Debunking the Gold Bubble Myth

http://www.sprott.com/Docs/MarketsataGlance/2011/02%20_11_Debunking%20the%20Gold%20Bubble%20Myth.pdf


Gold’s continuous ten-year rise hasn’t
sheltered it from controversy. Despite
producing consistent returns in virtually
all currencies year after year, some
market pundits still question its validity as
an asset class. It’s true that gold doesn’t
pay any interest, and it’s also true that
much of the gold produced throughout
history still exists in some form today.
But these characteristics shouldn’t inhibit
it from performing as a monetary asset.
Cash, after all, doesn’t pay real interest
either, and there is more fiat money in
existence today than ever before. So
why does gold still receive such harsh
criticism?
We believe much of it stems from a
widely held misconception that gold is
forming a financial bubble. It’s a fairly
straightforward view – that gold buyers
are merely foolhardy speculators buying
on a whim with no rationale other than to
sell to the ‘greater fool’ at higher prices in
the future. It’s a view that assumes that
gold has no intrinsic value and is simply
a speculative asset that has captured
investors’ imaginations.
We don’t take these views on gold lightly.
We’ve seen bubbles before and fully
know how they end. We have no interest
whatsoever in participating in some sort
of speculative frenzy – that’s a recipe
for disaster in the investment business.
Thankfully, however, our gold investments
present no such risk. As our analysis has
revealed, gold is actually a surprisingly
under-owned asset class – and one
that has generated far more attention
in the media than it probably deserves.
While its exemplary performance since
2000 is certainly worthy of discussion,
gold simply hasn’t commanded enough
investment to warrant the bubble fears it
seems to have aroused among market
pundits and business commentators.
The truth about gold is that most people
simply don’t own it…yet.
By: Eric Sprott & Andrew Morris
Contributing Editor: David Baker
www.Sprott.com
Debunking the
Gold Bubble Myth
February 20112
To be clear, a speculative bubble forms when prices for an asset class rise above a level justified by its
fundamentals. For this to happen, increasing amounts of capital must flow into the asset class, bidding it up
to irrational levels. Gold may be trading at all-time nominal highs, but a look at investment flows proves that
it isn’t anywhere close to being overbought.
In their  Gold Yearbook 2010, CPM Group noted that in 1968, gold held by individuals for investment
purposes represented approximately 5% of global financial assets. By 1980 that amount had fallen to
roughly 3%. By 1990 it had dropped significantly 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 estimate
that gold had increased to represent a mere 0.6% of global financial 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 financial assets in 2010.
1
 So despite gold reaching record nominal highs, the world holds about
the same portion of its wealth in gold as it did over two decades ago. While this probably says more about
the proliferation of financial assets over the past decade than it does about gold investment, it is surprising
to note how trivial gold ownership is when compared to the size of global financial assets.
The increase in gold ownership from 0.2% in 2000 to 0.7% in 2010 is also misleading. If you consider the
approximate $227 billion that was invested in gold bullion in 2000, that level of investment would have
grown to $1.18 trillion, or 0.6% of financial assets, by the end of 2010 - based purely on gold appreciation
alone.
2
 In other words, the actual amount of new investment into gold since 2000 represents only 0.1%
of current global financial assets, or about $250 billion. Although this number may seem large, consider
that roughly $98 trillion of new capital flowed into global financial assets over the same period, so gold’s
approximate 0.3% share of global investment flows is essentially trivial.
3
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 require
over $9 trillion of gold investment today, or about 6.5 billion ounces of gold at the current gold price. This
would represent well over 1.3 times the amount of gold ever produced throughout history and four times the
amount of known gold reserves.
4,5
 So not only is the public relatively underinvested in gold, but at current
prices it isn’t even possible to increase our gold holdings back to a meaningful level.
Gold’s apparent underinvestment also applies to gold equity financings since 2000. According to our
sources, gold companies raised approximately $78 billion of equity capital in new financings over the past
11 years.
6
 To put this amount in perspective, this is equivalent to the total amount of equity raised by
technology companies in the first three months of 2000.
7
To further illustrate the lack of activity in the gold equity capital markets, we compare last year’s gold
company financings with the technology company financings in the year 2000 (Chart 1). Once again,
looking at the relative amount of capital market activity in the gold equity markets, we find no indication of
a bubble whatsoever.
