Precious metals: how to navigate a bubble

Identifying a bubble is easy after it has burst. So, we shouldn’t be surprised if we encounter a bit of ‘I told you so’ about the past week’s slide in gold and silver. But how obvious was it ahead of time? And where do we go from here? Should we call time on the gold rush?

Let’s start with some definitions. To navigate a bubble, you’ve got to see it coming. How can you spot one while you can still do something about it?

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I think of the symptoms in three categories: the ‘what’, the ‘why’ and the ‘how’. A bubble is always characterised by a rapid increase in prices. This is usually reflected in excessive valuations. It invariably triggers an upsurge in media interest. This is the ‘what’.

The ‘why’ is normally some variant of a new era or paradigm. Think internet, AI, or house prices that will never fall. This is the story that fuels bullish sentiment. What former Fed chair Alan Greenspan called ‘irrational exuberance’. The ‘why’ at the individual level is always a form of FOMO. It’s the thought of missing out that prompts the foolishness.

Then there’s the ‘how’. This is when investment becomes speculation - buying something just because it’s going up. Leverage, borrowing to speculate, is a key component of the ‘how’. It is most dangerous when employed by new or inexperienced investors.

One of the most useful guides to toppy markets over the years has been interest in investment from unexpected people - famously shoe-shine boys and cabbies in 1929. I find the two of my three children who don’t work in investment to be a good indication of froth. When they ask me market-related questions, my antennae twitch. 
Every bubble throughout history can be described in these terms. From tulips to railways, from dot.com to US housing, it’s always the same story. Identifying the bubble is relatively easy. Knowing when the music’s going to stop is harder.

All the best investors predicted the bursting of the internet bubble. Unfortunately, most of them did so four or five years early. You can’t fault the judgement of Ray Dalio, Warren Buffett, Peter Lynch and others. But they were warning of the dangers in 1995 or 1996. The Nasdaq peaked in March 2000. In investment, the right call at the wrong time is only slightly better than the wrong call at the right time.

One of the reasons it is so hard to time the top is that valuations are a great guide to long-term investment outcomes but useless at telling you what’s going to happen in the short run. There’s a neat negative correlation between the price of a share and its return over the subsequent 10 years. It tells you nothing about what the next 12 months will bring.

So, the ‘what’ is no help. What about the ‘why’? Again, new paradigm narratives are better at telling you that a bubble is forming than indicating when it will burst. There’s always some truth in the ‘why’ of a market boom. The internet really did change the world, in due course, and so will AI. Bulls can be rational too.

Which leaves the ‘how’. The way in which people are behaving is the best guide to what’s going on. Not least because it can be more measurable. A hundred years ago, you’d have needed to take a lot of taxi rides to get a statistically significant feel for what cabbies were thinking. These days, a quick visit to Google Trends will tell you what’s on people’s minds.

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The Economist recently produced a nice table of returns for a range of investments in the year after a spike in Google searches for the relevant word. With no exceptions, a surge in interest was an excellent contrarian indicator. Heavy losses always followed peak Google.

So, I was unsurprised to see that searches for ‘gold’ doubled a week before the recent high. Over the same short period, searches for ‘silver’ trebled. It was the final confirmation that precious metals were ready to bubble over.

Looking back through my list of ‘what’, ‘why’ and ‘how’, it’s a full house. Rapid increase in price? Check. Overvaluation versus history? Yes. New era narrative? Certainly. Friends making money, FOMO, media frenzy, new investors, speculation, leverage? I think so.

So, yes, I’m not surprised by what has happened in the past week to gold and silver. But that is a very long way from claiming I saw it coming. I didn’t. And I certainly didn’t act on it. I still own gold, both the metal through an ETF and shares in gold miners through a fund. As the aptly named James Goldsmith used to say, ‘when you see a bandwagon, it’s too late’.

I also don’t know what comes next. Back in 1979, the echoes of which are too glaring to ignore today, the gold price doubled between January and September. Over the next two months, it fell back by more than 10%. Plenty of happy but nervous investors would have taken their profits at this point. But by the end of the year, gold had doubled again.
An investor who cashed in at that first sign of trouble missed out on the explosive last hurrah of the 1970s gold boom. That much is evident. But they also saved themselves from 20 years of disappointment. The price of gold was 20% lower in 1999 after two decades of drift. If they had switched into an S&P tracker in September 1979, they would have instead grown their money 12-fold. This is how the gold price goes. Short bursts of euphoria, which late arrivals to the party can regret at their leisure.

This article was originally published in The Telegraph.

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