Monday Morning: Golden opportunity may be near an end

Gold has long fascinated us, as evidenced by the many myths about it dating back to antiquity. The allure of the precious metal comes from its scarcity, its beauty and its indestructibility.

For millennia, gold was used as money. Back then, it represented the promise of real value behind paper currencies.

But most countries abandoned this “gold standard” in the 1970s, and the glittery element began to fade from our collective consciousness except as jewelry and as an inflation hedge in the late 1970s and early 1980s.

But recently, gold appears to have undergone a rehabilitation as an investment vehicle and has gradually regained its luster.

Indeed, the price of gold had skyrocketed to almost $358 an ounce as of last Thursday, from $271 at the beginning of 2001.

What’s more, gold mutual funds were among the best performers last year, with some of them up more than 100%.

Why are gold and gold-oriented mutual funds suddenly popular again, and could the increased interest be a trap for the unwary?

The most obvious reason for the spike in gold prices is the possibility of war with Iraq.

Gold has always been a popular investment in times of uncertainty. That’s because it is almost universally accepted as a medium of exchange, and small, easily hidden amounts represent lots of purchasing power.

No doubt, some of the increased demand for gold that is pushing up its value comes from citizens in countries near Iraq, who fear the war may spill over into their nations.

Another driver is the political and economic uncertainty in Venezuela, Argentina and Brazil.

Set to level off

In the face of this increased demand, supply has stabilized. For much of the 1990s, central banks around the world were selling off large parts of their gold reserves, pushing its value down.

The selling trend now seems to have run its course, reducing supply.

Paul Kasriel, director of economic research at Chicago-based Northern Trust Corp., says low returns on money market instruments are another reason for the increased interest in gold as an investment.

Investors fear not getting a positive inflation-adjusted return on their money market investments, he says, so they turn to other liquid assets that will at least preserve their purchasing power. Gold has historically been one of these liquid assets, he notes.

In 2002, Mr. Kasriel says, the inflation-adjusted return on a three-month investment in terms of the U.S. dollar was -1%.

While positive returns are still available in some foreign-currency investments, the signs indicate that that won’t continue.

And the price of gold is rising, not only in terms of dollars but in pounds and euros as well.

While it seems likely the value of gold will continue to soar until the crisis over Iraq is resolved, the long-term prospects are uncertain.

A satisfactory conclusion to the crisis would remove fear-driven demand, though what Mr. Kasriel calls the “honest return” demand would continue and even rise if European governments continued to cut short-term rates.

fear-driven demand

There’s no way to measure whether such a demand would be enough to offset a drop in fear-driven demand.

But it’s likely that the biggest gains in the price of gold have already been seen.

It may still make sense for gold or gold-oriented mutual funds to make up a small part of an individual’s portfolio, because academic studies have shown that such commitments can be a useful diversifier.

But the danger at the present time is that when the Iraq crisis ends, the price of gold will once again plummet, just as it did in the early 1980s, when inflation – which had driven the price to more than $800 an ounce – subsided.

Mike Clowes is editorial director of InvestmentNews and sister publication Pensions & Investments.