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Back in 1987, I was working retail for a company that was then a major foreign exchange and precious metals dealer. A non-descript man entered the office with his family. The man, who was wearing a flannel shirt one might use for garden work, asked me what our price to buy gold was. I asked what form his metal was in, expecting one-ounce bullion or coins. “Kilo bars,” he said. We didn’t even have a price for a kilo bar on hand, so I asked the customer to wait for a moment while my coworkers and I scrambled behind the scenes to get a quote. When I gave the customer the price, he dropped almost $30,000 in gold in on the counter, then enough to buy two new cars—one a BMW.

While this experience (and my speculation that the man had just unearthed the gold from his yard) forever cemented my impression of gold as a safe-haven asset, other aspects of the situation are instructive regarding the current gold market. The man was selling his gold at a price that was probably around $450 an ounce, and history showed that he was wise to do so. Even with gold’s recent appreciation and the financial crisis crushing the stock market, large cap equities (going from Dow 2500 to 10,332 as of market close on November 19) have outperformed gold (about $450 to $1141 an ounce) by a large margin since 1987. And that doesn’t even take into account that stocks can earn dividends, while holding gold can incur costs in the form of storage and/or insurance expenses. (For that reason, other than for people who want to keep a stash of gold at home to prepare for the most extreme scenarios, I suggest that people who want to invest in gold consider equity-based investments like the dividend yielding shares of one of the established gold mining companies such as Barrick Gold (ABX), Newmont Mining (NEM) and Gold Fields Limited (GFI).)

The shorter term of the current decade paints a different picture. Gold was in the high $200’s in 1999, and now stands over $1,100 an ounce, while the Dow crossed 10,000 for the first time in 1999, to where it has just about returned. In this decade, with the 9/11 attacks in 2001 and the financial storm beginning last year, the United States has experienced the most significant challenges to its national and economic security in generations. Given that gold is marketed as a hedge against events that disrupt other markets, there is a strong temptation to correlate its rise to the heightened risks of the current environment. There may be some truth to this perceived causation, as reflected by reports of investors piling money into gold and other defensive assets as unemployment persists. But it’s also possible that the relationship between these risk factors and the gold price is exaggerated.

This leads me to the main point of this post: while there are long-term factors that will support gold prices regardless of where the U.S. economy goes, principally consumer demand in emerging nations, there are some significant short and medium term risks.

A combined 2.5 billion people live in China and India, over eight times the population of the United States (307 million). But China and India are already the world’s two leading gold consumers, India being first, and both already have far more demand for gold jewelry than the United States. 1 This means that while there is still lots room for China and India to develop more gold demand as large segments of their huge populations morph into a massive middle class, temporary reductions in their demand can move gold down.

Such downward pressure is particularly likely in the case of India, where people of modest means have traditionally preferred to put their savings in gold instead of banks, and the government has long sought to discourage gold hoarding to catalyze development of the banking system. 2 Currently in India, people who have purchased gold all along are selling it to profit from the high prices. 3 While gold buying typically picks up during the Indian wedding season that runs from October through December,4 once that’s over the downward pressure from Indian gold selling may resume.

Also, to the degree that the current financial turbulence is driving the gold market, there is a significant risk that the party will end. At some point, the U.S. Federal Reserve will raise interest rates, making dollar denominated bank accounts more attractive to international investors, and creating pressure for the dollar to rise against other currencies and gold. While deficit spending in the U.S. has created a concern for coming hyperinflation and further deterioration of the dollar, I have argued in a previous post that the current fear of hyperinflation is exaggerated because U.S. tax rates are still well below those of other nations with a triple-A credit rating. These possibilities both provide potential catalysts for the gold price to eventually experience a correction, compounded by reduced demand when the Indian wedding season ends.

In comparison, the transformation of the Chinese and Indian populations into a broad consumer group with enough wealth to further support long-term gold appreciation is likely to take place on a longer and less predictable path than the recovery from the current recession. What this means for investors is that now is not the time to bet big on gold or gold-related assets. It’s good to diversify and having some gold-related holdings can be a good defensive position. For those who don’t currently have assets tied to gold and have resources to invest, given the uncertainty of the current times it’s rational to start to gradually cultivate a gold related position in conjunction with building other investments. But in my view those who assume that they’ll turn a big short-term profit at current gold price levels risk being disappointed. The recent statement by Barrick Gold CEO Aaron Regent that gold could fall from current highs acknowledges that risk. 5 Those who are prepared to accumulate gold-related assets over time are more likely in my view to be able to capitalize on future dips and long-term appreciation.

  1. See “China’s Gold Demand Sparkles in Q2,” Chinamining.org, August 24, 2009. [↩]
  2. R. Kannan & Sarat Dahl, Indian Journal of Economics and Business, "India’s demand for gold: some issues for economic development and macroeconomic policy", June 2008, screens 1-3 & 8. [↩]
  3. India Buys Gold; Indians Don’t,” Goldnews, November 9, 2009,. [↩]
  4. India gold demand abates after early week’s pick-up,” Reuters, October 30, 2009; "Gold hits new high on weak dollar,” BBC News, November 9, 2009, . [↩]
  5. UPDATE 1-Barrick chief says sell off in gold possible-FT,” Reuters, November 11, 2009,. [↩]

Disclosure: The author is long on Barrick Gold (ABX) as of the original publication date of this post. The author does not hold a securities position in Newmont Mining (NEM) or Gold Fields Limited (GFI).

Source: Use Caution Investing in Gold This Quarter