With the current bearish market, more and more investors are turning to gold to help hedge their portfolios. Currently, gold prices have gone as high as $1900 per ounce. Anyone who has held gold over the last few years has earned huge returns, and many analysts expect gold prices to cross $2000 pretty soon. The current futures market expects gold prices to taper off, with December 2013 futures trading at $1928.3 and September 2011 futures trading at $1899 at the close of trading on Friday. However, this tiny expected increase is due mainly to low interest rates. The truth is that gold prices can hit $3000 by the end of next year at the rate things are going.
Why Have Prices Increased?
There are two major reasons why gold prices have increased. First, demand for gold jewelry has increased over the past couple of years. This demand increase is not from developed countries, but instead from India and China.
Between 2009 and 2010, gold jewelry consumption has increased 17 percent worldwide, to 2059.6 tonnes. 36.2 percent of this consumption came from India, which is startling. India's interest in gold is very cultural, and as long as India continues to grow as a country, its citizens will demand more and more gold. India's gold consumption increased 69 percent in 2010 and accounted for almost all of the increased gold consumption in the world. Without India in the picture, the rest of the world's gold jewelry consumption actually decreased by 0.3 percent. China's gold jewelry consumption increased by 14 percent to 428 tonnes in 2010.
It is important to see how the skyrocketing price of gold is entirely leveraged by India and China, while the rest of the world is consuming less gold jewelry as a result of increased prices. I am a strong believer that gold's value as an investment is firmly anchored on gold jewelry demand and anybody who holds a strong position in gold should closely follow the gold jewelry market.
The second reason why gold prices have skyrocketed is investment demand. Gold prices were unaffected by the financial crisis of 2008 and many institutional investors who succeeded in beating the market had a lot of gold in their portfolios. Many investors now want to hedge against their positions by making gold a larger part of their portfolios. This has allowed demand for gold to increase even further and has caused prices to further increase.
What Can Bring Down Prices?
There are three ways which I can see this potential gold "bubble" bursting. These are:
1. If gold companies substantially increase their output of gold. These increased prices allow gold producing companies to take on riskier projects and pay extra money to mine gold. If this increase in worldwide production and match or exceed the increased demand for gold, prices can take a hit. Since the cost of mining gold will increase from companies increasing output, gold will not drop back to previous levels, but prices could potentially fall to levels around $1400 per ounce in a year or two.
2. If investor demand for gold tapers off. It is estimated that about 85 percent of all gold ever mined is still in circulation. Since gold can never tarnish and only a very negligible amount cannot be recovered, once investors increase their gold holdings to a comfortable level, they will simply stop buying gold, thus decreasing demand. This will eventually lower demand and bring down prices. If decreasing gold prices sparks an investor selloff, we can see prices plummet.
3. If India faces an economic downturn. This last reason is not likely, but if India's economy does not grow at its expected rates, the expected future demand of gold jewelry in India will decrease and bring down prices. Once again, consumer gold demand is driven almost entirely by India, and discretionary income in India is necessary for gold prices to stay high.
There are plenty of ways to invest in gold. One can buy gold futures, invest in ETFs like GLD and IAU, invest in gold mining companies like ABX and AUY, or buy gold bullion though the purchase of gold coins or investment gold. Whether you are long or short gold, it is important to know what drives the price of gold and what risk factors your position holds. Gold can easily return 50 percent over the next year, but there is no such thing as a risk-free 50 percent return, especially with treasury bills trading at historically low interest rates. Gold is a risky investment, but may pay off if you can properly monitor the risk factors and know the market.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.