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ROI

JUNE 4, 2009, 5:18 P.M. ET

Gold: Headed For A Bubble?

Investment bubbles usually begin as legitimate bull markets, and I wouldn't be surprised if gold were next.

First, there's a serious investment case. Central banks are flooding the world economy with liquidity. That's a peril to all paper currencies. Anything scarce and valuable, such as precious metals, ought to benefit. Gold is also coming off a very low floor from 10 years ago.

And it's captured investors' imaginations. Boston is the home of many of the biggest mutual fund companies in America -- including Fidelity, Putnam, MFS and Wellington -- but one of the busiest places around the financial district right now is J.J. Teaparty, a well-known shop dealing in bullion and rare coins. All day, a steady stream of customers stop in to buy gold and silver bars and coins. A number of local mutual fund managers -- "stocks for the long run" notwithstanding -- have been seen sneaking off during their lunch hours to do the same.

Gold may be a great bet at these levels. But people should be aware of the risks of buying bullion -- either through an exchange-traded fund, or directly.

To say this metal is volatile is an understatement. Since the start of 2008, the price of gold has swung between $1000 and around $700 (it's currently at $965). This is a safe haven? When the stock market does this, it's on the front page.

And while U.S. and other Western investors are jumping aboard the golden caravan, many in Asia -- who rode it all the way from $260 an ounce -- are quietly disembarking. The World Gold Council, an industry body, reports that Asian investors were actually net sellers during the first quarter, while westerners bought heavily and sent prices soaring.

Ordinary U.S. investors, on average, aren't timing this market too well. Money flows into, and out of, exchange-traded bullions funds like GLD, and are tracked monthly by Financial Research Corp., an analytics company. Comparing them to gold prices over the past year is disheartening.

Gold spiked well above $900 an ounce in July 2008 and again this February and March. Those, of course, were the months when bullion funds reported by far their biggest net inflows. Yet when gold slumped, as it did last October and November and again in April, so did fund sales.

Rarely does anyone discuss the biggest problem with gold -- no one actually knows what this metal is really worth. After all, it generates no income. All the gains come from capital appreciation. And that, of course, is a gamble.

Don't believe me? Try this: What will an ounce of gold sell for in 2038? Are you confident it will sell for more than $3,500? Yes? No? Maybe?

I don't know either, and I'm skeptical of anyone who insists they do know. Anyone buying gold today is basically betting on it.

Today you can buy zero-coupon Treasurys guaranteed to turn $965 into $3,500 by then. That's an annual return of about 4.6%. If you're buying gold, which has no guarantees, you are gambling that it will do a lot better.

(Of course you may hope to sell long before then. But if you want to make a profit, you will still have to find someone else willing to bet gold will be higher than $3,500 by 2038)

While the public has become excited about bullion, shares in mining companies have been left behind. Sales of mutual funds that buy gold-mining shares have been anemic. Both the big and small companies look reasonably cheap compared to their product. A basket of them ought to give many of the benefits of bullion with fewer risks.

Many mutual fund companies offer funds that invest in mining stocks. Among them, U.S. Global Investors World Precious Minerals (UNWPX) is rare for focusing on small stocks. Many funds, including for example Tocqueville Gold (TGLDX), Fidelity Select Gold (FSAGX), and Vanguard Precious Metals and Mining Fund (VGPMX) are flexible and can hold stocks and some bullion too if they choose.

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