Should You Join the Gold Rush?

Photo (cc) by Muffet

Gold has been in the news a lot lately, and for good reason. While everything from housing to stocks have been hard-hit in the world’s ongoing financial turmoil, the Midas metal has been a consistent winner for much of the last decade. From a low of $263/oz. in January of 2001, gold is now changing hands at around $1,200/oz. – a gain of more than 400%.

The question for today’s investor: does this 21st century gold rush still have legs, or is the gold bubble on the verge of bursting? The answer depends on your view of the future.

Before we get into specifics, take a look at the following recent news story. We’ll continue the conversation on the other side.

As I said in the story above, my view is that the easy money in gold has already been made. In other words, while gold could go higher, especially in the short term, it’s too late in the cycle to expect much higher prices.

My view arises from my belief that the world economy is on the mend. Many others disagree, however, stressing that factors pushing gold prices higher may persist for years to come.

Let’s look at both sides of the argument so you can form your own conclusion.

The positive (bullish) case for gold.

While gold prices are somewhat related to demand for gold in jewelry and industrial applications, what’s driven gold prices higher in recent years stems from its role as a safe-haven investment. In other words, investors turn to gold when they’re afraid of things like economic or political turmoil, inflation, currency devaluation and declining stock markets.

It’s easy to understand why gold has looked so appealing in recent years: the economies of many countries – especially the U.S. and Europe – have been in recession and in many cases teetering on the brink of depression. To combat negative growth, governments world-wide have essentially been printing money, which has in turn lead to currency devaluation and potential future inflation.

Many believe these problems aren’t over yet. They believe that a European debt crisis is looming, and rather than recovering, the economies in the U.S. and Europe will soon be in recession again – a double-dip. They believe that the U.S. budget deficit isn’t being adequately addressed, which will lead to more money-printing, more currency devaluation and more inflation. All of these scenarios could lead to lower stock and bond prices and higher gold prices.

For clues to European economic health, investors are awaiting the results of European financial “stress tests” of 91 banks, which will be released on July 23rd. These tests are designed to reveal whether European banks are sufficiently capitalized. (Translation: whether they have enough money to withstand an economic downturn.) If these tests reveal that European banks are weak, that will strengthen the bullish case for gold.

On this side of the Atlantic, growth has been slowing, suggesting to some the U.S. recovery is over and our country is instead slipping back into recession. If that happens, stocks and the U.S. dollar will slide and gold prices will probably go up.

For clues to U.S. economic health, pay attention to unemployment and housing data, along with second quarter corporate earnings, which started being reported this week.

To learn more about the bullish case for gold, check out this recent article from CNN/Money.

The negative (bearish) case for gold.

Gold is a risky investment. From August 1976, gold prices rose 800% to peak at $850/oz in January 1980. But from there, prices dropped for the next 20 years, bottoming in 2001 at $263/oz.

If it turns out that the world economy isn’t going to hell in a hand basket and is instead improving, we could have a repeat of that miserable performance in coming years.

In other words, if the U.S. and other Western countries begin to successfully tackle their budget deficits and world economic growth remains on track, the gold bubble could easily burst.

In fact, even if things do go from bad to worse, gold could lose its luster. For example, if economic reports indicate a worsening economy – a double dip – that would decrease the odds of inflation and increase the odds of the opposite problem: deflation, or falling prices.

Deflation is horrible for pretty nearly every type of investment, save perhaps Treasury bonds. So in that scenario gold could take a hit.

To read more about the negative case for gold, see this article from MSNBC.

How to invest in gold

My optimism around an economic recovery means that I’m a gold bear rather than a gold bug. As I said above and in the video news story, I think the easy money has been made and that the odds favor lower prices in the years ahead. That being said, however, I still own some gold. Why? Simple: because I could be wrong, and gold offers a kind of insurance for my stock investments.

I own gold through an ETF (exchange traded fund) that trades on the NYSE under the symbol GLD. This ETF owns $50 billion worth of gold bullion and trades like a stock, which means I can sell it any time for a commission of $7.50. As you can see when you look at my online portfolio, I purchased 100 shares in 2009 at an average price of about $88/share – about 30% lower than where it’s trading today. I put about 10% of this portfolio into gold, which is a good percentage for this kind of insurance.

While I think a gold ETF offers the most hassle-free way to own gold, it’s not the only way. You can buy gold mining stocks, gold coins or even gold bullion. But if you’re thinking of buying bullion or coins, be aware that transaction costs can eat up a lot of your potential profit. And avoid the heavily-advertised outfits you see on TV. Here’s an excerpt from the MSNBC article mentioned above:

Last month, Rep. Anthony Weiner, D-N.Y., assailed metals dealer Goldline, a sponsor of Glenn Beck’s radio program, for its “aggressive sales tactics.”

Weiner said in a report that Goldline marks up the price of gold an average of 90 percent over melt value, and cited one case in which the price was 208 percent above the melt value.

Beck and other conservatives use “their shows to prey on the public’s fears of inflation and socialist takeovers while actively promoting the purchase of gold coins as insurance against this purported government overreach,” Weiner said.

So if you’re going to buy gold, my advice is to buy an ETF, where transaction costs are a lot lower. But note that since ETFs trade like stocks, they also feature a potential negative of any stock: if the fundamental picture changes and gold suddenly falls out of favor, a selling stampede could develop that pushes the ETF price below the value of the underlying gold.

And if you’re thinking of selling the gold you have around the house while prices are high, be especially careful for the same reasons cited in the MSNBC excerpt above: There are a lot of unscrupulous dealers ripping people off by offering way less than the melt value of the gold they’re receiving. Check out this story we did last year. Avoid any national company advertising on TV, urging you to mail them your gold. Instead, get face-to-face quotes from at least three jewelers or pawn shops in your area.

Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.

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