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Investing

Gold Is Ready for a Fall

My advice is to wait for a correction in the price of gold and then buy mining stocks.

Peter Bernstein began his book The Power of Gold: The History of an Obsession, published in 2000, with a parable about a man who goes to sea carrying his wealth in a bag of gold coins. A storm comes up, and the captain tells the passengers to abandon ship. The man straps the bag to his waist, jumps into the sea, quickly sinks to the bottom and drowns.

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TRY OUR QUIZ: ARE YOU GOLD'S FOOL?

For an entire generation, investors who held on to gold had much in common with the unfortunate passenger. Yes, gold soared from about $100 an ounce in 1976 to more than $800 in 1980, but it soon collapsed and traded consistently below $400 for most of the next quarter-century or so. Meanwhile, from 1980 on, the Dow Jones industrials rose more than tenfold.

The fear premium.

Gold's previous bull market coincided with a sharp increase in inflation. Today, with inflation tame, fear seems to be the source of the obsession that has led to a tripling of bullion prices in barely five years. At a time when many investors see government deficits spiraling out of control, gold appears an obvious place to store cash until the storm blows over. As a result, the metal enjoys a fear premium. Without it, gold, which sold for $1,220 an ounce in early June, would trade at $800, says Michael Crook, of Barclays.

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It is easier than ever to buy gold. SPDR Gold Shares (symbol GLD), an exchange-traded fund that tracks the price of bullion, now holds $50 billion. Investors who are especially fearful can own physical gold, in the form of bars or coins (American Eagles, for example). You can keep the yellow metal in a safe-deposit box—unless you're worried that someday the bank doors won't open—or even bury it in your backyard.

In case you haven't guessed, I am skeptical of gold as a fear-based investment. You should certainly be worried about future inflation. But there are far better hedges than gold, which historically has exhibited little correlation to the consumer price index. By contrast, returns of Treasury inflation-protected securities are tied directly to the general level of consumer prices.

Worried about European countries defaulting on their debts? U.S. Treasury bonds should hold their value as investors stampede to safe havens. (See Treasuries: The Brand to Trust.) Concerned about the U.S. defaulting on its debt? My advice is to pull the covers over your head and go back to sleep. Do you dread terror attacks or other unforeseen horrors? The best hedge isn't gold but an ETF, such as ProShares Short S&P 500 (SH), that rises when the stock market goes down.

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Still, there are reasons to buy gold. Demand might rise because the new rich, especially in developing nations, may buy more jewelry or because the Chinese government, which now holds only 1.6% of its reserves in gold, may decide to diversify out of dollars and euros. (For more on China’s currency moves, see Interpreting the Yuan.)

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Supply is a more complicated matter. Imagine what would happen if the price of gold dropped sharply as the fear premium dissipated. Mining companies would probably cut back on production, which in turn would cause prices to rise.

My advice is to wait for a correction in the price of gold and then buy mining stocks. The stocks often pay dividends (typically small) and benefit from both rising productivity and leverage (meaning that the shares tend to rise more dramatically than the price of gold). Among top producers are Barrick Gold (ABX), with 140 million ounces of reserves, and Newmont Mining (NEM), with 92 million ounces.

Gold is not just an obsession, it is a mystery. Predicting the direction of its price is fraught with peril. "Bullion has no direct link to economic growth, as do other commodities, doesn't earn a return, offers limited hedging advantages and hasn't kept pace with inflation." All true. But since Michael Sesit wrote those words on Bloomberg.com on October 5, 2007, just days before the stock market peaked, the price of gold has climbed 65%. Proceed with caution.

James K. Glassman is executive director of the George W. Bush Institute in Dallas. His next investing book will be published in early 2011.

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