means an upward price movement over an extended range which then implodes.
What causes bubbles in financial markets? Economists are, as always, divided, but most of them point out the rise in money supply and low interest rates as main drivers of the speculative manias. Easy money – typical for the phase of boom during the business cycle – feeds ‘irrational exuberance’, as Alan Greenspan called the asset bubbles. Low interest rates and cheap credit increases demand for assets, triggering a rise in the price of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers. Thus, psychological factors, as well as moral hazard, also contribute to bubbles.
Economic Bubbles and Gold
All bubbles have to burst. The easy money cannot last forever and the market psychology changes. Investors have to learn how to profit during bubbles, but also how to prepare for the bust. One of the best ideas is to purchase gold, which is a good diversifier. The yellow metal has low or negative correlation with other assets. Therefore, usually gold shines when other asset markets crash. The best example is the Great Recession. After the Lehman bankruptcy, the stock market bubble burst, which pushed the price of gold up.
Some people believe that gold was in a speculative bubble in the second half of the 2000s, which burst in 2011. The problem with detecting bubbles in the gold market is that gold has no yield, therefore it is practically impossible to assess gold’s fundamental value. How can you say that the price of gold is too high, when you do not have an internal benchmark? Moreover, it seems that the price of gold rallied because its fundamental drivers changed. In 2000s, the U.S. dollar was depreciating reflecting the deteriorated fiscal position of the U.S. In 2008, the stock market collapsed, risk-aversion sky-rocketed, while real interest rates plunged. When the markets calmed down in 2011 (partly due to unprecedented Fed actions), the price of gold declined. However, it did not fall to the levels seen before its rally. It is the main argument against a bubble existing in gold in the 2000s, as when bubbles burst, asset prices usually fall to the ‘true levels’ recorded prior to the beginning of the bubble (for example, the price of oil dropped in 2016 even below the lowest point in 2009, when the bubble started).
We encourage you to learn more about gold – not only how to use it as insurance against the financial bubbles, but also how to successfully apply gold as an investment and how to profitably trade it. A great way to start is to sign up for our gold newsletter today. It's free and if you don't like it, you can easily unsubscribe.