The Real Value In Gold

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OCEAN CITY – As an investment, gold has always stood apart. Once the standard upon which many world monetary systems were based, it now functions as a kind of alternative currency—a holding with intrinsic value that can serve as a portfolio anchor during turbulent times. Although it receives greater attention when markets are shaky, even in a bull market there are advantages to holding gold. It adds diversification and generally provides an effective hedge against future inflation.

Not surprisingly, the current economic crisis has created a huge spike in the price of gold — taking it from about $710 an ounce last November to around $1,000 recently — as battered investors have put their faith in the precious metal. But that price rise is also fueling speculation, which may pose significant short-term risks, say Banc of America Securities–Merrill Lynch Research (BAS-ML) analysts. Individual investors turning to gold for safety in these challenging markets should be wary of its allure and understand its risks.

The demand for gold has come from many quarters. Small-cap value stock funds, for example, now have some 2% of their assets in one of the most popular gold exchange-traded funds—up from virtually nothing in 2008. And that same ETF has seen its outstanding shares rise by a third since the beginning of the year, according to Francisco Blanch, BAS-ML Commodity Strategist. Moreover, hedge funds have a roughly $11.3 billion net long exposure to gold, says Mary Ann Bartels, BAS-ML Technical Market Analyst.

But this rush to buy gold raises questions about the role of the metal in a personal portfolio. “The quick moves suggest gold may have become a momentum investment rather than a fundamental one,” says Bartels, who notes a dramatic change in the correlation between gold and the U.S. dollar. Typically, when gold rises, the dollar falls. During this most recent run-up, however, both the metal and the greenback have appreciated in value.

That uncommon correlation may support the idea that speculation rather than fundamental value is driving up prices and pushing the gold market beyond its traditional role as a monetary hedge into what is looking more and more like a “hot sector.” Because speculative interest can vanish as quickly as it materializes, holding gold now may pose the risk of short-term volatility, with which it is not usually associated.

In the longer run, however, gold may continue to be an attractive tool for diversification. During the past five years, the metal has had one of the lowest correlations to the Standard & Poor’s 500-stock index—prices of the two asset classes have tended not to rise and fall together. The only assets with a lower correlation to stocks during that period have been fine art and long-term U.S. Treasury bonds.

We expect to see stock market volatility continue for some time, and with the U.S. government pouring hundreds of billions of dollars into the struggling economy, inflation concerns may again loom large. Given those factors, we believe an investment in gold could have long-term appeal, says Blanch. In his opinion, gold could reach $1,500 an ounce within three years. Bartels’s technical assessment also suggests that $1,500 to $1,600 would be a reasonable target price for the commodity.

“Keeping in mind the near-term risks, anyone seeking longer-term diversification may want to include some gold in their portfolios,” recommends Blanch, who suggests limiting one’s allocation of the metal to no more than 5%. Gold can be an excellent diversifier for many portfolios — as long as you’re not buying it with the expectation of an overnight windfall.

(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)

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