From the December 2011 issue of Investment Advisor • Subscribe!

Precious Metal

Gold’s long history as a safe haven is beginning to change. Will investors be able to stomach the new environment?

Melissa Sayer, a resident of Westfield, N.J., was dying to get an iPad. However, she couldn’t justify the expense of a gadget she didn’t really need, no matter how “cool” it was.

Then, in August, a friend told Sayer she should consider selling her gold jewelry.

“The price of gold was high, my friend said, and since I never wear gold—I prefer funky silver jewelry—I thought, ‘let’s just see what happens,’” she says.

She picked out some necklaces and a pin she hadn’t worn for over 10 years, threw in her high school class ring for good measure, and went down to a local jewelry store that was purchasing gold.

“[The store] bought my gold and gave me enough money to buy an iPad and a bunch of apps,” Sayer says. “I was thrilled—I felt like I got a great deal.”

Scores of people the world over who, like Sayer, have cashed in on the high gold prices, have no doubt felt the same way. Whether it’s about selling gold or buying gold, investing in gold ETFs or purchasing gold bullion as an alternative to currency, something that many central banks have been increasingly doing, the world has been caught up in the throes of a major gold rush, one that seems to have no end in sight.

On one level, that’s not surprising. Humankind has had an unconditional trust in gold and an unequivocal belief that nothing can ever diminish its worth, and in troubled times, gold has always been a safe haven for investors. The run-up in gold prices in the aftermath of the 2008–2009 financial crisis is proof of this. Even now, despite a recent market sell-off and a fall in the price of gold, the lure of this most precious of precious metals continues to attract investment dollars, and it remains the ultimate safe haven investment destination.

All the same, experts believe that the gold story may have changed slightly and that there has been a paradigm shift in how the investment world views gold. That paradigm shift will determine, they say, the direction of gold prices going forward and condition the forces that drive the price of gold up or down.

The Fear Factor Versus High Gold Prices

For the past few years, the fear factor—the extreme, all-consuming fear that governs investor attitude and investment choice—drove the price of gold to all-time highs. Gold is and always has been the ultimate investment to hedge fear, says Malcolm Gissen, founder of Malcolm H. Gissen & Associates and co-manager of the Encompass Fund (ENCPX). Even today, Gissen believes that fear is still rampant in the world. The ever-present fears over the health of the global financial system and the uncertainty over the United States and the global economy are very real, he says, and they will continue to drive the price of gold higher.

“I believe that the price of gold will continue to rise because I believe that we are still in an environment of fear,” Gissen says.

Investor fear is based upon many factors, Gissen says, but at this point in time, Congress’s inability to come to an agreement on how to deal with the country’s deficit is one of the greatest drivers of fear.

“The constant headlines that we are no doubt going to continue seeing through 2012 about the lack of compromise between our political parties will drive investor fear,” Gissen says. “We are so polarized as a nation and we have elected legislators that just don’t seem able to compromise. So long as we have complete fear, people will invest in gold, no matter how high prices are.”

According to Stephen Land, though, fear—or at any rate the deep-set, all-consuming fear of a systemic meltdown that investors had between 2008 and 2010—is not as much of a driver of gold prices as it was. Granted, the U.S. debt problem is very real, and the European sovereign crisis is still unresolved. But while investors may still be fearful of the impact of these issues, Land, the co-portfolio manager for Franklin Templeton Investments’ Franklin Natural Resources Fund (FRNRX), believes they are less worried about the direction of the financial markets and the situation of the global economy, and more concerned about the actual price of gold itself as well as the possibility of having to buy gold again at record highs. As such, balancing the fear of a systemic meltdown against fear of paying too much for gold will determine its price going forward, he says.

“This trend is new and it shows that gold has, in a sense, grown up,” Land says.

The greatest change in the gold price dynamic may well be that investors have made it clear that too much of a good thing may indeed be just that, and that there is a price level beyond which they will not pay for gold, no matter its status as the investment of last resort.

The recent dynamics of the gold trade have shown that gold can be as volatile as any other asset class, says Oliver Pursche, president of Gary Goldberg Financial Services and co-manager of the GMG Defensive Beta Fund (MPDAX). This has resulted in a realization that gold may not be as safe a haven as investors have always thought it to be.

More than that, though, investors seem to have come to the realization that a daily rise in gold prices with no fundamental valuation is unsustainable, he says.

“Too many investors were chasing gold without there being a fundamental justification for it,” Pursche says. “In the past months, gold has sold off significantly as the dynamics of investing have changed, and as painful as it has been to some, it has brought some reality to the market and a recognition that there is no such thing as the price of gold always going up. It’s hard to say what will happen going forward, but we have seen that investors will sell gold once it gets to a level where they feel the price is too much.”

