All eyes are on gold.
Investment demand is soaring as individuals catch gold fever. Governments are stockpiling record amounts of the shiny metal.
Mints are pumping out new coins as fast as they can.
Even hedge funds are piling on, buying up tons of bullion and futures contracts.
No wonder the price of gold hit all-time highs in April, topping out at over $1575 an ounce, after nearly tripling in the previous five years.
But shortly after hitting those new highs, the shiny metal took a breather and dipped below the technically important $1500 level.
These up and down gyrations leave investors faced with a choice - should you use any weakness to load up, or is it time to take some money off the table?
There are many good reasons to have some gold in your portfolio. Diversifying 5%-10% of your holdings into precious metals can reduce volatility, or provide a nice hedge against inflation and currency devaluation.
But too much of anything can be bad for you. And gold is no different.
In fact, there are strong indications that speculators who add to their holdings right now could end up with iron pyrite - fool's gold - on their hands.
Fundamentals No Longer Driving Gold Prices
Under the best of circumstances, it's tough to put a value on gold.
It doesn't pay interest like bonds. And it doesn't throw off earnings or dividends like stocks.
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What's more, unlike most commodities, gold has little industrial or intrinsic value. Its purpose is almost entirely ornamental.
One could even say the only reason gold is even classified as a precious metal is because humans have found it attractive as jewelry for thousands of years.
Fact is jewelry demand has been the driving factor behind the price of gold for centuries... until recently.
Everything changed in 2000, when investors began to hoard gold as a store of value against inflation and other market forces.
Until then, global demand for yellow jewelry drove the market... and prices.
Investment demand was almost nil in 2000, at the beginning of the latest bull market. In fact, jewelry demand was 65 times bigger than investment demand.
Now, let's jump ahead to 2010. As the price of gold has risen, demand for gold jewelry has been nearly cut in half while demand for gold as an investment has skyrocketed.
The Financial Times reports that industry experts believe there has been a long-term shift away from gold jewelry, especially in the west, where people are selling more old gold items for scrap than buying new jewelry.
You might want to read that again.
Not only are Americans and Europeans not buying gold jewelry, most of them are actually dumping their precious treasure. They are net sellers.
In fact, you could make the case that the 10 year-old bull market in gold is almost entirely due to investment demand.
So, let's get this straight.
The central driver of gold demand throughout history is now plummeting like a rock, while the barbarous relic is now relying increasingly on speculative interest to support its sky-high price.
As an investor then, you have to ask yourself one important question before adding to your holdings: As demand for gold jewelry slows, what will support the price of gold if global investment demand erodes?
Fed Could Spell Trouble for Gold Shares
The media is full of warnings about the global financial system. Dire predictions surround all the fiat currencies, which are now backed solely by good faith.
Meanwhile, the Federal Reserve has been flooding the economy with liquidity for almost three years now, pumping over $3 trillion into the U.S. economy from QE1 and QE2 alone.
In fact, the Fed's so-called "funny money" policy provides gold bugs with their most important rationale for owning precious metals in the first place. They contendbuying gold is the best hedge against the eventual collapse of the dollar and inflation.
But what will happen when the Fed pulls back the proverbial punchbowl? At some point, Washington will have to stop pumping money into the system and start raising interest rates.
What's more, the Fed practically laid out a blueprint for raising interest rates when it released the minutes from its last monetary policy meeting in May.
Turns out, that could hammer the shares of miners and producers, the preferred method of investing in gold for investors who shy away from storing physical gold or coins.
In fact, investors can expect the shares of gold producers to start lagging the market before the end of the year.
The Fed could start raising its key interest rate in the first quarter of 2012. And research shows gold starts to falter about six months before a rate-hiking campaign begins.
In fact, in the last three rate-hiking campaigns - in 1994, 1999 and 2004 - gold stocks lagged well behind the S&P/TSX composite index. An identical pattern has held true in 16 of 18 such rate hikes.
History also shows the U.S. dollar tends to strengthen and bond yields rise during rate raising campaigns - neither of which is good for gold.
