Bubble talk has progressed from AI companies to gold following the sharp rally in the precious metal price this year. The Bank for International Settlements has warned that gold and US stocks are showing signs of being in a bubble, pointing towards hype and exuberance among investors.
Gold has increased by 60% this year to $4,218 per ounce thanks to strong interest from investors and central banks. The metal has traditionally had the reputation of safe-haven qualities, holding its value during times of market stress.
With so much uncertainty around politics, trade, and war this year, it is easy to see why gold has attracted retail investors. Adding to the buying spree has been a trend among central banks to diversify their reserves away from the US dollar through gold.
While equity markets have performed well this year, they have become more volatile in recent months amid concerns about the gigantic sums big tech firms are spending on AI. This equity volatility has led to another leg-up in the gold price after it pulled back in October.
What is all this bubble talk?
The Bank for International Settlements acts as a bank for central banks and provides analysis and insights on core policy issues. Therefore, when it starts to talk about potential bubbles in financial markets, it is worth taking notice.
It says bubbles are characterised by rapid and accelerating price surges – “reminiscent of an explosive behaviour” – followed by sharp corrections.
Notably, the Bank for International Settlements has flagged that gold prices went up at the same time as other risk assets (i.e. shares) earlier this year. If investors are excited about shares, one might expect reduced appetite for gold – not hunger for both in tandem.
It commented: “Fund flow data reveal it was mostly retail investors who recently poured money into US equities and gold funds. Furthermore, retail investors have increasingly taken trading positions that run counter to those of their institutional counterparts: the latter were taking money out of US equities or maintaining flat positions in gold, while retail investors recorded inflows.
“Although the influx of retail investors has mitigated the impact of institutional investor outflows, their growing prominence could threaten market stability down the road, given their propensity to engage in herd-like behaviour, amplifying price gyrations should fire sales occur.”
Can gold protect portfolios?
During the 2020 Covid market crash, investors used gold as a source of liquidity. It was a case of sell what you could, rather than what you wanted to sell.
On 21 October this year, the price of gold dropped by 5.7% in a single day. This is worse than the largest single-day drop of the MSCI World following Liberation Day in April, where the fall was 4.7%.
This begs the questions: how good is gold at protecting portfolios in a market dip? In the 2008 global financial crisis, gold couldn’t make a steady split from equities until over 150 days after the initial market drop. Before this period, the pricing was erratic.
Eventually, it did recover faster than equities, but this behaviour does not necessarily offer the stability sought by investors.
As the chart indicates, in three of the 10 worst quarterly global equity market declines of the past 25 years, gold fell in price before rebounding. At times, gold has been able to cushion portfolios when equities dip, but this is far from a certainty. Other assets, such as short duration bonds, have functioned as a more stable diversifier.
No-one knows exactly how gold, or even bonds, will behave if we get another market correction. But history shows the power of diversification, spreading risks across different asset classes so you are not reliant on one thing to do well.
Learn more about gold
If you would like to learn more about the outlook for gold, watch our recent interview with fund manager Evy Hambro from the BlackRock World Mining Trust. He talks about the precious metal, the companies that dig it out of the ground, and what has been driving the gold price higher.
Dan Coatsworth: Head of Markets
Dan Coatsworth is AJ Bell's Head of Markets. Dan has been with the company since December 2012 and has more than 18 years' experience in the industry, following the markets and all things investing. He...
