Look Before You Leap Into the Gold Market

Some things you just have to wait for. Tickets to “Phantom of the Opera.” The Chicago Cubs winning a pennant. And in the financial world, many investors have been waiting for the price of gold to take off.

Finally, after slumping for almost two years, gold has begun to rebound in recent weeks. Since bottoming out at $354.75 an ounce in mid-September--its lowest level in three years--the price of gold has risen 9% to $386.80 as measured by the spot contract traded on the New York Commodity Exchange.

Rises in stocks that invest in gold mining companies have been even sharper. Some have gained as much as 10% to 20% in the past month. Mutual funds investing in gold and gold stocks have been the hands-down top performers among mutual funds in recent weeks, gaining 5.31% in the past week alone, according to Lipper Analytical Services. When gold stocks take off, the metal often follows.

Accordingly, these jumps have sparked hopes among some gold bugs and analysts that a new bull market in the metal has begun.

“It looks like the bear market for gold has ended for the time being. We’re in the process of base building. This could result in a bull market,” says Bernard Savaiko, precious metals analyst at Paine Webber Inc. in New York.

Should you believe it? Is this a good time to invest?

Maybe, but move carefully. Gold prices have cried wolf with false rallies before, and the outlook this time is not all that convincing. The fundamentals that normally propel gold--threats of higher inflation or international crises--are not compelling. And some of the easy money, at least in gold stocks, has already been made.

Gold and gold stocks are up in part because investors are worried about the stock market. Gold often does well when paper assets are in retreat.

“Investors are looking to diversify their portfolios,” says Joseph Rosta, analyst at CPM Group, a precious metals research firm in New York. “In the stock market, they see greater volatility. They are looking to invest in a hedge against equities.”

And investors think that gold is overdue for a rally. Gold shares often move on a two-year cycle, and the last peak was in December, 1987, when the price nearly hit $500 an ounce.

“A lot of investors have realized that of all the investment sectors, precious metals have lagged far behind,” says Bruce Kaplan, president of Kaplan & Co., a Santa Monica precious metals consulting firm.

And now, even declining interest rates are being interpreted by some analysts as possibly bullish for gold. That sounds strange because declining interest rates normally indicate declining inflation and a slowing economy. But the logic is that declining rates also reflect an easier Federal Reserve credit policy that could stimulate increased business activity, which in turn could rekindle inflation down the road.

Some analysts are even arguing that a recession could be bullish for gold. A severe slowdown would cause massive bankruptcies, they argue. With corporate debt at historically high levels, the government will have to pump huge sums of money into the financial system to keep it afloat. That’s inflationary, and that’s good for gold, these analysts say.

Sounds plausible. But things could easily work out just the opposite. A slowdown or severe recession could just as easily be deflationary. That’s bad for gold.

Further, an important reason that people haven’t been buying gold is that “real” interest rates--interest rates adjusted for inflation--have remained stubbornly high at around 3% to 4%. High real interest rates are probably gold’s greatest nemesis. Investors would rather earn high real rates of interest through bonds or savings instruments than hold gold, which pays no interest and costs you money in terms of storage fees, inspection, insurance and other charges. No wonder that in the 1970s and early 1980s, when real interest rates were low or even negative, gold rose dramatically.

But with inflation going down along with interest rates, real interest rates show no sign of dramatically easing.

Further, production of gold worldwide is up. And the Soviets, a major gold producer facing another poor grain harvest, are selling gold in a bid to raise currency to finance grain purchases.

Also, not much fundamentally has changed about the role of gold as an investment. The metal is a great inflation hedge, but when inflation is not a major threat, stocks and bonds outperform it hands down. And because of the metal’s risk and volatility, even gold bulls say prudent investors shouldn’t commit much more than 10% of their portfolios to gold.

So it’s not a convincing bet that gold is taking off on a big bull market. Prices may rise more, but they could be driven more by emotion than by fundamentals.

“Money currently going into precious metals is coming out of stocks and bonds,” says Kaplan. “But whether this is the beginning of a massive bull market, I doubt it.”

So if you want to invest in gold now, do so cautiously. Buy when the price dips. Or, Kaplan suggests, use dollar-cost averaging: Instead of investing all at once, invest a set amount each month or quarter. Then if gold makes a big time move later, you’ll still enjoy the ride. But if gold tumbles, you’ll get in at a lower average cost.