Investors catching the gold bug
By KATHLEEN PENDER
May 11, 2006
The Federal Reserve might be thinking inflation is not a problem, but gold investors seem to believe otherwise.
This week, bullion closed above $700 an ounce for the first time in a quarter-century. Since the year began, gold has soared $191 per ounce, or 37 percent.
Historically, gold has been seen as a hedge against inflation. The first time gold hit $700 per ounce, in January 1980, the inflation rate - which had been rising sharply for more than two years - was more than 13 percent.
Later that year, gold and inflation both reached a peak (gold briefly touched $850 per ounce) and embarked on a decadeslong decline.
Today, the backdrop is different. Although inflation has been creeping up, at 3.4 percent it is still low by historical standards.
So why are investors gobbling up gold?
"The perception is, the Fed is done raising rates," says Axel Merk, manager of the Merk Hard Currency Fund. "But many people think underlying inflation cannot be beaten with rates where they are now. What may happen, with (the federal funds rate) at 5 percent, the economy may slow down but inflation is not beaten yet."
He says the Fed might be afraid to raise rates to fight inflation because "our economy is much more leveraged (i.e. debt-ridden) than it has been in the past.
Merk says inflation is not showing up in the Consumer Price Index because it mostly measures goods we import from Asia, which are cheap and in many cases getting cheaper.
"In areas where we can't import, such as education and health care, prices are through the roof," he says.
Of course the U.S. inflation rate is only one factor in the global gold market. Gold prices are also influenced by interest rates, currency values, political crises, other commodity prices and plain old speculation.
Unlike silver, copper and other metals, gold has little industrial value. It is purchased mainly as jewelry or as an investment.
Strong growth in Asian countries, especially China and India, has been adding to demand.
"In India, when people gain a little wealth they want to wear gold on their bodies. They want to do that before they get a car or bank account. It's a high-priority item," says Rob Lutts, president and chief investment officer of Cabot Money Management.
Gold is also moving on rumors the Chinese government might increase its gold reserves to diversify its large holdings of U.S. securities and to hedge against a rising yuan and falling dollar.
China also has relaxed restrictions that prevented individuals from owning gold. Some state-owned banks now sell certificates that track the price of gold, and at least one bank is letting customers take delivery of gold bullion.
There is also speculation that other Asian countries and Russia will increase their gold reserves.
"Although a number of central banks have increased their gold reserves over the past decade, the sector as a whole has been a net seller," the World Gold Council reports.
A new source of U.S. demand comes from two trusts that let investors buy gold bullion without hauling or storing it. Shares in the trusts trade on stock exchanges throughout the day, similar to exchange traded funds.
Each share in the trusts is backed by one-tenth of an ounce of gold. To cover expenses, the trusts sell a small part of their gold hoard. The shares track the price of gold, minus expenses. (Both funds charge 0.4 percent of assets per year.)
State Street Global Securities was first out of the gate, in November 2004, with the streetTracks Gold Shares, which trades under the ticker symbol GLD. Since inception, this trust has acquired $8 billion worth of bullion.
Barclays Global Investors followed in January 2005 with the iShares Comex Gold Trust, which trades as IAU. It has acquired almost $1 billion worth of gold.
(Warning to investors: The Internal Revenue Service has determined that an investment in these trusts is a "collectible." As a result, if held for more than a year, profits are taxed at 28 percent, the federal tax rate on collectibles. They do not qualify for the reduced rate - 10 or 15 percent - on long-term capital gains.)
Another way to buy gold is to purchase shares in a gold-mining company or in a mutual fund that invests in gold-mining stocks.
Unlike the gold trusts, gold-mining stocks can do substantially better or worse than the price of gold, depending on their operating leverage, cost of labor and capital, and whether they produce other metals as well.
Year to date, precious-metals funds are up 44 percent on average, according to Morningstar.
Despite gold's steep rise, some advisers say it could go higher. Although it is approaching its nominal peak of $850, it is far below its real or inflation-adjusted high.
According to the Bureau of Labor Statistics inflation calculator, $850 in 1980 would be worth $2,100 today.
"I don't think we're in the mania stage yet," says Lutts, of Cabot Money Management. "We have over 1,000 clients. None have called and asked me to buy gold. I still have half a dozen who restrict it."
Many pundits expect that the dollar will continue to fall, especially if foreign governments cut back on their purchases of U.S. securities. That could be good for bullion prices.
But Merk also warns against going crazy over gold. "Just as with anything that goes up in a straight line, be careful," he says.
(E-mail Kathleen Pender at kpender(at)sfchronicle.com.)
(Distributed by Scripps Howard News Service, www.shns.com.)
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