Furthermore, we compiled information on mutual fund flows to get a sense for the average retail investor’s
appetite for gold equity investments (Chart 2). We found very familiar results in this area as well: compared
to the $2.5 trillion dollars that was invested in US mutual funds since 2000, precious metal equity funds have
seen a mere $12 billion in inflows. If there is a bubble in gold investments, the average retail investor hasn’t
participated in it.
www.Sprott.com
1
SAM estimate based on data obtained from McKinsey & Co., IMF, CPM Group, Thomson Reuters, BIS
2
“CPM Gold Yearbook 2010” CPM Group (March 2010)
3
SAM estimate based on data obtained from McKinsey & Co., IMF, CPM Group, Thomson Reuters, BIS
4
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
5
“Mineral Commodity Summaries 2011” US Geological Survey (January 2011). Retrieved March 7, 2011 from: http://minerals.usgs.gov/minerals/pubs/
mcs/2011/mcs2011.pdf
6
RBC Capital Markets, Dealogic
7
Ibid.www.Sprott.com 3
Source: Bloomberg, Sprott Asset Management LP
CHART 3
Price-to- EBITDA (TTM)
0
500
1000
1500
2000
2500
3000
CHART 2
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 beneficial to review equity valuations,
since they provide an excellent lens into
investor sentiment for an asset class.
Certainly if a bubble was forming in gold,
it would likely rear its head in the stock
market, where speculative manias have
been fleecing ‘greater fools’ for centuries.
The best gold index to review for valuation
is the Amex Gold Bugs Index (HUI),
which has returned a stunning 674%
since 2000. It is certainly an index that
could be mistaken for a bubble based
on its incredible performance… until one
considers its relative valuation. In Chart 3
we present a time series chart comparing
the price-to-EBITDA of the HUI vs. that
of the Nasdaq Composite since 1998.
Price-to-EBITDA is a valuation metric
that compares a company’s stock price
to its profits before accounting for taxes,
interest payments, and non-cash charges
like depreciation and amortization. It is
similar to the ubiquitous price-to-earnings
(P/E) multiple but allows for a comparison
across periods where net earnings are
negative and P/E ratio’s incalculable.
Looking at the price-to-EBITDA multiple
for the HUI Index we see absolutely
no evidence of a frothy market for gold
stocks. At the current level of 13 times
EBITDA, the HUI is actually trading below
its 15-year average of 14 times. Moreover,
valuations for gold stocks are currently
one-third of the levels reached by the
Nasdaq in late 1999. There simply isn’t
any evidence of excessive valuations in
gold stocks, which is most certainly where
we would expect the excesses to be most
apparent.
Based on our findings, this notion of a
gold bubble is patently false. The current
investment interest in gold relative to other
financial assets remains surprisingly low
- about where it was two decades ago.
Moreover, the modest valuations of gold
equities highlight the absence of unbridled
investor enthusiasm for gold investments.
Source: RBC Capital Markets, Deal Logic, Sprott Asset Management LP
CHART 1
0
50
100
150
200
250
$US billions
TotalSprott Asset Management LP
Royal Bank Plaza
South Tower
200 Bay Street
Suite 2700, P.O Box 27
Toronto, Ontario
M5J 2J1
T: 416 943 6707
F: 416 943 6497
Toll Free: 888 362 7172
www.sprott.com
The opinions, estimates and projections (“information”) contained within this report are solely those of Sprott Asset
Management LP (“SAM LP”) and are subject to change without notice. SAM LP makes every effort to ensure that the
information has been derived from sources believed to be reliable and accurate. However, SAM LP assumes no responsibility
for any losses or damages, whether direct or indirect, which arise out of the use of this information. SAM LP is not under
any obligation to update or keep current the information contained herein. The information should not be regarded by
recipients as a substitute for the exercise of their own judgment. Please contact your own personal advisor on your particular
circumstances.
Views expressed regarding a particular company, security, industry or market sector should not be considered an indication
of trading intent of any investment funds managed by Sprott Asset Management LP. These views are not to be considered as
investment advice nor should they be considered a recommendation to buy or sell.
The information contained herein does not constitute an offer or solicitation by anyone in the United States or in
any other jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful
to make such an offer or solicitation. Prospective investors who are not resident in Canada should contact their
financial advisor to determine whether securities of the Funds may be lawfully sold in their jurisdiction.
4
The fact is, despite all this talk about the gold bubble, the capital flows into gold vis-à-vis other financial assets
have simply not been large enough to indicate any speculative mania. Investors can rest assured that they
are not participating in any speculative bubble by owning gold. They are merely protecting their wealth.