Should You Join the Crowd Piling Into Gold?

The price of gold has quadrupled in the last 10 years, but it was the financial crisis and the subsequent drop in interest rates on safe U.S. Treasury bonds that sent investors scurrying into the precious metal. Is this just a herd mentality at work, or is it a wise assessment of the economic road that lies ahead?

Gold closed was trading at $1,248 an ounce at the New York Mercantile Exchange on Thursday. That's a pretty dramatic run-up from $274.25 on Sept. 1, 2001.

Thanks to the Greek debt crisis and other economic shocks, investors have been piling into gold since the first of the year. The SPDR Gold Trust (GLD), one of largest exchange-traded funds on Wall Street, took in $7.7 billion in the first half alone. It now stands at over $50 billion.

Physical Gold or Gold-Mining Stocks?

John Person, an investment adviser and coauthor of the Commodities Trader's Almanac, says that given the momentum behind gold, he could see the price reaching $1,300 by year-end.

He says the rising price is a combination of retail demand for gold, particularly in countries like China, and speculative investments in gold bullion and gold-mining equities. Person says his firm, nationalfutures.com, favors investing in physical gold rather than the mining stocks.

Mark Johnson, vice president of equities at San Antonio, Texas-based investment manager USAA, says gold is so attractive right now because interest rates are so low.

"The wind is at the market's back," says Johnson, whose firm manages $2 billion in the USAA Precious Metals and Minerals Fund (USAGX). He cites two factors: Treasury Inflation-Protected securities (TIPs) yield just 1.5% and the yield curve, a chart of interest rates from the very short term to 30 years, is steep. That means long-term rates are much higher than short-term rates. He says when these two factors coincide, gold's price often rises dramatically.

"A Bubble With Some Foundation"

USAA invests primarily in mining shares because those stocks move more dramatically than gold bullion, which means you don't have to put as much money in that sector, Johnson says. Gold bullion, and even ETFs that own it, have been ruled to be "collectibles" by the U.S. Internal Revenue Service, which means they're not eligible for long-term capital gains tax treatment.

Asked if it's possible that a gold bubble is forming with so many investors piling in, Johnson says: "If it's a bubble, it's a bubble with some foundation. There is a heightened risk element in the economy, and as long as you have that heightened risk, there's a good foundation for gold to continue to rise."

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But not everyone recommends gold for the small investor. Roubini Global Economics, a New York consulting firm, last week issued a report encouraging investors "not to get giddy about surging gold prices."

Over the long-term, Roubini's economists recommended underweighting or zero-weighting gold in portfolios. They said a state-issued currency system, like the U.S. has, will prevail, with moderate inflation and low growth in high-income countries reducing the need for gold's safe haven benefit. They added that there are "better financial risk/return trade-offs than gold."

Some investors are using gold as protection against possibly higher future inflation fueled by government spending and huge federal deficits. But a study by Goldman Sachs found that gold rises only 23% of the time when the U.S. has consumer price inflation, so the argument that gold is a good inflation hedge is weak.

"Closer to the Bottom Than the Top"

That doesn't deter determined gold bugs like Peter Schiff, president and chief global strategist for Euro-Pacific Capital in Westport, Conn. Schiff says he has been heavily invested in gold since 2001 and now keep roughly 50% of his portfolio in the metal.

"Gold is going to go much higher," he says. "It's still closer to the bottom than the top."

Schiff maintains that the Federal Reserve's decision to expand its balance sheet from $800 billion to more than $2 trillion at the height of the financial crisis has caused inflation, but he says there's a delay between the expansion of the money supply and a rise in prices, which most people consider to be the definition of inflation.

Schiff recommends investors keep 5% of their portfolios in physical gold and another 5% to 10% in gold-mining shares. He recommends Goldcorp (GG).