IAU: Can Spot Gold Continue Its Tear?

Includes: GLD, IAU
by: Don Dion

The value of an ounce of gold began climbing last September and hasn’t stopped as of late February. Gold futures hit a new all-time high of $952 per ounce last week, up from about $840 at the start of 2008. Gold’s steep six-month rally—interrupted by only a few slight pullbacks—sent iShares Comex Gold Trust (NYSEARCA:IAU) to the top position of the ETF Momentum Tracker sector ranking.

It’s no coincidence that gold caught fire around the same time the broader stock market began sinking. Gold often increases in value during economic downturns and periods of high inflation. There’s been no shortage in recent months of signs that the economy could be in the midst of a recession, or at least a severe slowdown. Meanwhile, unprecedented oil prices and the Fed’s recent slashing of interest rates have increased worries about inflation. These concerns spurred investors who view gold as a safe haven to bid up prices of the metal. IAU gained more than 40% since September 1, while the S&P 500 fell nearly 6%.

Unlike many funds focusing on precious metals, IAU invests directly in gold rather than in stocks of mining companies. Each share of IAU represents one-tenth of an ounce of gold, meaning that if gold futures are trading at $1,000 an ounce—a level they may soon reach—one share of IAU would trade for about $100, minus the fund’s 0.40% expense ratio.

IAU’s approach has some advantages: Stocks in gold producers are exposed to company-specific and industry-related troubles. Gold mining is an expensive process that often occurs in politically unstable countries. By investing directly in gold bullion, IAU maintains a degree of distance from such factors, making it slightly more stable than most gold-oriented equity funds. For example, Fidelity Select Gold, which invests in stocks of gold producers, recently had an eye-popping standard deviation of more than 28, while IAU’s was only 15.79 (which still represented roughly twice the volatility of the stock market).

Pessimistic views of the economy are not the only factor driving gold prices upward. Demand for gold has also increased in recent years, driven by a sudden surge in the popularity of jewelry made with the metal—much of which stems from a newly emerging middle class in countries such as India. Industrial and dental uses of the metal also have risen sharply. In fact, demand has out-stripped supply every year since 2004—reversing a seven-year stretch of excess supply. China, which recently surpassed the U.S. to become the world’s second-largest gold consumer after India, used 302 tons of gold to produce jewelry in 2007. By the end of the year, the country’s overall gold demand had increased 26% from 2006.

If demand for gold continues to rise, investors with a stake in the metal are likely to benefit. But slowing economic growth and steep prices for the commodity could reverse the trend. That seems to be starting to happen in India, where demand suddenly fell 64% in the fourth quarter of 2007 from a year earlier.

Another factor that could be fueling the ascent of gold prices is the new ease of investing in the commodity. IAU, which had its inception in January 2005, was one of the first ETFs to provide direct exposure to gold. IAU and several similar funds have attracted an enormous amount of assets to the metal in a relatively short time, with IAU itself accumulating more than $1.8 billion. There are some concerns that all the gold being bought up by ETF trusts will have an unpredictable effect on the future of gold prices, possibly causing increased volatility. Considering that investing in gold has been legal in the U.S. for only 33 years, it’s hard to tell how the commodity will react to its fairly new status as a mainstream, easily accessible investment.

While the current rally extends back only about six months, gold prices have trended upward for several years. After sinking well below $300 per ounce in the late 1990s, prices began to climb in earnest during 2002. Still, as recently as August 2006, prices remained below $600 per ounce. The last time prices climbed as high as this—when they peaked at $870 amid 1980’s stagflation—they subsequently pulled back sharply.

If the most bearish voices are proven right and the economy stumbles into a multiyear contraction, those who bought into IAU early could benefit from a prolonged period of elevated gold prices. But while its value has historically shown virtually no correlation with broad market indices, gold has always been a volatile commodity. Gold prices could certainly climb higher, but when economic winds begin to shift, the metal might have a long way to fall.