4 Factors That May Restrain Gold's Gains

By Alexander Green, Investment U's chief investment strategist

NEW YORK ( TheStreet) -- Speculators should sell their gold.

I know most readers will disagree -- I've been down this road before.

To wit: In 2000, we called investors' love affair with Internet and technology shares "perhaps the greatest investment mania of all time." Readers wrote in that we "just didn't get it," that we didn't understand the New Era. And, indeed, it made no sense to me.

In addition, six years ago, when I warned of the dangers of the housing bubble, readers chimed in again, telling me that real estate always goes up. (They said that even though it had fallen for 14 consecutive years in Japan.)

So my opening line may irritate the majority again.

But gold, now priced at more than $1,365 an ounce, is trading in La-La Land. And if you're piling into it now, you're taking a very poor risk.

Don't get me wrong: High-quality gold shares should be part of any well-diversified portfolio.

Unlike the metal itself, blue-chip gold stocks have delivered an average annual compounded return of about 12% over the past 50 years. And they're not correlated with the broad market, which gives your portfolio higher returns with less volatility.

That's why we own the Vanguard Precious Metals and Mining Fund ( VGPMX) in The Oxford Club's Gone Fishin' Portfolio and AngloGold Ashanti ( AU) in our Oxford Trading Portfolio.

But gold has more than tripled in the past five years and quintupled over the past 10. Gold bugs say it will go much higher, but there are good reasons to be skeptical.

Gold is a wonderful hedge against inflation and economic calamity. And since we recently experienced a full-blown financial crisis, it's natural that gold prices spiked.

But why is it still climbing? Things are getting better, not worse. The risk of a catastrophic meltdown has lessened considerably over the past year and a half.

And inflation? The CPI has dropped from 2.7% at the end of 2009 to 1.2% at the end of 2010. Inflation is not a threat.

"Expect that to change," the gold bulls insist. They predict that higher inflation is just ahead because commodity prices are rising, the Fed is printing money and Congress is spreading it around with a fire hose.

But there are significant disinflationary forces at work right now.

Factors That Could Stall Gold's Price Rise:

1. The real estate meltdown: It's far from over. Most Americans' biggest asset is their home and as values continue to slide, it will make homeowners even more reluctant to spend.

2. High unemployment: Traditionally, inflation moves higher during periods of higher wages and benefits. But with one in 10 workers on the sidelines, that's not a significant threat.

3. The Fed: Despite how often you've heard it, the Fed is not "printing money." That is a myth. The amount of currency in circulation isn't changing. The money supply hasn't changed in any significant way. The Fed is buying Treasury securities to lower long-term interest rates and stimulate the economy. I believe this policy is unwise and unnecessary, but it hasn't proved inflationary, and it could be revoked at any time.

4. Gold price projections: The way that some gold bulls forecast future prices is ridiculous. Under the best of circumstances, gold is tough to value. It doesn't pay interest like bonds. It has no earnings or dividends like stocks. It can't house you or provide rental income like real estate. So how do you project where gold should be trading?

That's the $6 million question.

The Problem With Predicting the Price of Gold

For example, I hear bulls talking about record deficits and the problems in the eurozone and so forth. Indeed, those are serious issues. But they may prove deflationary instead of inflationary. How does it tell you what the price of gold should be?

If gold were currently trading at $3,000 an ounce and these same problems existed, would that mean gold should be trading at $4,000, or $5,000, or $10,000? Who can say? After all, the world's economic problems are no secret, and the markets have had plenty of time to absorb the news.

Some analysts point out that gold was trading for $850 an ounce in 1980 and if you just adjust for inflation, the price should be around $2,300 today. But that's just guesswork gussied up with charts.

Gold has often underperformed inflation for decades, as it did between 1980 and 2000, when it rather spectacularly lost 70% of its value. How can you be sure that won't happen again?

I'm not saying it will happen. But I am saying that -- while the next move in a bubble is anyone's guess -- looking back five or 10 years from now, this is likely to be viewed as yet another investment mania. (Bear in mind that in 2005, investors made up 16% of the demand for gold. Today, it's more than 40%.)

If you pile into the barbarous relic at these prices, you may get the same shellacking that Internet investors and real estate speculators got a few years ago.

My advice? Keep 5% to 10% of your portfolio in high-quality gold shares as a hedge against inflation and potential economic calamity.

But if you own gold purely for speculative purposes, do yourself a favor. Take profits now.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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