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What is a gold bubble and why is it formed?

A gold bubble is formed when the price of gold increases rapidly for no reason. When in a short period due to the activity of dealers, the price of gold rises and exceeds its intrinsic value, then a price bubble has occurred.

Unlike real estate, oil, or company stocks that generate income, gold has very little fundamental value on which to base its true price. This makes the price of gold more easily influenced by dealers.

To determine if a gold bubble has occurred, let’s examine the following:

  • Where does the demand for gold come from?
  • What is a price bubble?
  • Why is gold no longer money?
  • What is the fundamental value of gold?

In this article from the Wallex blog, we discuss more about the factors that affect the price of gold and the conditions that make gold prone to bubbles.

What is a price bubble?

bubble one Economic cycle It is characterized by a rapid increase in market value, especially in asset prices. This rapid inflation is accompanied by a rapid devaluation or contraction, sometimes referred to as a bubble burst.

Typically, a bubble is created by rising asset prices that result from bullish market behavior. During a bubble, assets typically trade at a price or in a price range that is much higher than the intrinsic value of the asset (the price does not match the fundamentals of the asset).

The cause of bubbles is discussed by economists. Some even disagree that bubbles occur at all (on the basis that asset prices often deviate from their intrinsic value). However, bubbles are usually identified and investigated only after a sharp price drop.

Calculate the value of gold

Unlike other investments, most of gold’s value is not determined by its contribution to society; People need housing to live, they use oil and gasoline for transportation, if gold does not meet people’s needs.

Gold is most widely used as a raw material for the production of luxury decorative items and in the jewelry industry, which accounts for about 78% of the production of this precious metal. Other industries such as electronics, medicine and dentistry use only 12% of its annual production, the rest of the production is also used in financial transactions.

As it was said, gold is not an asset in principle; Because it is not a stock that has profit, you cannot earn profit from its rent and it does not generate cash income. However, it is traded on feature exchanges and offered by FX brokers. As of December 2019, the average daily trading volume of gold was calculated by the World Gold Council to be US$145.5 billion, placing gold in third place among US securities and stocks of the S&P 500 index.

Gold is not just a commodity; Because only a small part of it is used in the industry. In 2019, 6.326 metric tons of gold were demanded by the global technology sector, which is relatively small compared to demand from central banks, investment purposes and jewelry.

The highest demand for gold belongs to the jewelry industry. In 2019, the global jewelry market reached a staggering 2,119 tons.

The ambiguity surrounding gold also affects how it is taxed and how the law treats it. For example, in most Western countries, gold is not subject to VAT; Because it is considered an investment. In addition, gold is not subject to capital gains tax because it is not considered an asset.

Gold is considered by central banks, private banks and many individual investors as the best safe-haven asset, ideal for preserving wealth for decades or even centuries.

What is a gold bubble?

Gold price bubble

More than any other commodity, the price of gold goes up mainly because people think it will! For example, people may believe that gold is a good hedge against inflation. As a result, when inflation starts, they also look to buy it. In fact, there is no logical reason why the value of gold should increase as the dollar depreciates. Rather, it happens simply because people think so.

Keynesian view on the gold bubble in recent years

There is controversy over the idea that we are currently experiencing a gold bubble in July 2022. For example, Arthur Pinkasovitch, an analyst at Investopedia, believes that a long-term change in fundamentals has caused a slow but steady rise in the price of gold. However, there is a compelling argument that the gold bubble is real and we are experiencing it now.

Historically, the price of gold has been largely stable or has grown incrementally. In 1980 there was a jump to $615 per ounce, followed by a fall to around $300 per ounce, with prices more or less stable until 2006. Since that year, the price of gold has risen above $1,900 per ounce. The Wall Street Journal reports that gold has returned 25% per year over the past five years, far above the average return for other assets.

Detection of gold price bubble

Gold bubbles were easier to spot in the past. Because today there are many opinions; Some argue that gold is not a bubble and that what is happening is a natural price increase. Others argue the opposite, perhaps because it puts their assets at risk, conflicts with their interests, or is bitter to believe they’ve missed an opportunity.

When the price of gold skyrockets, everyone thinks that a gold bubble has happened; But it’s actually hard to classify something as a bubble, especially until the bubble bursts.

Signs of a bubble can be recognized when the price of an asset rises above and beyond its fundamental value. By identifying behavior that aligns with the early stages of a gold bubble, it may be possible to detect an economic bubble while it’s happening, although it’s impossible to know whether prices will eventually fall.

In the following, we will examine the signs of a gold bubble so that it can be more easily recognized.

5 stages of price bubble formation

Stages of gold price bubble formation

Hyman P. Minsky (Hyman P. Minsky) was one of the first economists to research financial instability and its relationship with the economy. In his book on Unsustainable Economics (1986), he was able to identify five stages of a price bubble in a typical economic cycle. These steps apply to all price bubbles, including gold.

Step 1: Moving

A shift occurs when investors turn to buying and investing in gold in a frenzy over a change in the economy, such as the advent of an innovative new technology or a drop in interest rates.

Stage 2: Boom

Prices initially rise slowly following the move, but as more and more investors enter the market, they gain momentum, setting the stage for the boom phase.

At this stage, gold receives widespread attention from the media. The fear of missing out on a once-in-a-lifetime opportunity motivates more people and attracts a significant number of investors and traders.

Step 3: Euphoria

During the euphoric phase, investors throw caution to the wind and asset prices skyrocket. Valuations for assets reach very high levels, often new types of metrics and performance indicators are introduced in an attempt to justify the higher values. At this stage, investors think there is no ceiling to how expensive the asset can become and always believe that someone else will be willing to buy the asset at a higher price.

Step 4: Profitability

At this point, institutional investors, who have access to more market information, begin to sell positions and take profits. But estimating the exact time when the gold bubble will burst can be difficult. Because, as economist John Maynard Keynes said: “Markets can be more irrational than you think.”

Step 5: Panic

It may only take one minor event to burst the gold bubble. But once the gold bubble bursts, the bubble cannot be inflated again. During the panic phase, asset prices reverse their course and fall as fast as they rose.

Investors and brokers who have faced the decline in the value of their assets, now want to liquidate their assets at any price. In this case, the supply will overcome the demand and the price of the assets will decrease drastically.

Is gold a good option for long-term investment?

It’s up to you to decide whether gold is right for your investment portfolio; How much risk you are willing to take, whether you are able to combine your portfolio, is also related to your investment goals and the amount of capital you have, among other factors.

But don’t forget one basic thing: you should never invest money you can’t afford to lose.

Have you ever fallen into a bubble trap? Fear of losing what kind of property has overcome your logic?

What is a gold bubble and why is it formed? The first time in the blog Valx. appeared.

Amirim

hello my name is amir; i love bitcoin and dogecoin 🎯

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