Beware Gold’s Sharp Double Edges

11/25/2011 7:30 am EST

Focus: COMMODITIES

Demand for gold is up. This is largely why the price of gold is high, but you need to understand how to invest in gold first, says Marc Johnson of The Investment Reporter.

The price of gold usually moves in the opposite direction of the US dollar. Since gold trades in dollars, it becomes more affordable abroad when the dollar declines.

Thus, the large US deficit, rising US debt, and the recent credit-rating downgrade is likely to lower the dollar in favor of the price of gold.

Emerging markets such as China and India have seen their rapid growth cause inflation. Some citizens have bought gold as a special store of value.

Inflation is less of a concern in the developed world. Government cutbacks in Europe and a weaker global economy can keep inflation in check. Still, some worry that loose monetary policies in the developed world, stimulative fiscal policies in countries such as the US, and the demise of the gold-based monetary system will touch off inflation. The fear of inflation has prompted some to buy gold.

Most of the Eurozone is in trouble. Investors who distrust paper currencies such as the euro are likely to buy gold. And some central banks would rather hold reserves of appreciating gold instead of reserves of depreciating dollars or euros.

Gold’s price rise in recent years is attracting momentum investors. More generally, we see investment demand continuing to drive the price of gold.

The demand for gold jewelry is also recovering. Analyst Charles Clark says the demand for gold used in jewelry was up by 6.4% over the previous 12 months. This consumed 2,075 metric tons of gold, and growth should continue in the years ahead.

The high price of gold also acts to raise supply. Global mine production is likely to grow. High gold prices make it profitable to put new, old, and even marginal mines into production. Gold companies are also likely to bring on more reserves to take advantage of the high price. Also, gold scrap recoveries should rise.

The International Monetary Fund may need to sell some of its gold to raise money. This also adds to the supply of gold. Still, given gold’s rarity, we expect only a modest increase in supply.

On balance, we expect the price of gold to remain high. This will help gold companies profit, especially those that can increase their production. Despite the rise in the price of gold bullion, the rise in the shares of gold producers has lagged behind significantly.

Alternatives to stocks are gold exchange traded funds or physical gold itself. Just remember that given gold’s drawbacks, it’s best to hold only a little gold to diversify your portfolio.

NEXT: The Downside of Gold

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The Downside of Gold
Gold hit a record high of $1,908 an ounce on August 22—though it now trades around $1,700 an ounce.

Many speculators remain in the yellow metal. To help you resist following the crowd into gold, we again remind you of some of gold’s drawbacks.

One problem with gold stocks is that they have a certain je ne sais quoi that leads some investors to overpay for them. Some of them trade at high price-to-earnings ratios. Were these companies in any other industry, most investors would refuse to pay such high multiples. Yet investors do pay these high multiples, likely rationalizing that "it’s a gold mine."

You can buy the metal itself. This will avoid the problems of any given gold stock—a sudden jump in taxes, a drop in ore grades, strikes, floods, and so on.

The disadvantage of holding physical gold is that you’ll earn little if any income. More likely, you’ll have to pay for its safe-keeping. One way around this is to buy gold exchange-traded funds.

A third drawback is that unforeseeable events can affect the price of gold. For instance, geopolitical instability can drive up the price of gold. The trouble is, how can you plan for unforeseeable events?

More important, gold has a terrible long-term record as an investment. For more than 200 years, gold has delivered very poor real (inflation-adjusted) returns.

Jeremy Siegel, a professor of finance at the University of Pennsylvania’s Wharton School, studied the returns of different classes of investments from 1802 through 2006. One was gold.

Say one of your ancestors had invested a US dollar in gold in 1802. At the start of 2007, it would’ve risen to only $1.95. That’s a real return of just 0.3% a year.

True, the number would now be higher due to the recent jump in the price of gold to the current price of $1,700 an ounce. But the fact remains that for most of the 20th century, that dollar in gold was worth less than a dollar.

By contrast, had another of your ancestors invested a dollar in stocks, it would’ve turned into $755,163 at the start of 2007— even after accounting for inflation.

Professor Siegel concludes, “In the long run, gold offers investors protection against inflation, but little else. Holding these assets will exert a considerable drag on the return of a long-term investor’s portfolio.”

Indeed, after a run-up in the price of gold to a record high in 1979 and 1980, gold subsequently declined and languished at low prices until recently.

Even so, some investors worry that the poor finances of the US and European governments will lead to higher inflation. The printing of paper currencies is no longer held in check by the former gold-standard monetary system.

Also, higher inflation lightens the debt burdens of governments. They get more taxes from higher nominal salaries and profits. And inflation lets them repay debt in depreciated currencies.

Indeed, despite sharp government cutbacks in Europe and economic weakness in the US, inflation is a problem in some parts of the world.

If you’re worried about inflation, then you might buy "hard" assets, such as gold (or antiques and real estate). Gold is best used to reduce the risk of your portfolio. But given its poor long-term record, limit your investment in the yellow metal to a small part of your portfolio.

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