Should Investors Bet on Gold in 2009?

The yellow metal roared early in 2008, faltered, then rallied. What's the New Year's case for gold and how can you play it?

You would expect gold to be a great investment in 2009 if the U.S. dollar remains under pressure because the Federal Reserve embraces a more accommodative monetary policy than those adopted by other key central banks. But there's a sticking point: The market remains more concerned about deflation than inflation in the near term, weakening one of the more compelling rationales to buy gold.

It can be argued that gold's price spike to a record high of almost $1,030 an ounce last March had more to do with a surge of strength in commodities as a whole than anything specific to the yellow metal. Unable to buck the general sell-off in commodities since the summer, gold sank to a low of $680 in November before rebounding above $800 as the end of the year approached. Now that a new era for commodities seems to have begun—one likely to be characterized by greater price stability—any future gains by gold will have to come on its merits as a perceived safe-haven store of wealth, a hedge against inflation, and as a desirable component of jewelry.

In his outlook report for 2009, Dave Meger, managing director of metals services at Alaron Trading in Chicago, cited questions he has received as to whether gold is still a safe haven asset—and if so, why the metal hasn't performed better during the recent economic tumult. Meger believes gold remains a safe haven asset and says it has weathered much smaller percentage decreases in price than have other commodities while avoiding the extreme volatility seen in other financial instruments. In fact, some of the selling pressure has been the direct result of gold's function as a store of wealth with easy liquidity, he points out.

Inflation Fears are key to gold gains

The main reason for the most recent surge in gold prices has been the dollar's weakening in the run-up to—and following—the Fed's cutting of the Fed funds rate to a record low of zero to 0.25% as European central banks were resisting such extreme measures. Meger predicts the Fed's interest rate policy will continue to support higher gold prices in the first quarter of the new year, after which he expects the price to weaken as global financial turmoil re-emerges and the world comes to rely more on the dollar as its preferred reserve currency. The recession will cause jewelry demand in the U.S. and Europe to slacken next year, but demand in India—the world's biggest consumer of gold jewelry—should hold up because of gold's cultural importance. Gold prices are likely to rise on pre-holiday buying in India and in other parts of the world starting in the fall, Meger said in a conference call Dec. 18.

The true inflection point for gold, however, will come when concerns about deflation give way to inflation worries, Meger predicts.

That's likely to come once an economic recovery is in place, since the two are necessarily linked, says Victor Sperandeo, chief executive of Alpha Financial Technologies, a quantitative research firm in Dallas, and author of Trader Vic on Commodities: What's Unknown, Misunderstood, and Too Good to be True.

gold's price: discounting a recovery

"With all the stimulus past and still to come, you have to accompany a rally in the economy with a rally in inflation," says Sperandeo. "There still are effectively shortages—if demand increases—on the same things {as} before the recession: industrial metals, grains, and oil."

Much like the stock market, which is way ahead of the economy, the price of gold is reflecting the market's belief that the worst of the recession is over, he says. "When you see the Fed putting trillions of dollars [into the banking system], you don't wait for inflation to [become] an issue," he says. He draws a parallel between the rally in gold and the bounce in the Standard & Poor's 500 stock index since Nov. 20.

Most economists and strategists, however, expect economic conditions to deteriorate further in the first part of 2009 as unemployment rises and consumption weakens. If the recession worsens on a hiccup in commercial real estate or some other market—or because the stimulus doesn't have the desired effect—Sperandeo expects gold prices to come down in concert with stocks "until the Treasury throws something else at it to make things better in the future."

on doomsday, what use are gold ETFs?

Not everyone favors gold, even as a mere hedge against inflation. Historically, the returns on the physical commodity are miserable, although commodity futures are "somewhat more favorable as a diversifier," according to Rick Miller, founder of Sensible Financial Planning and Management in Cambridge, Mass. Those looking to gold as a store of wealth as part of a doomsday portfolio are better off holding gold coins, which they can keep in their physical possession, he says.

"If the worst happens and you want gold because nothing else is worth anything, being able to say 'I have shares in this gold ETF' and going to the vault of a bank to get it out is unlikely to cut much ice," Miller says.

Prices of gold coins have spiked in the last six to seven weeks due to a shortage of supply and a jump in demand, even as gold futures prices have come down on the Comex division of the New York Mercantile Exchange. The American gold eagle, one of the three most popular gold coins, is now selling for the spot price of $845 plus a premium of $80 to $100, compared with the usual premium of 4.5% to 6.0%—or $38 to $51, says Dave Heller, owner of FH Coin and Collectibles in New York.

Another hedge: TIPS and TIPS funds

"That's indicates small investors are moving more and more into gold because they're worried about the economy," says Ernest Hathaway, principal at Financial Strategies Institute in Midvale, Utah. Hathaway recommends people allocate a fair portion of their savings to gold until there's a convincing turnaround in the economy, but he prefers to use an ETF such as The SPDR Gold Shares (GLD) over coins.

It's clear that the volume of money the U.S. government is pumping into banks and the national fiscal stimulus package are setting us up for inflation sometime in the future, says Miller. But he advises clients to invest in inflation-indexed bonds such as Treasury Inflation Protected Securities, or TIPS, as a hedge. The iShares Barclays TIPS Bond Fund(TIP), an exchange-traded fund, and Vanguard Inflation-Protected Securities Fund (VIPSX) are both very efficient ways to hold these assets, he says.

Many investment advisors and strategists do see gold as part of a portfolio diversification strategy. The yellow metal's allure will likely be enhanced as long as uncertainty about the economy persists.

    Before it's here, it's on the Bloomberg Terminal.