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After the Gold Rush

By Michael Wallace Back in early February, we suggested, with a healthy dose of realism, that the nascent rally in the gold market had room to run. We cited some fundamental signs suggesting that the yellow metal's gains could prove more durable than in previous rallies (see BW Online, 2/11/02, "Has Gold Regained Its Long-Term Luster?").

Among the factors propelling gold's rise early this year were its appeal as a simple hedge against the uncertainties caused by the Enron meltdown and other accounting woes faced by Corporate America, loose fiscal and monetary policy in the U.S., sovereign default in Argentina, and the worrisome specter of deflation in Japan. These encouraged investors to bid the price higher and ignore gold's built-in shortcomings -- it costs money to store the stuff, bullion and coins don't pay interest or dividends, and central banks can play havoc with the market by selling off their holdings.

Three months later, amid a welter of geopolitical-security, and financial-market worries, risk-averse investors have driven its price even higher. While gold did retreat from its early-spring highs near $310 an ounce, it soon found its legs again under $290.

HEEDING THE PROFITS. Since then, it has rallied about 12%, to above $325. That's its highest level in 2 years. It hit a peak of $338 in the wake of the October, 1998, collapse of hedge fund Long Term Capital Management, which sparked fears of financial-market meltdowns around the globe. One sign of just how durable the current move may be: The Russian central bank chief denied that the bank would sell its gold reserves, instead opting to liquidate some hard-currency reserves.

Still, a round trip to gold's previous high in the past decade -- around $417 in February, 1996 -- is unlikely. As the recovery gathers momentum and investor confidence returns, gold may struggle to compete with more attractive returns offered by corporate securities and other assets. So while diehard gold bugs will hang in there, those who have been won over more recently may look to take some profits after the recent run-up.

They may prove the wisest of all. It's worth remembering that the overall price trend for gold over the past couple of decades has been bearish. True, sharp episodic counter-trend gains -- like the one we're seeing now -- reappear every so often. The hype inevitably wears off, however, leaving the metal out of favor once more -- and its fans patiently waiting for gold's next big, albeit transitory, rally.

SHELTER FROM THE STORM? Can the gold rally keep its luster in the short term? Yes, it looks like prices will continue to enjoy support from investors' growing aversion to risk -- and the ongoing upturn in the economic cycle. S&P's previous conservative price target of $319 per ounce has been surpassed. And the recent sharp rise suggests some profit-taking may be in store that could create a temporary pull-back to lower levels -- around $310 to $300 from $325 -- before the metal readies itself for a run to new highs, in the range of $334 to $338.

This time around, there are even more reasons investors are flocking to gold. The recent weakness in the U.S. dollar, new revelations about corporate-accounting chicanery and Wall Street's unethical equity-research practices, continued tension in the Middle East, the threat of an India-Pakistan war, and domestic terrorism warnings have spurred buying. There are also reasons specific to the gold market. Supplies of the metal are tighter, and gold-mining companies have over-hedged their positions, forcing them to buy more gold than expected in the spot market.

Also, the global economic upswing now under way has tempered the relative safety premium of bonds, gold's chief rival as a safe-harbor investment. Suffice to say that the borrowing of gold and yen, which puts downward pressure on prices, is typically a cheap way to finance investment or speculative positions in other assets such as equities or Treasuries. And the flip-side is recent strength in gold and yen -- indicative of a reduction in leverage as risk-aversion rises. The yen has been stubbornly strong even in the face of Bank of Japan intervention to weaken it vs. the U.S. dollar. Yen and gold strength clearly suggest increased risk-aversion, particularly with regard to U.S. assets.

LESSER LUSTER. Investors in gold-mining stocks have had it even better -- the shares have zoomed over the past quarter. They've offered some savvy market players even greater returns than those on the metal itself because investors can borrow on margin to buy the stocks, compounding their gains. Of course, shares of gold-mining companies carry an added risk: exposure to unfavorable political developments in gold-mining countries.

Overall, gold mavens should enjoy their short-term return to the limelight while they can. Barring another major unexpected shock to the system -- such as another terrorist attack -- the metal will lose some of its shine as the economic recovery stabilizes and corporate profits rebound. Wallace is a senior market strategist for Standard & Poor's/MMS International

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