Should I Buy Gold? 3 Pros, 3 Cons

by Tom Taulli | April 16, 2013 12:32 pm

While gold has lost a lot of its glitter thanks to a 15% plunge in just two trading sessions, long-term, gold has been a rock-solid play. In roughly a decade, prices on the metal have rocketed from about $300 per ounce to a high of almost $1,900 in late 2011.

Investors haven’t been completely without warning of gold’s prolonged slide since those highs, however. Goldman Sachs, Citigroup, UBS and Societe Generale are among a number of firms that have, at various intervals, put out bearish notes on gold’s prospects.

Today, gold has had something of a relief rally, with the SPDR Gold Shares (NYSE:GLD[1]) up more than 2%. But should investors duck in now thinking we’ve seen the worst, or was today merely a dead-cat bounce? To see, let’s examine the pros and cons:

Pros

Central Banks: A few years ago, the world’s central banks became net buyers of gold — a major development, and a potentially substantial long-term driver. The biggest buyers have been from export-heavy countries like China and India, which mostly want to find ways to diversify their massive U.S. dollar holdings. True, some central banks may be forced to sell gold — for instance, this might be the case with Cyprus as it tries to deal with a financial crisis, and there’s even buzz that other central banks in weak European countries Portugal and Spain might do so as well. That said, these countries have relatively small holdings. Also, should we see a massive selloff, that could be an indication of a worsening crisis, which actually should end up being a positive for gold.

Safe Haven: This perceived status has been one of gold’s hallmarks. In previous times of geopolitical uncertainty, investors have piled into the precious metal for stability. During the past decade, events like the Sept. 11, 2001 terrorist attacks and the financial crisis have helped to promote that status. In fact, during 2008, gold was one of the few assets that increased in value.

Tight Supply: Despite the long bull market in gold, supply has not expanded substantially. Miners like Barrick Gold (NYSE:ABX[2]), Newmont Mining (NYSE:NEM[3]) and Goldcorp (NYSE:GG[4]) have had troubles finding new deposits. This could be exacerbated if gold prices continue to weaken, as it would spur these and other miners to pull back on production.

Cons

Gold Bubble? For years, gold had become a no-brainer trade attracting every type of investor, from fast-money hedge funds to retail investors. That’s partly thanks to how easy it has become to get exposure to gold via ETFs like GLD and the iShares Gold Trust (NYSE:IAU[5]). However, that easy access also has a big downside — cascading risk of redemptions[6], a vicious cycle where fund redemptions drive down the price of gold, prompting more redemptions, and so on. That means unwinding can be severe and prolonged, and many investors might now avoid gold, fearing it’s poised for a long-term bear market. For those in the market during the 1980s and ’90s, this isn’t an unreasonable concern.

Inflation: Gold, which you can’t print, is considered to be a hedge against inflation. During the 1970s, for example, gold saw huge upside moves as inflation became an issue across the globe. When the Federal Reserve initiated its aggressive efforts for quantitative easing, there certainly was a threat of inflation, and remember that other central banks adopted similar easing policies. But so far, inflation has remained tame, and is likely to stay that way as global growth remains sluggish and unemployment restrains wages.

Use For Gold: While gold has some industrial applications, its main purpose is for jewelry — and jewelry is under pressure, importantly in India, where gold traditionally is a key part of wedding rites. The Indian government also recently hiked the gold import tax up 50%, to 6%. Another problem for gold is that it produces nothing. It’s essentially a negative-yield investment since there are ongoing expenses for storage and insurance. That is why some legendary investors, like Berkshire Hathaway‘s (NYSE:BRK.A[7], BRK.B[8]) Warren Buffett, have famously shunned gold.

Verdict

Gold’s correction was painful, but overdue.

However, the reflex response has been that somehow gold is no longer a safe haven or an inflation hedge. That’s unlikely — gold has been a core part of the global financial system for centuries, and a sudden drop in price doesn’t necessarily mean that special status has come to an end.

Nonetheless, investors still should be wary in the short run. Whenever an investment of any type is subjected to a major shock, it can suffer ongoing weakness.

So should you buy gold? Not yet — wait until prices show real signs of stabilizing before considering an investment.

Tom Taulli runs the InvestorPlace blog IPO Playbook[9]. He is also the author of High-Profit IPO Strategies[10]All About Commodities[11], and All About Short Selling[12]. Follow him on Twitter at @ttaulli[13]. As of this writing, he did not hold a position in any of the aforementioned securities.

Endnotes:
  1. GLD: http://studio-5.financialcontent.com/investplace/quote?Symbol=GLD
  2. ABX: http://studio-5.financialcontent.com/investplace/quote?Symbol=ABX
  3. NEM: http://studio-5.financialcontent.com/investplace/quote?Symbol=NEM
  4. GG: http://studio-5.financialcontent.com/investplace/quote?Symbol=GG
  5. IAU: http://studio-5.financialcontent.com/investplace/quote?Symbol=IAU
  6. cascading risk of redemptions: http://slant.investorplace.com/2013/03/strong-dollar-and-massive-redemptions-squash-gold/
  7. BRK.A: http://studio-5.financialcontent.com/investplace/quote?Symbol=BRK.A
  8. BRK.B: http://studio-5.financialcontent.com/investplace/quote?Symbol=BRK.B
  9. IPO Playbook: http://investorplace.com/ipo-playbook/
  10. High-Profit IPO Strategies: http://goo.gl/TXQsz
  11. All About Commodities: http://goo.gl/FfP8R
  12. All About Short Selling: http://goo.gl/t5Jzb
  13. @ttaulli: https://twitter.com/ttaulli

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