Gold price nears $500: time to invest or divest?

The fear of inflation is what is behind gold's recent price upturn. But the first half of 2005 saw gold give back some of its gains in late 2004, and it is only really since August that the precious metal has delivered decent returns, gaining around 11%.

Some investors will therefore be persuaded to call it a day at $500 and exit the market. But there are others who think that the gold market may deliver a Nasdaq-style upsurge in the next couple of years, and that to exit now would be foolish.

Certainly an examination of the gold price graph shows a steeper and steeper rate of growth, consistent with an imminent price blow-off, which has yet to happen. Most recently it is a fear of inflation that has rallied gold prices higher, fuelled by the very obvious existence of actual inflation in the system from higher energy prices.

Gold still dead cheap

However, gold is still very low in comparison to the cost of oil which it has historically shadowed. Indeed, gold is at a 25-year low if priced in barrels of oil. That means that either oil is far too expensive or gold is far too cheap.

Expert opinion suggests oil prices will trade around $50-a-barrel for the next couple of years due to supply constraints. Hence the logical conclusion is that gold prices have a lot of room for upward movement.

Another factor is simply that global investors are short of alternative investments. With interest rates rising to combat inflation bonds looks a miserable buy, but then equally equities don't look that bright either with markets at multi-year highs and the outlook for non-energy profits uncertain. Higher interest rates are not good for real estate too.

That leaves gold. Unlike paper currencies the central banks can not create more gold. Its supply is fixed or rising very slowly, so gold is a hedge against inflation. It is also a safe haven in times of financial crisis, and after reaching multi-year highs can the outlook be that good for global equities?

US debt crisis

Many observers believe that the US will have to inflate the supply of dollars to cut the real cost of servicing its debt at some point, and this would likely follow a financial crisis. Again gold would be a protection against the declining value of US dollar assets, something that ought to be particularly attractive to the Oil States.

Which brings us to the Arab petrodollar surplus: would it not make sense for regional central banks to also buy gold to hedge against a declining US dollar and store money for future use? Certainly the current buying of US Treasury bonds in the face of higher interest rates looks a sure-fire way to loose money big time.

So the smaller investor could be well advised to hold a portion of a portfolio in gold, either through buying gold bars and coins, or gold mining shares.