The price of gold keeps rising and has already reached a level of 1,116 dollar per ounce after surging by 57 percent in the past twelve months. In the last decade, the commodity has increased by about 280 percent - on average, 28 percent a year (not adjusted for inflation).
The commodity closed the year 2008 with the eighth annual increase in a row, and in the year to date, the performance has been outstanding as well with a 26 percent increase. In comparison, the S&P 500, which measure the performance of the broad domestic economy by tracking the market value of the biggest 500 companies, rose by 21 percent year to date and lost 22 percent in the past 10 years.
Some investors claim that the positive momentum of the gold should continue mainly because the depreciation of the dollar, continuous uncertainty with regard to the real economy and concerns over future inflationary pressures.
Analysts and investors estimate that the golden metal will reach a level of about 1,400 dollars by the end of the year - which reflects a return of 26%. Other bullish investors see the price of gold reaching levels of 2,500 dollars and even more in the next five years. On the other hand, some investors claim that the current rally is unjustified and it is fueled by sentiment or speculative reasons and not based on real grounds.
So what are actually the factors that fuel the price of gold?
Firstly, it is important to note that about 60 percent of the world's demand for gold comes from financial and speculative investments such as exchange traded funds (ETFs) or retail trade. This means that just 40 percent of the commodity's demand is used for industrial purposes (technology, jewelry, surgeries etc.) which reflect the real demand. From the supply side of the equation, since gold is not perishable, about half of its supply is located above the ground. Meaning, the pace and cost of mining should not affect its price significantly. Thus, by knowing these two factors, we can conclude that there is no mathematical model that can calculate the present or the future real value of gold. The real demand and the real supply are too small and too limited for price evaluation purposes.
There are several factors that fueling the demand of the gold's financial related products. First, in times of uncertainty investors turn to Gold as a hedge against unexpected disasters since gold is an investments that is not simultaneously an asset and someone else's liability. The commodity will always maintain an intrinsic value and it will not get lost in a market collapse.
In addition, the lack of confidence in major currencies will push investors toward gold as a hedge against devaluation by the world's largest economies. On the same correlated basis, the investment in gold will be used as a hedge against future inflation.
Although it is difficult to determine the effect of the "real" demand on the real economic gold's price, investors cannot ignore the demand trends in the economy such as the growing demand from China and India. India is the largest
gold consuming nation in the world and China has the fastest-growing economy in modern history.
Both countries are in the process of liberalizing laws related to the import and sale of gold in ways that will smooth the progress of gold purchases on a massive scale. Recently, India announced that it will buy 200 metric tonnes of gold from the International Monetary Fund (IMF), while China encourages its citizens, through the media, to purchase gold.
Invest or don't invest?
An effective way to diversify investors' portfolio and protect their wealth is to invest in assets that are correlated with the factors that are mentioned above. Gold is the ideal diversifier for a stock portfolio, simply because the economy is still weak. The uncertainty concerning the future is still high, the major currencies, especially the dollar, suffer from downside risks, and the government policies may lead to inflation in the future.
Although the price of gold can be volatile in the short-term, gold has maintained its value over the long term and served as a hedge against the erosion of the purchasing power of paper money. In addition, gold should serve as an important part of a portfolio since its price increases in response to events that erode the value of traditional investments like equities and corporate bonds.
The writer is Chief Analyst and Strategist at Alumot-Sprint Investment House and also a regular writer for several leading financial papers and websites