All That Glitters Is Not Gold

Gold prices hit 17-year high, but few see level as sustainable

With gold prices at 17-year highs -- up more than 5% since the Friday before Hurricane Katrina hit the U.S. gulf coast -- investors are weighing whether there still is upside to the prices of gold stocks.

Valuations suggest there may be better buying opportunities, especially since gold stocks in S&P's coverage universe have climbed approximately 20% since August 26th.

"Since we see little upside potential at this point, we do not recommend adding to holdings" of gold-producing stocks like Barrick Gold Corp. (ABX), Newmont Mining Corp. (NEM) or Placer Dome Inc. (PDG), says Leo Larkin, S&P's gold equity analyst.

Similarly, S&P recommends against investing in gold directly. "In general, we think gold is a bad investment because it is very seldom that gold outperforms any other investment, like stocks or bonds," says David Wyss, chief economist at S&P.

Still, investors may be wondering why the price of gold continues to surpass its already tony levels. Overnight, December gold futures reached a high of $471.05 and spot gold jumped to $474.90. There are many reasons. Erratic returns in other asset classes may have driven some investors to gold this year. Also, "we believe the low level of gold prices in the late 1990s led to sharply reduced exploration, which we think will result in flat to lower production even if the metal price rises dramatically," says Larkin. In other words, demand is outstripping supply, leading to higher prices, a refrain echoed by close observers of oil prices. Crude futures jumped 7% yesterday, settling at $67.39, on fears of another hurricane barreling down on the already-strapped oil production and refining capabilities in the Gulf of Mexico area.

However, few market observers see either of these commodities' high prices as sustainable. Wyss said that he believes that currently high gold prices are susceptible to downside risk because of the historic influence of oil prices on gold. Gold prices tend to rise when oil prices do the same; conversely, both commodities tend to fall at the same time. Wyss cited some evidence that oil producers appear to be taking profits to buy gold. He said he expected this gold-buying trend to halt as oil prices likely reverse and momentum in other asset classes, such as currencies, likely gain investors. S&P sees a year-end per-barrel oil price of $62, falling to $52 by the end of 2006.

Doug Groh, senior investment analyst at Tocqueville Asset Management, the company behind the $500-million Tocqueville Gold Fund (TGLDX), sees gold's future support level at around $439 an ounce, or pre-Hurricane Katrina prices. He said he doubts gold prices would go much below that.

He notes that an investment in gold is traditionally used as a hedge against inflation. However, S&P is not forecasting a big increase in the inflation rate. And Groh believes that investors don't want to be gold buyers in this environment. "If you believe inflation is in front of us, you probably want to buy against that hedge, but it may be too late now" because of the high valuation.

Meanwhile, risks to gold stocks are many, Groh says, due to the rise in operating costs that miners experience, which include labor, heavy-duty equipment, fuel, and imports (such as steel to build mines or chemicals to process the gold ore). Mining equipment is in relatively short supply, on a worldwide basis, at this time, Groh says.

Mutual funds that hold gold stocks pose their own risks, since underlying gold shares are highly volatile, and can be subject to sharp selloffs. Indeed, gold funds have a high standard deviation, a measure of volatility, as illustrated in the chart below.

While gold funds have been strong performers the past three years, longer term they have not kept pace with stocks and bonds. For the ten years ended in August, the average gold fund registered an annualized return of 1.9%, versus 9.8% for the S&P 500, and 6.8% for the Lehman Brothers U.S. Aggregate Bond index.

TOP-PERFORMING GOLD/PRECIOUS METALS FUNDS FOR THREE-YEAR PERIOD*

FUND

ANNUALIZED RETURN*

STANDARD DEVIATION

US Global Investors Fds:World Prec Minerals (UNWPX)

+31.8%

35.77

Vanguard Precious Metals Fund (VGPMX)

+31.0%

22.45

Scudder Gold & Precious Metals Fund/AARP (SGLDX)

+23.5%

32.14

US Global Investors Fds:Gold Shares (USERX)

+22.6%

35.94

Evergreen Precious Metals/I (EKWYX)

+22.0%

30.36

S&P 500

+12.0%

13.12

Source: Standard & Poor's

*Through Aug. 31, 2005

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