Why Own Gold?

I last wrote about gold in April of 2007 when gold was trading around $700 an ounce. Many believed it was overpriced at that time, and although it traded sideways for several months after that, it finally broke to the upside and hasn’t looked back since. In early January it broke to a new all time high with conviction. Now trading above $900, there are still many who believe it is overpriced and getting ahead of itself. Although it is likely to consolidate for a short time, the trend for gold is still up. There are many factors that will contribute to the continuing rise of gold, many reasons why investors own gold and why you should consider owning the yellow metal.

The big lure to gold continues to be its tendency to hold value when the rest of the investment picture turns uncertain. With U.S. inflation hitting multi-decade highs, U.S. stock markets starting off the year with declines and the global outlook looking both inflationary and at risk of a slowdown, investors are looking for alternative investments. With the Fed cutting rates, the dollar will continue to weaken and gold will continue to rise. Although some are concerned that gold will dip as the Fed attempts to fight inflation, Fed Chief Bernanke seemed to suggest in recent statements that the Fed will put inflation on the backburner as it attempts to thwart a possible recession.

Gold is a monetary metal whose price is determined by inflation, by fluctuations in the dollar and U.S. stocks, by currency-related crises, interest rate volatility and international tensions, and by increases or decreases in the prices of other commodities. The price of gold reacts to supply and demand changes. Gold is different from other precious metals such as palladium, platinum and silver because the demand for these precious metals comes mainly from their industrial applications. Gold is produced primarily for accumulation; other commodities are produced primarily for consumption. Gold is money.

INFLATION HEDGE
Gold is renowned as a hedge against inflation. The most consistent factor determining the price of gold has been inflation - as inflation goes up, the price of gold goes up along with it. Since the end of World War II, the five years in which U.S. inflation was at its highest were 1946, 1974, 1975, 1979, and 1980. During those five years, the average real return on stocks, as measured by the Dow, was -12.33%; the average real return on gold was 130.4%.
Today, a number of factors are creating an inflationary environment: the current monetary policy which is extremely stimulative, a major tax cut, a long term decline in the dollar, a spike in oil prices, a huge trade deficit, and America’s status as the world’s biggest debtor nation. There is no denying that inflation is on the rise, and with the choice between fighting inflation or fighting recession, it seems that the Fed has chosen to focus on keeping the U.S. out of a recession.

HEDGE AGAINST A DECLINING DOLLAR
Gold is bought and sold in U.S. dollars, so any decline in the value of the dollar causes the price of gold to rise. The U.S. dollar is the world's reserve currency - the primary instrument for international transactions, the currency in which the worth of commodities and equities are calculated, and the currency primarily held as reserves by the world's central banks. However, now that it has been stripped of its gold backing, the dollar is nothing more than a fancy piece of paper. The dollar remains in a long term decline, and any signs of strength have only been short-lived bounces. Downward pressure on the dollar will help support gold’s rise.

SAFE HAVEN
Gold often tends to outperform other investments during periods of world tensions. There are a multitude of problems festering around the world, any one of which could erupt with little warning. The very same factors that cause other investments to suffer cause the price of gold to rise. A bad economy can sink poorly run banks. Bad banks can sink an entire economy. As banking crises occur, the public begins to distrust paper assets and turns to gold for a safe haven. When all else fails, governments rescue themselves with the printing press, making their currency worth less and gold worth more. Gold has always risen the most when confidence in government is at its lowest.

SUPPLY AND DEMAND
First, demand is outpacing supply across the board. Gold production is declining; copper production is declining; the production of lead and other metals is declining. It is very difficult to open new mines when the whole process takes about seven years on average, making it hard to address the supply issue quickly. Gold output in South Africa, the world's largest gold producer, fell to its lowest level in nearly 75 years. And the recent shut down of several mines due to power shortages in South Africa does not help the production.
India is the largest gold-consuming nation in the world. China, on the other hand, has the fastest-growing economy in modern history. Both India and China are in the process of liberalizing laws relating to the import and sale of gold in ways that will facilitate gold purchases on a mammoth scale. China recently passed legislation that will allow the country's four major commercial banks to sell gold bars to their customers in the near future.

DIVERSIFY YOUR PORTFOLIO
Diversification of investments can improve overall portfolio performance. The most effective way to diversify your portfolio is to invest in assets that are negatively correlated with those in the stock and financial markets and that are not closely correlated to one another. Gold is the ideal diversifier for a stock portfolio, simply because it is among the most negatively correlated assets to stocks.

Although the price of gold can be volatile in the short-term, gold has maintained its value over the long-term, serving as a hedge against the erosion of the purchasing power of paper money. Gold is an important part of a diversified investment portfolio because its price increases in response to events that erode the value of traditional paper investments like stocks and bonds.

Although gold is a very volatile commodity and is subject to large swings in price from time to time, it has still proven to be a worthwhile long term investment. I would look at any significant pullbacks in the price of gold as a buying opportunity.