A Bumpy Ride Up Gold's Yellow Brick Road

In times of trouble, investors go to gold, but so do speculators

Whenever investors get serious jitters about the U.S. economy or seek a refuge from a drop in the dollar, they turn to gold. Given the current state of their psyches, it's no surprise that gold, long viewed as a safe haven, closed recently just a shade below its all-time high of $850 an ounce in 1980.

After reaching $841 on Nov. 8, the price retreated to $789 by Nov. 30, spurred by profit-taking after a three-month rally fueled by mounting fears about the health of the financial system. The 1980 rally came amidst an inflation surge and the Soviet Union's invasion of Afghanistan. That spike was followed by a swift plunge, but the latest gold swell probably isn't over. Adjusting for inflation, that 1980 high would be about $1,800 in 2007 dollars, according to Haver Analytics, an economic research firm. That suggests today's price has room to run.

Analysts and fund managers also point to supply-and-demand factors that are keeping them bullish on bullion. For 2007, demand for gold is expected to outstrip new supply by 234 tons, the first deficit since 1979, according to Barclays Capital in London. That's more than 6% of the annual supply of 3,600 tons that comes mostly from mines but also from sales by central banks and recycled scrap.

It could be a wild ride in the coming months. Speculators and hedge funds made large bullish bets in the futures market starting in August as the Federal Reserve started to cut interest rates. Once the Fed stops paring rates and the dollar stabilizes, gold becomes a less attractive investment. That should happen early next year, says Suki Cooper, a precious-metals analyst at Barclays Capital. Wall Street leader Goldman Sachs (GS) even recommended selling gold as one of its 10 best trading ideas for 2008.

Investors with a longer time horizon should view those dips as a buying opportunity, says Joseph Foster, manager of the Van Eck International Gold Fund. During gold's current five-year climb, the metal's price often dropped between January and May before rallying toward the end of the year, Foster says. Even Goldman's gold watchers are predicting the metal will be higher over the next 12 months.

Demand is growing, thanks to an increase in jewelry purchases by the burgeoning consumer classes in India and China. Increasingly popular exchange-traded funds around the world also make investing directly in gold easier than ever. On the supply side, mining outfits are struggling with higher costs, political upheavals, and less productive mines. "Even at $800 an ounce, it's difficult to make money mining it in some places," says Peter Schiff, president of Euro Pacific Capital in Darien, Conn., and a longtime gold investor.

Exchange-traded funds, like the $15 billion Streettracks Gold Shares Trust, are the new kids on the block. Gold-oriented mutual funds have been around for years, but they mainly buy mining stocks. The new ETFs, rolled out over the past three years, buy actual bars of gold and store them in warehouses. By holding gold directly, the funds affect the price because they remove supply. The Streettracks fund, run by State Street Corp. (STT) in Boston, owns 609 tons of gold held in a London vault.

In the third quarter, ETFs bought 138 tons of gold, or 15% of all the gold produced and six times more than they bought in 2006's third quarter. Because much of the demand for the ETFs has come from long-term investors, the funds are rarely sellers. "I call them vacuum accounts because the gold goes in and just stays there," says James Vail, manager of the ING Global Natural Resources Fund.

In the past, rising gold prices have also boosted mining stocks. The miners are up about 18% this year, but that's only about half of the gain for the metal. Their main problem is that costs for steel, fuel oil, and other materials have risen even faster than gold prices. Shares of NovaGold Resources (NG), a mining company based in Canada, tumbled more than 50% on Nov. 26 after the company said it had to stop construction of a new gold, silver, and copper mine in Galore Creek, B.C., because of rising costs. Last year the company estimated the mine would cost less than $2 billion. The cancellation followed a new projection of $5 billion. That's bad news for the mining stock shareholders, but a plus for anyone who already owns gold and is banking on higher prices in the years ahead.

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