Inflation: The New Fear

The recent pullback from gold “let some air out of the balloon,” says Pursche, and has resulted in a more realistic and measured approach toward it by investors. Of course, since that pullback, the price of gold has once again climbed, but Pursche expects that the rise will be more measured going forward, especially since many feel the global situation is not as precarious as it was.

But while investors may not be so fearful of an out-and-out systemic collapse, whatever concerns they have now are just as legitimate, particularly with respect to inflation, which many believe will be the strongest driver of gold prices going forward.

With central banks across the globe maintaining interest rates at low levels, the threat of inflation around the world is high, Land says, and this makes gold more attractive.

“If we do have inflation, there will be more printing of dollars and euros, and at the same time, we don’t see a huge amount of [gold] mine supply coming,” he says. “If we have inflation that results in, say, 15% money growth and gold is only growing at 2%, then its value is going to appreciate relative to paper currency.”

Gold as a replacement for money has been an ongoing trend over the past few years and is set to become stronger in an inflationary environment, agrees Fred Sturm, who manages the Ivy Global Natural Resources Fund (IGNAX) for Waddell & Reed Ivy Investment Company. “As the stock of currency rises, the demand for gold has upward pressure, and this basically speaks to gold as a replacement for the debasement of money,” he says. “We expect that monetary policy around the world will have an embedded inflation upside and the printing of money will continue, so we expect the upward trend in gold to continue.”

The price of gold fell as the fear of a collapse of the banking system and a financial market meltdown became less pronounced, but now, with inflation looming on the horizon, gold once again has the potential to rise, agrees Nathan Rowader, Forward Management’s director of investments and lead manager of the Forward Commodity Long/Short Strategy Fund (FCOMX).

“Gold is not such a great investment in a period of low inflation, but now we’re stuck in an environment where everyone is looking at Europe to take action on the issues that plague it, and when Europe does, inflation will rise, so people will buy gold to hedge currencies,” he says.

Gold allows for diversification away from the U.S. dollar, Land says, a move that many think is a good one to make in these times. Gold, he says, also has a very low correlation to major indices, so it provides great diversification opportunities.

The only thing that could crush the gold bug going forward would be “a central bank with a fly swatter,” says Sturm, one that would raise real interest rates to 2%. But given all that’s going on in the world, and the fact that central banks have been net buyers of gold as opposed to sellers, “we simply do not expect that that will happen within the next several years,” he says.

And From Whence Comes the Gold

The demand for gold has been huge, but what about the supply of gold?

According to Gissen, the supply side of the gold story has been largely ignored thus far, but it has the potential to become more interesting to investors going forward when they realize how undervalued gold mining equities actually are.

“Because people, out of fear, wanted to invest in an asset that is durable, they poured their money into gold ETFs, but not into the mining companies, and they are now seriously undervalued,” Gissen says. “But because of the strong demand for gold, many mining companies are sitting on piles of cash. Yet people are not aware of this because their fear led them to invest in the commodity.”

It is much easier to invest in a gold ETF, Gissen says, because it takes time and decisiveness to decide what gold company to invest in. However, companies like Canada’s Avion Gold and Extorre Gold Mines, an emerging gold and silver producer in Argentina, are companies with great potential that are worth looking at because they have solid cash reserves and their stocks are, at present, seriously undervalued.

There is little doubt that there is a big disconnect between gold, which is up 20%, and most gold equities, which are down, says Land. But for investors to consider those stocks as an investment alternative that forms a part of the overall gold story, they need to judge them for their ability to create wealth over time, not least because mining companies have historically not been the greatest of performers.

“Prior to 2005, they generated very little free cash, and there is 40 years worth of data to show that this is a value-destroying industry,” Land says. “It is only now that we have seen margins starting to open up. With gold prices at $1,700 an ounce and the cost—including the cost to replace and extract—well below $1,000 an ounce, you are indeed looking at companies with very good prospects, and investors do not really understand this yet.”

Like many resource sectors, gold mining companies can only create wealth by finding gold, and to the extent that companies have been successful in making discoveries, their shares have been rewarded, says Sturm. Companies like South Africa’s Rand Gold have done well in terms of exploring and developing, and its share price has actually outperformed the gold bullion price, he says.

“But it is only recently that the gold price has advanced enough for profit margins to have improved substantially for major mining companies. In this backdrop, well-run companies with a deep resource base will indeed generate handsome profit margins and that will, in turn, make them attractive as investments.”

If investors put their money into gold mining stocks, they could fare very well indeed, says Gissen.

“At this point, if the price of gold goes up, it will only go up by about 30% or so, but if you invest in any of the gold mining companies that are undervalued and they have a good year, they could double or even triple in value and keep going from there,” he says. “We bought gold equities at $3 and now we see those stocks trading in the $20 range. In addition to investing in the gold itself, investors now need to look at who is actually getting them the gold.”

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