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Is gold our new best friend?

Where is Howard Ruff when we need him? Back in the 1970s, this Danville resident was the premier promoter of gold. His newsletter, "The Ruff Times," was like a bible for people who bought into the theory that gold was an investment that just couldn't lose.

But then, over the next few years, the price of gold dropped from $800 an ounce to roughly $300. It remained at that level for about 25 years. Beyond just the $500 they lost, "gold bugs" of the day lost the earnings made over 25 years that could have been compounding on other investments, known as the "opportunity cost" or the cost of a lost opportunity.

Reviewing the recent performance of some gold-oriented mutual funds, I couldn't help but notice that they have increased in value by almost two-and-a-half times since 2000. First Eagle Gold was up 106 percent in 2002 alone. Vanguard's Precious Metals and Mining has been flooded with money and is now closed to new investors.

Taking a page from John Spooner's book, "Do you Want to Make Money or Would You Rather Fool Around?", I succumbed to the gold fund temptation last year and enjoyed a run-up on a small amount of my portfolio.

But now, in this frothy atmosphere, gold prices managed to lose 6.2 percent in a day last week -- they've lost 21 percent since their 25-year high of last month.

Good grief. What's a gold bug to do?

By far the greatest impact on gold prices is its use as a hedge against falling dollar values caused by both inflation in the United States and excess supply of dollars overseas. If investors think that dollars will be cheapened in value, then gold will be an alternative that will maintain or increase its relative value.

Gold prices also are influenced by demand in manufacturing and jewelry. Plus, it's considered a "safe haven" in the face of a world calamity. But these influences pale in comparison to the role of gold as a hedge against the dollar.

What illustrates this is the fact that the 20 percent decline in a month resulted solely from the Federal Reserve's commitment to increase interest rates and curb inflation. After all, there was no lull in manufacturing demand, and nothing has happened to ease the world's many crises.

The fact that gold didn't fall any further after almost doubling in value in 2005 speaks volumes about the investing public's anticipation of inflation and a cheaper dollar.

What threatens the dollar more, according to some economists, is the balance of payments situation between us and other countries. When a country starts receiving more and more dollars in exchange for goods it manufactures and sells to us, it reaches a point where the supply of dollars is more than they want to own.

Currency values respond to supply and demand just like any other product. When there are too many dollars outside the U.S., they begin to lose their value relative to other currencies. A country wanting to trade in its excess dollars for, say, Swiss francs, will find currency traders beating down the value of those too plentiful dollars.

The Fed can help prop up the value of dollars by paying more interest on dollar-denominated bonds, but that may not be enough.

George Soros, the legendary investor reputed to have made $805 million last year, was quoted last week by Bloomberg News as saying that the best investment today is cash in any major currency other than dollars.

Economists speculate, only half jokingly, that the Chinese at their present rate will own virtually all U.S. government debt by 2012. We are peering into the abyss.

A collapse of the dollar would lead to a powerful upside explosion in gold prices and an exports boom.

We have to remember that one-third of all revenue coming to the Standard & Poor's 500 companies comes from their overseas sales and operations. A collapse of the dollar may not be all bad.

However, the problem in the short-term is fear of the unknown. We know that interest rates will spike in an effort to make the dollar more attractive, but even that might not stop the "flight from the dollar."

In 1987, I paid 24 percent interest on a copy-machine lease and it left me permanently scarred. Home mortgages were in the double digits.

In the face of these uncertainties, large companies with little debt and overseas sales (i.e., large-cap value-oriented mutual funds for us) make good sense.

Financial adviser Richard Young, author of online advice column Intelligence Report, thinks gold is still a good buy, considering the magnitude of the dollar's dilemma. For the rest of us, investing is an exercise of assessing our individual situations and "selling down to the sleeping point."

But how would our current mix of investments respond to a collapse of the worldwide economy?