Has gold's 25-year bear market come to an end, wonders Patrick Lawless
Sunday Independent - November 20th 2006

FOR many centuries, gold has acted as a central reserve currency for countries and kingdoms throughout the world. It's ridiculously heavy and far too soft -- so what other role could it fill?

However, it now appears that the metal's 25-year bear market has come to an end. The recent rally has been explosive, and in a world where global excess liquidity is being steadily withdrawn, many claim that real assets are bubbling while macro-economic risks are growing. Against this background, gold has risen towards $650.

So, is gold merely a speculative play, or are there other qualities? In short, does it make investment sense?

Let's look at some of gold's characteristics, while keeping a sense of history.
Gold standards of the past included the Venetian ducat and the British pound sterling in the 19th century, and gold was also the basis of the Bretton Woods Agreement which collapsed in 1971/72.

It was this collapse which signalled the end of the international gold standard. During the 1990s, countries such as Russia and Germany sold their physical gold holdings to get liquid currency.

Since then, there has been an entrenched belief that gold acts as a hedge against inflation. It has been a very reliable predictor for global inflation over the last 50 or so years.

Sharp rises in gold in 1975 and 1982 were followed by substantial rises in inflation. Likewise, gold fell before periods of disinflation in the Fifties, Sixties and Nineties. Although inflation looks under control, due to productivity gains, other factors are at work within the gold market.

Supply and demand is a key dynamic and (with apologies to Mark Twain) some people even feel we should buy gold because "they're not making any more of it". Gold has seen significant decreases in investment in mining and production -- and supply has therefore fallen 15 per cent since the Nineties, while demand has risen slightly.

Jewellery accounts for almost 70 per cent of total demand, with the balance mostly industrial. Demand from China, India and other parts of Asia has risen substantially for gold jewellery.

Gold is also seen to be negatively correlated with the US dollar and (as witnessed last week) it now appears that the US dollar may continue to weaken as US rates appear to have peaked. In the Seventies, the last time the world gave a vote of no confidence to the US dollar, it declined 30 per cent, while gold increased over 2,500 per cent!

The key problem for the US economy is that GDP growth, although rising, is rising at a slower rate than increased debt levels. Today, it takes $7 of increased debt to create $1 of GDP. The M3 economic indicator, which is largely regarded as a barometer of total money supply, including debt, has risen at an annualised level of 15 per cent, approximately $1 trillion annually over the last 30 years.

In short, the US has become the world's largest debtor and there is simply too much debt at every level throughout the world. If you believe that interest rates could bite on the consumer, due to these substantial debt levels, then gold may provide a safe haven. Over the last couple of years, much work has been done to create alternative investment funds (private equity, venture capital, hedge funds and gold funds) in order to try and attract higher returns while lowering risk.

It is interesting to note that gold has a negative or low correlation with any of the other asset classes, including property, equities and bonds. However, gold will not be a one-way bet, as many countries have been reducing their exposure as prices rise. Gold prices have recently fallen from $715 in May 2006 to the mid-$500s as it was thought that Germany might sell some of its reserves.

In country terms, the US is the biggest holder (8,134 tons), followed by Germany (3,428 tons). The precious metal market is worth $2 trillion (compared to the $50 trillion in financial assets). So, even a modest switch from financial assets to precious metals could increase the demand and cause prices to move dramatically. Hedge funds and other large speculators have more than tripled their net long positions in gold, due to concerns about the US economy and dollar. So what is the best way to invest?

Gold-mining companies have been outperforming the commodity index as their profits have risen faster than the metal price. But these companies are volatile. If you feel cautious, and as part of a diversified portfolio, invest in the direct bullion through the EFT by buying gold bullion securities. If you feel brave, go for gold equities.

Patrick Lawless is MD of Appian Asset Management, one of Ireland's top private client investment managers.