What Glitters ... Is Gold

For a long time, gold seemed to have lost luster as an investment. But in recent days (months actually), gold has been a shining beacon in an otherwise dark time.

Wednesday, gold futures rose as high as $307.50 per ounce before sliding back to close down 0.3% at $298.30. Gold's failure to close above the psychologically significant $300 market price encouraged the metal's many skeptics; I received an unsolicited call from one who declared gold's reversal was technically significant and likely signaled a top for the metal, at least for the time being.

One could certainly argue that gold stocks are due for a pause after what has been a heady run for the sector. Since bottoming at $236.10 per ounce on Feb. 7. 2001, the price of gold has risen 26.3%.

Gold stocks have fared even better, with the Philadelphia Stock Exchange Gold & Silver Index up 39% for the past 12 months prior to today, when it slid 4.3%. More than a dozen gold stocks have risen more than 100% in the past year, led by Glamis Gold (GLG Quote), which has climbed more than 260%.

As expected, gold's recent rally has so-called gold bugs in a tizzy, including those who believe the metal's recent advance is going to continue skewering those entities they believe have conspired to keep gold subdued lo these many years. Like most good conspiracy theories, the gold-collusion one is enticing, but it's also nearly impossible to prove, as I discovered long ago.

Furthermore, it's not the issue investors should be focused on, according to Nick Moore, portfolio manager at Jurika & Voyles, an Oakland, Calif.-based money management firm with $2 billion in assets.

Additionally, those interested in gold should also set aside questions of whether gold's move is a sign of investors' desire for safety -- perceived or actual -- or views about inflation and/or the dollar's future.

There are elements of each in the gold story, but "the bull case should be based on supply," Moore said. "With any commodity you have to make a case [that]supply is going to be tight," rather than trying to project what demand is going to look like. "Supply is more powerful."

For example, Japanese retail investors have been buying gold because of concerns about their nation's financial straits and forthcoming caps on bank-deposit insurance.

But Japanese retail buying of gold isn't the cause of gold's big rally, Moore stressed. "Big swings are generally caused by producers," he said. "In commodity markets, it's the actual players" who determine prices.

Mining accounts for roughly 60% of the gold supply, with 20% each from central banks' sales and scrap markets, according to Daniel McConvey of Goldman Sachs.

"After going up for two decades, [mine supply] is leveling off and starting to fall," McConvey said. "Once it does, it will fall consistently over the course of several years because the turnaround time" for finding new deposits, building mines and getting it out of the ground is five to seven years.

In 2001, gold mining production rose less than 1% after falling fractionally in 2000, the first year of falling output since 1995, according to Gold Fields Mineral Services, a London-based commodity research and consulting firm.

Gold producers have been doing less mining and less exploration for the simple reason it was unprofitable to do so. Most producers, especially those in North America, require gold prices well above $300 per ounce to operate existing mines profitability.

The supply of gold has also been diminished by the shuttering of mines and industry consolidation, including Barrick Gold's (ABX Quote) purchase of Homestake Mining in June and Newmont Mining's (NEM Quote) more recent purchase of Australia's Normandy Mining and Canada's Franco-Nevada Mining.

A similar development occurred in the energy sector in the late 1990s, much to the delight of those who owned energy stocks from 1999 until mid-2001.

Finally, the supply of gold is being crimped by a reduction in hedging, or forward-selling, by gold producers. Notably, South Africa's AngloGold (AU Quote), which had previously hedged up to 50% of its production, recently announced a reduction in its hedge book and plans to continue scaling back such practices.

For some time now, gold has been in contango, where futures prices were higher than the metal's spot price. But gold is approaching backwardation, when spot prices are higher than the futures, nullifying an incentive for producers to sell forward their current production.

Additionally, the dramatic lowering of the fed funds rate in the past year means there is no incentive to sell forward because the trade -- shorting gold, going long dollars -- is not as profitable, Jurika & Voyles' Moore said.

For that reason, Newmont Mining is "the last thing I would sell," Moore said, describing the company as an unhedged, low-cost producer, a liquid name and "quality in an iffy business."

Jurika & Voyles also has long positions in AngloGold and some smaller players, although Moore declined to name them.

"We could end up where gold has significant investor demand" because of investors' lack of confidence in corporate earnings, weakness in the dollar, or stagflation or inflationary pressures," Moore said, getting back to the original point. (Notably, he argued Treasury Inflation Protection Securities are a far superior inflation hedge than gold).

"Maybe we're going to have a commodity bull market vs. a stock bull market," he said. "I wouldn't rule it out if people are uneasy about holding electrons."

But when that demand arises is "anyone's guess" and based on emotional factors, he said, advising investors to view gold as a commodity in which those dealing with the physical assets are responsible for large moves. From that perspective, "this is when [gold] should work."