Is it Time to Invest in Gold?
By Richard Halverson

I have never been a fan of investing in gold.  Commodity investing has always been difficult.  Gold is a commodity with political overlays.  As an asset gold does not pay interest or dividends.  Interest and dividends, whether reinvested by the investor or the company, are an important source of compounding and compounding is crucial to building long term wealth.  Gold does not generate a positive cash flow.  In fact, it consumes money.  The owner of gold must store it and insure it.  Not only does storing gold cost money it, but it also presents a real problem if the investor has very much.  Gold bars should not be stored in your basement next to the food storage.  Burglars may not break into your house to steal your wheat and water, but they will steal your gold.

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After being in the doldrums for twenty years, gold has been moving up in price.  This chart shows the great run up in gold price that peaked at 880 in March of 1980.  That spike was followed quickly by a collapse.  Its price then drifted sideways and down to about 250.  It has been rising rather steadily ever since early 2001.  This is attracting attention, and some are wondering if it is time to consider buying gold.  Even though I have never been a fan of gold investing there are some valid things to think about.

Gold as an Inflation Hedge

Inflation has been mild in the United States for many years.  Now inflation seems to be creeping in.  It is important to remind ourselves what inflation is and where it comes from.  Inflation can be viewed in two ways.  Either the value of things is rising in terms of paper dollars or the value of paper dollars is falling relative to the value of things to be purchased.  This can be an important difference.

The value of paper money can go down if the government is printing too much money.  Money creation in the United States is handled by the Federal Reserve.  Despite the well publicized government deficits to date, the FED seems to be handling the money supply well.  The interest rate increases of the past year and a half are part of an effort to keep the value of the U S dollar from falling.

Inflation can also occur if the value of important resources rises relative to the value of paper money.  Oil is the culprit this time.  It has been rising dramatically in price.  Oil is an important resource.  It goes far beyond just gasoline.  Oil is a feedstock in many types of materials.  That means that increases in the price of oil must eventually be reflected in increased prices for everything from plastics to airline tickets.

Oil is a commodity, a worldwide commodity.  That means it is subject to rules of supply and demand.  By now nearly all informed citizens are aware that oil supplies have not been rising as rapidly as demand in recent years.  This has been due to an expanding economy in the United States and the rapid growth from very low levels in China and India.  Additionally, we have been reminded that refining capacity in the United States is extremely tight.  There hasn’t been a new refinery built in 20 years in the U.S.

On top of this, capacity has been temporarily affected by the hurricanes in the Gulf.  Now with the price of oil jumping, concern about inflation is rising (no pun intended).  The storm-related problems are temporary; fundamental problems will take longer to resolve.  But they will be resolved.  That is one of the characteristics of a commodity.  Rising prices attract additional supply and reduced demand.  Eventually the market stabilizes.  (Incidentally, it is just silly to believe that high oil prices are due to a monopolistic conspiracy on the part of large oil companies.  Even a cursory understanding of the enormously complex world oil markets will dispel this all-too-popular myth.)

The first question for investors looking at gold as an inflation hedge becomes, is there going to be a period of high inflation where the price of nearly everything rises?  Or are we experiencing inflation in a single but very important commodity?  If it is a general inflation, gold will almost certainly be a good hedge because it is a commodity and will hold its value while the value of paper money declines.

Whether there is general inflation is still an open question.  We do know that oil is rising in price. The next question, then, is will gold be a good hedge against the rising price of oil?  Gold has historically been a good hedge against oil.  And it has been thus far in this cycle.  However, there is no direct connection between these two commodities. 

For example, almost no oil is used in the mining or refining of gold or vice versa.  High oil prices do mean that a lot of dollars, euros, yen and other paper currencies are pouring into oil producing countries and in some cases the pockets of wealthy royal families.  Historically, a portion of those paper currencies has gone to buy gold.

Finally, if an investor were to conclude that gold is a good hedge against oil inflation, is that investor willing to bet that the price of oil will continue to climb?  If the price of oil has already peaked with the hurricane disasters, will the price of gold settle back? Then if gold is a hedge for oil is the price of oil at a peak, or will it continue to rise? 

Gold as a Hedge Against International Tension

Historically gold has been the currency of last resort.  During periods when a specific country or the whole world seems to be in turmoil gold represented value when paper money did not.  When a government and an entire country collapse no one wants to be holding their paper money.

I do not believe the United States government, or any of the major economic powers, is about to fall apart.  There has been a lot of bad news in recent years — from terrorist attacks, to wars, to hurricanes. It is unsettling to realize that no government can protect us from all these things. 

However, we are a very long way from failure, and as awful as some of these things are there is little indication the government is about to collapse and its currency become worthless.  For example, we are not yet experiencing anything even as bad as what the country went through in the 70’s and early 80’s and we survived that.  What we are going through is not that bad yet!  Maybe it’s coming. If you think it is, buy gold.  (Incidentally, I have read the prophecies.  A lot of terrible things are going to happen.  Spiritual gold will probably be more important than physical gold during those times.)

Gold as an Investment

The two previous sections imply that the only reason to invest in gold is if an investor is expecting that bad things such as inflation or anarchy are going to happen.  In fact, gold is an important metal with everyday natural uses in manufacturing, medicine, jewelry and other areas.  Some analysts indicate that for years the demand for gold has outstripped the mined supply of gold by 60% or more.  Some of this deficit has been made up by central banks selling portions of their gold reserves on the world markets.  Hard numbers are difficult to come by.  However, the persistent rise in the price of gold since the spring of 2001 suggests a shortage does exist.

Higher prices will eventually result in more supply being made available.  I know of no study suggesting that all the gold on the planet has been found and dug up.

How to Invest in Gold

As I indicated in the beginning, I am not a big fan of investing in gold.  Personally, I especially dislike the idea of owning actual gold bullion or coins.  If your major concern is that the government will collapse, then you have little choice but to hold the metal itself.  However, if an investor would like to invest in gold as a hedge against inflation, or international tensions or as supply/demand play I recommend using a mutual fund that specializes in gold.  A simple web search will bring up a list of potential funds to research and consider.  Additionally, there are gold mining companies that are publicly traded.  If gold continues to rise, so will they.

Do Not Speculate

One thing you definitely should not do is this:  Do not get caught up in a speculative frenzy.  Look at the chart at the top.  See that spike in 1980 — that took gold to almost $900 an ounce.  If you think this chart looks a lot like a chart of Internet stocks in 2000, you are right.  Both represented massive speculative bubbles.  Many investors poured money in with the idea that things could never end.  I believe we are a long way from a speculative bubble in gold right now.  But for those who know nothing about it investing in gold, now could be just as speculative as 1980.  Study the market; know what your objectives are and what events will cause them to be realized.

Gold has a lot of valuable uses.  In my opinion the most important use of all time was its use to preserve the spiritual records of a great nation.  Fortunately, no one’s ever been allowed to make any money of that.  But if you feel you need gold as a hedge against difficult times, may I suggest that before you fill your basement with South African Krugerrands you follow the counsel of the Brethren and fill your basement with food storage.  In the end, gold is just one more thing that’s hard to take care of, hard to hold to and one more thing you can’t take with you.