Is gold a bubble waiting to burst?

11th November 2010

In January 2000 you could buy an ounce of gold for less than 300 dollars. That same purchase today would cost almost five times as much.

Traditionally investors used gold as a store of value to protect their wealth against the impact of inflation, but the latest surge in demand owes more to the currency wars and the new round of quantitative easing by the US Federal Reserve.

"Gold is often considered a quasi-currency but, unlike paper money, banks cannot churn out unlimited amounts of it," explains Paul Duncombe, head of multi-asset investment solutions at Schroders.

Investors are concerned that QE2 will undermine the value of the dollar and are diversifying away from traditional dollar denominated safe havens like US Treasury Bills into gold and other real assets.

According to Duncombe, gold is a good defensive asset when times are as uncertain as they are now. "With investors still nervous about the double dip, unsure about equities and lamenting signs that bond yields will stay low for a long time, I see no reason why gold won't appreciate further."

The main downsides are that it pays no income and its intrinsic value is based solely on what someone else is willing to pay for it.

Mark Harris, head of multi-manager business at Henderson Global Investors, doesn't believe that gold is in bubble territory, although he says it is certainly a candidate given the difficulties in valuing it.

"Gold has outperformed for nearly 10 years and is becoming increasingly popular, but most investors still have very meagre weightings. Whilst it is a little overbought short term, it has yet to go up by the multiples we have witnessed in previous bubbles."

His preferred way to benefit is to invest in gold mining stocks as these offer a leveraged exposure and look undervalued relative to the price of physical gold.

Phil Poole, global head of macro and investment strategy at HSBC, points out that gold has been much less correlated with the other asset classes and has continued to rise regardless of whether risk appetite is positive or negative.

"The main drivers have been: the renewed concern of currency debasement following QE2 and what this means in the future when the policy is unwound; the lack of new supply, which will continue to be a factor for the next couple of years; and the shift on the part of the Central Banks from net sellers to net buyers."

He says that the demand for investment purposes, jewellery and industrial uses have all risen and in view of this he expects the price of gold to remain pretty well supported.

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