Washington, DC, August 23 2011 --  

Bonds say no inflation. Gold says hyperinflation. Let's call the whole thing a bubble.

Of all the investments added to my portfolio over the past decade, by far the best rate of return came from a small buy order shortly before my wedding in 2005. The quarter ounce gold band on my finger has more than quadrupled in metal value -- from $61 in January 2005 to $277 yesterday^1,2. That's impressive -- except I won't be selling anytime soon.

Yesterday's record high of gold at over $1,900 ounce³ is just the latest in a decade old bull market. This rise is contrary to what has happened with many other investments. Stocks, with all their ups and downs, sell at a similar price as ten years ago. The same goes for real estate. Bonds, CDs, and other debt notes have been paying anemic returns in the Western world, compared with interest rates from earlier decades. Only a few commodities, led by gold, have given investors a tremendous run of appreciation.

If you believe what you read in countless blogs on the subject, gold is skyrocketing because of the impending end of the financial world. Hyperinflation is coming, because nations have debased their currencies. Fear of inflation has driven the price of gold from under $300 per ounce a decade ago to $1,900 yesterday.

This incredible price rise is not just a bubble -- it's as crazy as the theories in the gold blogs. In order to justify a six fold increase in the price of gold since 2001, an American investor fearing inflation must believe that the U.S. dollar will soon have one sixth the purchasing power that it did in 2001. This would be the same result as inflation at 25 percent per year for 5 years straight.

Is this really possible? While this column has long warned of inflationary dangers created by U.S. fiscal and monetary policy, such high and sustained rates of inflation are still unlikely. The 25 percent annual rate of inflation described above has never happened in any year since the Bureau of Labor Statistics created the Consumer Price Index in 1913. Even if it were to start happening, investors could then shift dollar assets into a safer alternatives before taking large losses. Only belief in a more sudden and dramatic drop in the value of the dollar -- like hyperinflation or a total financial collapse -- can justify current gold prices.

Yet if the markets believe a financial collapse is so imminent, then why is the interest rate it demands for government bonds so low? Despite the S&P downgrade of U.S. debt, 30-year Treasuries are earning less than 3.5 percent interest.⁴ Just to avoid losing money, investors in these bonds must believe that inflation will average under 3.5 percent each year for the next 30 years.

Why the huge market disparity between bonds and gold? The simplest explanation is that investors have diverged into two very different camps -- those who have total faith in paper money and those who have none. One of these groups -- either the bond fanatics or the gold fanatics -- must be spectacularly wrong here, and that group is going to lose a spectacularly large amount of money.

While both investment vehicles seem pretty large on the surface -- $10 trillion in gold exists at current prices^5,6, and $14.6 trillion in U.S. Treasury bonds⁷, the reality is that the gold investment market it much smaller. Much gold is held in the form of jewelry and by central banks mandated to retain it despite market conditions. The world's biggest grouping of gold funds, Exchange Traded Gold, claims a mere $94 billion in assets.⁸

Given the smaller amount of money that gold investors have been willing to put at stake, it is likely that they are influenced disproportionately by less sophisticated investors operating at a smaller scale. Thanks to the internet, any crackpot can have access to ample information to fuel his pet theory. The gold investors are more likely to be more wrong.

But that doesn't mean there won't be plenty of wrongness to go around. As usual, the truth probably lies somewhere in the middle between the bond market's no inflation prediction and the hyperinflation predicted by the gold market. Back in 1980, inflation in the United States topped out at 13 percent, and continued in the high single digits for several adjacent years.⁹ Such a prospect is hardly out of the question.

Back in the inflationary months of 1980, gold was also trading at the highest price in history -- a price that once adjusted for inflation is still higher than today. Just as investors now are overpaying for gold, so were investors in 1980. 25 percent annual inflation didn't come in 1981, and it isn't likely to come in 2012. Today as in 1980, the gold bubble is looking ready to pop.

Notes:

1. National Mining Association, Historical Gold Prices 1833 to Present, August 2011 ($420 per share in January 2005.)

2. Author's Calculation: 14K = 58.3% x 0.25 ounces = 0.14583 pure gold. @$420/oz = $61@1900/oz=$277

3. Wall Street Journal, Gold Tops $1,900, Then Pulls Back, August 23, 2011

4. Treasury Department, Daily Treasury Curve Yield Rates, August 23, 2011

5. World Gold Council, About Gold, August 2011 (165,000 metric tons)

6. Author's Calculation: 165,000 metric tons x 32,150 troy ounces / metric ton x $1900 /ounce = $10 trillion

7. Treasury Department, Debt to the Penny and Who Holds It, August 23, 2011 $14.6 trillion

8. Exchange Traded Gold, Summary of All Assets, August 23, 2011

9. Bureau of Labor Statistics, Inflation CPI Calculator, August 2011