No matter what happens, the price of gold will increase. If we have another wave of international banking failures and a deflationary collapse, gold will rise as investors flock to it as a safe haven. But if the economy recovers and we actually get inflation from all of the monetary stimulus unleashed by the Federal Reserve and European Central Bank, gold will rise as an inflation hedge. Apparently, there is no scenario under the sun in which gold won’t rise.

It all sounds great, of course. But this is precisely the kind of sentiment that breeds bubbles. Popular “can’t lose” investments always seem to have a way of losing money. You “couldn’t lose” buying tech stocks in the 1990s until you suddenly lost a bundle. Because of a shortage of coastal land, you “couldn’t lose” buying Miami condos either … until you did.

It’s impossible to ever say what the “correct” price for gold is because there is no good criteria to measure its value. It pays no dividends or interest, it has no earnings and it has little in the way of industrial value. Nothing of actual value is created.

So, without a proper measuring stick, we’re left with imperfect comparisons and a hodgepodge of anecdotal evidence. Still, the evidence we do have has suggested that gold has been forming a bubble for roughly the last year. Let us review:

  • Gold has decoupled from other commodities such as crude oil, and this has accelerated in the past six months. The divergence that is most inexplicable is that between gold and platinum. Consider Figure 1. During the past six months, platinum prices have been most flat while gold has shot to the moon. Even more strangely, platinum is considered to be a more prestigious and valuable precious metal than gold (and also has more industrial uses), yet today their prices are almost identical. As I write this, gold is trading at $1,853 per ounce and platinum for $1,873 per ounce.

Figure 1

  • Gold’s traditional use as jewelry appears to be in terminal decline. Consider Figure 2, which I originally included in an article I penned in January. Gold’s global use as jewelry has been cut nearly in half during the past decade, even as economic growth has been stellar in traditional gold-buying countries like India. Yet gold for “investment” has increased by a factor of 65. And remember, this data only goes through 2010. I’d love to see what the chart would look like were it updated for the recent investor stampede into gold.

Figure 2

When the underlying demand characteristics of an asset start to shift, look out. Condos in Miami got ludicrously expensive only when speculators began to flip them for profit with no intention of ever living in them. And it is worth mentioning the last time gold used for investment exceeded gold used for jewelry was 1980 — the year the last gold bubble burst.

  • Central banks and governments have become net buyers again. It is surprising given that central banks tend to be run by cerebral Ivy League economists, but central bankers tend to be absolutely horrid market timers. They were massive sellers of gold when it traded for $250 per ounce. Yet according to the World Gold Council, central banks have collectively imported 198 tons of gold in the first half of 2011. Even two years ago they were collectively selling 450 tons a year.

In perhaps the highest-profile move, Venezuelan President Hugo Chavez ordered the country’s central bank to repatriate 211 of its 365 tons of gold reserves currently held in U.S., European, Canadian and Swiss institutions. Chavez also decided to nationalize Venezuela’s gold mines. While I believe in studying the investment decisions of financial gurus to gain insights, Hugo Chavez does not come to mind as a sage investor I’d like to follow. One might consider Mr. Chavez’s rather noisy appearance on the gold scene as a sign that it is time to make your exit.

I could go on, but you get my point. The gold bubble appears to have reached the mania stage, and in its recent price spike it has started to go parabolic. I believe we might be seeing the final, spectacular blow-off top of the gold bubble taking shape. I could be wrong — or early — but gold would appear to be highly risky at this stage.

If you still own it, good for you. You’ve had a good run. But recognize the gold bubble for what it is, and don’t get greedy. If past bubbles are any indication, when gold cracks, you had better look out below.

Charles Lewis Sizemore, CFA

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