And the fact that the Fed is set to turn off the money spigot points to increasing confidence in the economic outlook - typically a bearish indicator for gold.
Big Investors Bailing
As we've noted above - now, more than ever - gold prices are reliant on investor sentiment rather than the fundamentals.
And as the fundamentals for gold deteriorate, there is plenty of anecdotal evidence gold might be getting frothy.
Sky-high prices and crummy fundamentals should have kept any rational investor away from dotcom stocks in 1999 and Las Vegas real estate in 2006.
Yet they didn't.
Lots of folks joined the feeding frenzy as the fear of being left behind overcame logic. They simply couldn't believe their own eyes.
Are conditions in today's gold market whispering a similar siren's song?
Gold-dispensing ATM machines andthe exploding number of "We Buy Gold" billboards across the country should raise caution flags for even the most brazen speculator.
The state of Utah upped the ante recently when it made gold legal tender in the state, although the move seems more political than practical. No one will be rushing out to buy a loaf of bread with gold anytime soon.
Yet when an asset class gets plastered on billboards and becomes a political football at cocktail parties, prudent investors might want to run - not walk - in the other direction.
More importantly, a few major high-profile speculators - including George Soros - have taken notice and started taking some of their bets off the table.
A recent securities filing by Soros Fund Management LLC, shows the hedge fund divested the bulk of its holdings in SPDR Gold Trust, selling over 4 million shares of the world's largest gold Exchange Traded Fund.
Soros also sold some 5 million shares in the iShares Gold Trust ETF and cut his interest in Kinross Gold Corp. His fund now holds 1.4 million shares, compared to 4 million earlier.
All in all, Soros jettisoned almost $800 million in gold.
Whether or not you believe that gold is in a bubble, you still have to ask yourself this question: At these levels, can gold still deliver decent long-term returns?
Warren Buffett, the Oracle of Omaha, may have put it best in a recent interview.
"You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth, you could buy all -- not some -- all of the farmland in the United States.
"Plus, you could buy 10 Exxon Mobiles, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?"
Despite all the hubbub, we still believe gold should be part of any well-diversified portfolio.
Investors can track the price of physical gold in the form of shares in the SPDR Gold Trust (NYSE: GLD). You should also own some quality stocks in the sector, many of which can be found in the Vanguard Precious Metals and Mining Fund (NYSE: VGPMX).
But keep this in mind: Recent monetary expansion has driven a wave of money into financial markets, and gold prices may have simply been swept up in the tide.
Gold is now rising for reasons that have very little to do with fundamentals. Investors should follow Soros's lead and lighten up on their holdings. Bank some profits, now. And wait until prices hit bottom before going on a new gold spending spree.
In the meantime, take a look at the various gold inverse funds on offer. These exchange-traded notes and funds are not designed for long-term investment, but when prices start to collapse, you can rack some excellent short-term gains betting against the yellow metal.
A couple of the best are:
PowerSharesDB Gold Short ETN (NYSE: DGZ) - This ETN is a near perfect negative correlation with the SPDR Gold Trust (NYSE: GLD) - even though it achieves that correlation in a roundabout way. DGZ positions the Deutsche Bank Liquid Commodity Index-Optimum Yield Gold against the returns from investing in 3-month U.S. Treasury Bills. And the result is one of the closest mirrors of the Gold Trust around.
ProShares UltraShort Gold (NYSE: GLL) - GLL offers double the upside (and downside) against the price of gold - with a 200% inverse ratio to daily performance. But instead of using a complicated equation it simply measures the movement of gold bullion in the fixing price for delivery in London. This is the global benchmark for gold prices. And it trades in the U.S. dollar.
Market Vectors Gold Miners ETF (NYSE: GDX) - As the price of gold falls, so will the stock prices of gold mining companies. And this ETF shorts the performance of those gold miners. GDX provides investors with inverse exposure to a wide spectrum of miners, with a balance weighted toward those in Canada, South Africa and the U.S.
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