Investment Strategies
Good as Gold: What's Next for This Sector?
Insights from experts on this volatile sector Published:
March 31, 2006 By Margaret A. Malaspina

Throughout the ages, gold has been coveted for its beauty, scarcity, and value as a hedge against inflation, hard times, and a sinking dollar. But, last year the shiny metal rose 18% in a relatively benign environment—and the average gold mutual fund returned more than 30%.1 So far in 2006, as of February 10, gold has climbed another 6%, setting a new 25-year high with each advance.

There's some evidence that speculators may be one of the driving forces behind the current surge in gold: new investors have poured into the market. And history shows that when investors have become overly ebullient, the higher prices may not last.

But something more than speculation may be working in favor of gold over the longer term, says Dan Dupont, manager of Fidelity Select Gold Portfolio. Dupont cites three factors that support his bullish case for gold: 1) demand has risen, 2) supply has been flat to diminishing, and going forward 3) the dollar could be in for another bout of weakness.

Supply and demand becoming more important
Despite the glamour surrounding gold, it is a commodity—and most commodities trade on the basis of supply and demand. But gold is different. Most of the world's gold supply is already above ground, held by central banks as reserves or for investment purposes. Current gold production represents only a small fraction of the vast supply of gold. Therefore, a decision by a central bank to sell gold reserves has the potential to move the price of gold more than an increase in demand.

However, demand has played a more important role in the metal's recent rally. For starters, demand for gold jewelry has risen sharply in Asia and the Middle East—especially in countries such as India and China where there has been a historical link between jewelry demand and strong economic growth. Global jewelry consumption grew by 12% in 2005, according to the World Gold Council.

Demand has also risen as the result of the introduction of gold exchange-traded funds (ETFs). The first gold ETF was launched in 2004 and since then, sales have soared. Unlike gold-oriented mutual funds, gold ETFs are required to physically hold gold. ETFs have purchased 232 tons of gold—the equivalent of 10% of the world's entire mine production of gold in 2004, according to the World Gold Council.

"In addition, the supply/demand relationship has been affected by reduced hedging among gold companies," says Dupont. When a company hedges, it basically sells gold into the market, fixing the price that it will receive a couple of years down the road. In order to reduce their hedges, companies must actually acquire gold, which adds to gold demand.

Finally, gold production has been flat to diminishing. "In the 1990s, it wasn't unusual to discover two or three major deposits in a single year," says Dupont. But lately there has been a dearth of new discoveries. "The number of major discoveries has dropped to one a year."

Follow the dollar
Last year, both the value of the dollar and the price of gold rose—a departure from the historically inverse relationship between the two. However, Dupont expects the historical relationship between the dollar and gold to be restored.

The long-term outlook for the dollar remains less than favorable. The current account deficit has grown and the budget deficit has expanded." These factors were generally ignored in 2005 as rising short-term interest rates made dollar-denominated Treasuries attractive to foreign investors. But now that the Fed has indicated it may be nearing the end of its cycle of rate increases, Dupont believes that the dollar is vulnerable once again.

"And if the dollar falls, gold could be in for an extended ride," says Dupont. Yet, he is cautious about the short-term prospects for the sector because speculators, who have entered the market of late, may not be prepared for the extreme volatility that has marked gold cycles over the decades.

Dupont's caution has figured into the way he manages his fund. He has reduced his exposure to more speculative companies, which have had a strong run in the past couple of months. He's added to higher-quality holdings, many of which have been ignored in the recent speculative frenzy. "I've tilted the portfolio toward companies with stronger balance sheets and more liquidity," he notes. "In general, I'm seeking to reduce the fund's exposure to geopolitical, geographic, financial, and development risk by raising quality and making it more diversified and more global.

Gold and your portfolio
Gold can add a valuable element of diversification to a portfolio that is already broadly allocated among domestic and foreign stocks and bonds. In fact, a portfolio that includes gold can improve performance consistency over the long term. That's because gold has a low to negative correlation with most other asset classes.

But if you're a new investor in gold, your approach should be cautious, consistent, and gradual. "Determine how big a position you can handle, and consider getting into the market with several smaller investments rather than rushing in all at once," says Roland Manarin, a personal financial advisor located in Omaha, Neb. Manarin has followed gold for more than 30 years. How large should your allocation be? The general consensus among financial advisors is between 5% and 10%. Manarin suggests 7%, but cautions clients to keep their positions in line with disciplined rebalancing. "If you decide to invest in gold now that it's hit a record high, you need to be prepared to stay with your allocation even if the price comes down," says Manarin. "And if you got in on the bull market in gold earlier in this cycle, it may be time to cut back on your exposure to keep your allocation on target.

Sell while the price is still soaring? It's hard to do, but it's especially important when it comes to gold, says Manarin. "Think of gold as insurance, as a hedge to protect your portfolio. When the price is soaring, you should be taking profits. If it's falling and your portfolio allocation is down, you should consider buying." Manarin believes that if you jump into gold just to make some quick money, you are almost certain to find yourself on the wrong side of one of the most revered principles of long term investing: buy low, sell high. But a disciplined strategy in this volatile segment of the market? "It's as good as gold," he says.