All That Glitters / Speculating About Gold

Sophisticated investors can make short-term profits in times of intense economic drama

Suddenly gold is all the rage. One of the people now talking about the yellow metal all the time is a name that attracts attention no matter what he does: John Paulson. (No, he's no relation to former treasury secretary Henry Paulson.)

Paulson, John that is, bet against the market for mortgage-backed securities last year and made a fortune for himself and his clients. $2 billion, to be precise.

Ten days ago the world learned that Paulson had bought $1.3 billion worth of shares in a gold-mining company. Paulson likes gold, we learn.

Gold has its aficionados here in the Holy Land, too. Two weeks ago the chief investment manager at Migdal Capital Markets, Jacob Weinstein, told an auditorium chock-full of investment advisers that gold would surge to $2,000 per ounce "soon," compared with $941 at the end of last week.

Weinstein isn't the only one. Over at Oscar Gruss, which provides local Israeli investors with investment and trading services in the United States, they're also warmly recommending gold.

Why? Unlike stocks, bonds or even currencies, gold isn't a financial investment. It isn't some financial asset to create value in the long run. While bonds bring their holders interest payments, and stocks bring dividends, gold offers no cash flow. On the contrary, holding gold costs money: It has to be protected from thieves. So when you invest in gold, you're undertaking all sorts of auxiliary costs.

In the very long term, gold is the worst of all investments. If you bought $1 worth of gold in 1801, by 2001 you'd have $14 worth of gold. That's pretty pathetic for an investment of two centuries. If you had put that dollar into a U.S. government bond, you'd have $14,000 in 2001. If you had put it into stocks, you'd be worth $9 million.

Historically, therefore, gold can shelter the investor against inflation, but that's about it.

So why are advanced investment mavens counseling investment in gold? Because it can be profitable as a short-term speculative move in times of intense economic drama.

Ask these gold adorers why they're buying it, and they cite two reasons. One is inflation. In the United States, Britain and various other countries, governments are printing money 10 times faster than usual. There's a general consensus that the current process must ultimately reduce the value of various assets: money (inflation), real estate and bonds. In a situation like that, an asset that can't just be created or duplicated through some industrial process has an upside. Gold meets that criterion.

The second reason is the level of interest rates. Gold doesn't generate returns, so when you put your money into it, you're losing potential returns on other investments. In other words, you're forgoing interest payments on bank deposits or dividends on stocks. But at present that "cost" is very low, given how low interest rates are.

The charts below show that the "alternative cost to holding gold," which is based on the price per ounce times the yield on 2-year U.S. treasuries, is near a 30-year low.

It's easy enough to buy gold. In America and here too, there are plenty of financial assets linked to gold. Some are ETFs grouping a bunch of gold-mining shares, and others buy the metal itself.

But watch out. Investment in gold is purely speculative. It should be based on an assessment that commodity prices have bottomed out and are likely to rebound, that the dollar is likely to weaken, and that inflation is about to start rising strongly in the United States and Europe.

Any other scenario will cause gold-holders to lose money, or simply not to profit.

Note this well. In the last 12 months, we've experienced the worst financial crisis in 70 years. We have seen violent fluctuations unprecedented in scope in all financial avenues. Yet the price of gold is exactly where it was a year ago.