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There are lots of good reasons to take a stake in gold, and right now the price is one of them.
After topping $1,000 an ounce in mid-February, the price of gold bullion had tumbled to $940 Monday. That's very close to a band of technical support at $935. Yet another layer at $900 should keep it from falling much lower.
Despite the lull, these are all relatively high prices historically. Yet as we face the threat of substantial global inflation as a result of recession fighting, gold's upside is enormous.
Adam Strauss, a co-manager of Appleseed Fund (APPLX), a diversified fund with a significant stake in gold, says all the steps governments are taking to fight the downturn will lead to inflation. "In fact, if you think of the ultimate way out of the housing mess, it is to devalue the dollar to get housing prices up again," he says.
Strauss is no gold bug or hard-money zealot; his fund bills itself as "socially responsible," and he says he favors investments "that allow shareholders to sleep well at night." Gold fills that bill. Appleseed bought its stake because its managers believed "gold was undervalued, and we still do, which is why we continue to own it," Strauss says.
A weakened dollar is gold's best friend. Assuming the price doesn't fall significantly below $900, "then we will start heading up again, and if we can get firmly above $1,000, I think we could run anywhere between $1,200 and $1,500" an ounce, says Mark Arbeter, the chief technical strategist for Standard & Poor's.
"Of course, some of this has to do with the action of the stock market," he adds. "The weaker the stock market is, the better gold will perform."
Call it gold lust
Individual investors have been flocking to gold in a way they haven't for at least a generation. And the longer we worry about stocks, recession, inflation and government bailouts and spending, the higher gold can go.
South Africa's Rand Refinery said in February that it had doubled production of blank gold coins to 20,000 ounces a week. These become Krugerrands, and demand for Krugerrands has risen to the highest level since 1986. The Wall Street Journal reported that some dealers in gold coins and bullion have seen their business double in the past year despite the high cost of transporting and storing the valuable metal.
Also last month, SPDR Gold Shares (GLD, news, msgs) saw its assets top $30 billion, making it the second-largest exchange-traded fund after SPDR S&P 500 Index Trust (SPY, news, msgs). The bullion Spider owns more gold than all but five nations and the International Monetary Fund, and three times as much as Great Britain.
Supported by this demand, the price of gold has remained at or near its highest price in history, $1,003.30, for the past 12 months. It hasn't gone still higher because all of the other demand for the metal -- i.e., all except the desire of Western investors -- is price-sensitive and has been beaten down by recession.
Industrial users, jewelers and Asian investors retreat from gold when its price spikes. Among Western investors, however, the opposite occurs: They get excited only when it rises.
Therefore, gold is an unusually volatile asset class. It's also a very poor long-term investment. It pays no dividend, that bit of cash a company delivers to shareholders just for owning it. In fact, owning actual gold costs you, because you have to store and protect it.
Expenses also cost you if you own the ETF. Shares of the Spider originally represented exactly a 10th of a troy ounce of gold, but the fund's expenses since it was launched 4 1/2 years ago have dragged the value down to 98% of that.
But gold's saving grace is its ability to retain its value. An ounce has roughly as much purchasing power today as it had in biblical times. That makes it an excellent inflation hedge -- and a good place for part of your wealth right now.
Continued: The inflation equation
The inflation equation
That's because while there's no inflation at the moment, the prospect for inflation has not been this high in decades.
Appleseed Fund, which usually invests strictly in stocks, began building a 5.5% position in gold Spiders just more than one year ago. Strauss says, "We bought it in reaction to what we were seeing in terms of the bursting of the housing bubble and the credit bubble, and our expectation of what the policy response would be."
That response, Strauss notes, has been to dramatically increase the money supply in order to supply cash for credit, notably mortgage credit; to underwrite insolvent financial institutions, almost without limit; and to significantly increase federal spending through borrowing.
Each of these things inevitably produces inflation. The combination of them could ignite the worst inflation since the 1970s, which was the last time gold was remotely as expensive as it is today.
In the current economic cycle, until now, investors have viewed U.S. Treasury debt as the world's safest place to keep money, forcing interest rates to record lows as they stuffed trillions into Treasurys. The gold market is infinitesimal in comparison.
But a serious bout of inflation would eviscerate the value of Treasurys, and investors would need another haven.
"The average investor is still in Treasurys," Strauss says. "Now think of the amount of money in Treasurys, and think of demand for gold." Even the current rally toward $1,000 an ounce "is just scratching the surface. There's a lot of upside if investors start to see gold as more of a safe haven than cash, which we do."
But what if stocks rally?
Both Treasurys and gold have benefited from a terrible period for stocks, which are trading around the same prices as in 1997. A big rally in the stock market would prick the gold bubble and send the metal reeling. So how likely is a big stock rally?
Not much, opines Arbeter, the Standard & Poor's strategist. After the S&P 500 Index ($INX) closed below its November low of 752 in February -- at that point, the low of this bear market -- it struggled back up briefly. But it's now fallen to about 700.
"Longer term, I am bearish," Arbeter says. "I think we'll break through the lows, and the next target (for the S&P 500) would be in the 625-to-675 area. The pattern that the S&P has been working on does not look like a typical bullish pattern that we've seen at bear market lows. Typically, prices are very volatile, and until recently it was actually fairly calm. This is not indicative of a long-term bottom."
Longtime readers of this column know that I rarely endorse gold, and never wholeheartedly. (Read "Fool's gold for your valentine" for more on the reasons.)
But the prospect of inflation is too great to ignore. Gold has very little downside at this point, I think, and a very significant upside. I would consider putting as much as 5% of total assets into gold, and I would do it through the gold Spider.
That's the best way to buy gold because the alternatives are not attractive. Gold mutual funds invest in mining company stocks, and the gold mining industry attracts fewer talented leaders than airlines. Moreover, gold mutual funds are so poorly managed as a class that Morningstar only recommends one of them, Vanguard Precious Metals & Mining (VGPMX), and it is closed to new investors.
Gold bullion itself isn't worth the hassle. If I bought more than a few coins, I'd need to rent vault space and pay for an armored car to transport it there.
I wouldn't plan on holding a significant gold stake forever, but I am envisioning holding it for years, because inflation is hard to eradicate once it begins to bite.
At the time of publication, Tim Middleton owned the following security mentioned in this column: SPDR Gold Shares.
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