Personal Finance: Gold is not a sure bet even amid inflation

Personal Finance: Gold is not a sure bet even amid inflation

May 11th, 2011 By Travis Flenniken in Business Diary

Would you be interested in an investment with the following characteristics?

It has no earnings, pays no dividends, has little practical industrial or societal application, it is priced almost three times higher than it was five years ago, and the only way for you to make a profit on it is to find someone to buy it from you at an even higher price at a later date?

If you said "yes," then perhaps gold is the investment for you.

The price of gold has been a hot topic of discussion in the last few years. Gold has been on everyone's mind as the value of a dollar continues to decline, recently reaching new lows relative to an index that holds a basket of global currencies. Since 1971, when the U.S. terminated convertibility of the dollar to gold, the dollar has lost 30 percent of its nominal value relative to the global currency index.

Inflation is essentially the weakening of your dollar's purchasing power. As the dollar loses value, we pay more for gas, food and other items. A weaker dollar is good for domestic businesses selling to other countries because it makes our goods cheaper, but it also makes the things we buy in America more expensive.

Gold is thought to be a good hedge against inflation because it tends to retain its purchasing power. According to the World Gold Council, relative to prices in 1900, gold has held its value better than any other monetary instrument in the world, enduring a century of inflation, wars, and other geopolitical shocks.

The prospect of never losing purchasing power is attractive, and apparently it has been attractive to investors around the world as sovereign nations, institutional investors, and retail investors have bid the price of gold to historic levels. But as gold approaches $1,500 per ounce, investors should take a hard look to determine if the current price reflects the true value of the precious metal.

Looking at data that goes back to the early 1970s, gold has been almost perfectly inversely correlated to the dollar index through the end of 2004, which means it was a great hedge against inflation.

However, something happened in 2004 that caused gold prices to skyrocket to the meteoric level it is at today. While gold prices increased 23.5 percent on an annualized basis, the Consumer Price Index, which measures inflation, increased at an annualized rate of 2.5 percent. The long-term dollar/gold relationship ceased to exist after 2004.

So what happened in 2004 that could be the cause for the sharp increase in gold? It may have something to do with the 2004 initial public offering of the SPDR Gold exchange-traded fund, or ETF. This security, which ticker is GLD, holds only gold as an asset and it is traded on an exchange like a stock. The creation of this ETF essentially made the purchase and storage of gold much easier than ever before, opening the door for everyone to participate in owning the precious metal.

Interestingly, the World Gold Council was the sponsor during the IPO, and guess what type of parties are members of the World Gold Council? Gold mining companies.

It was absolute genius for this trade organization to create demand for gold by making it easy to exchange and store. As a result, demand has shot up, while supply growth hasn't changed, moving the price higher, and making miners much richer.

Don't believe that an ETF can have a significant effect of a world market? Consider that GLD is the second largest ETF in existence, with a $60 billion market capitalization. Total combined market capitalization for all gold ETF is $70 billion. GLD dwarfs the others.

Is gold really more precious than other metals, such as palladium, platinum or silver? Or perhaps the metal's representative trade organization just has a better marketing strategy than the others? These other metals have representative ETF too, but gold has been branded as the metal of choice to protect purchasing power in uncertain times.

In light of gold's historic price increase relative to inflation, possibly proliferated by the introduction of gold ETFs and the strength of trade organization's marketing, one should be very cautious when considering the purchase of gold for investing purposes.

Gold is not a sure bet.

Ask anyone who purchased it in 1980 for $615 per ounce and saw the price fall and not return to that level again until 15 years later.

Travis Flenniken, a certified financial analyst, is vice president of investments at DeMoss Capital.