NEW YORK ( TheStreet ) -- Warren Buffett, legendary investor and head of Berkshire Hathaway ( BRK.B - Get Report), has slammed gold, yet again, saying it doesn't have any use and isn't procreative. In an adaption of his upcoming shareholder letter published on Fortune's Web site, Buffett rips into the intelligence of owning gold, saying that real demand for gold, defined as industrial and decorative, is incapable of soaking up new production and that the gold you own doesn't "do" anything. At the end of the day, gold is just an ounce of gold worth whatever someone is willing to pay for it. Buffett does acknowledge that gold's 10-year bull market has been helped by the multiplication of fear in the marketplace, which triggered a flood into the hard asset. But he writes this rally off by saying that "as 'bandwagon' investors join any party, they create their own truth -- for a while." XOM - Get Report) and still have $1 trillion left over. Since 2001, gold has rallied 539% while Exxon has climbed only 90%. Now, of course 16 Exxons would have produced a killer return, but why not own both? Most experts recommend that 5% to 10% of one's portfolio be in gold. Those that are more aggressive say 20%. Although Buffett is one of the best-known investors in the world, here is why he might be missing out on gold investing. It's not just retail investors or traders that are buying gold and making it a "bubble," but central banks are too. The "official sector" bought 430 tons of gold in 2011 -- the second year central banks were net buyers in more than two decades -- and the majority of these buyers are coming from emerging market countries that need to increase their reserve ratio. India now holds 6% in gold reserves, which is still considerably lower than the 20% of gold reserves it held in 1994. China holds 1.8% of its reserves in gold. Compare these numbers to the U.S., which holds more than 75% of its reserves in the yellow metal. All of Asia currently only holds 2% of its reserves in gold. Even if the continent were to reallocate their holdings to 3%, it would need to buy 1,000 tons. Central banks, in general, regard reserve allocation as an ongoing government policy and the more emerging markets rack up trade surpluses with the U.S., the more likely they will be to buy gold. Chinese companies that trade with the U.S. end up with dollars that are exchanged for yuan with the central bank. Then the central bank winds up buying a lot of Treasury bills with that money. The more dollars it accumulates, the more gold the country will have to buy in order to keep its asset ratio consistent. "Gold holdings are part of a broad set of assets and liabilities of a central bank and are held to ensure against the negative impact of a sudden withdrawal of foreign capital and adverse exchange rate movements," says James Steel, analyst at HSBC. He thinks emerging market central banks will keep adding gold to their portfolio. "We forecast that the official sector could account for 450 tons of net purchases in 2012," this number is more than quadruple mine supply in 2011.
Mine production is expected to continue to grow 3.2% in 2012, according to GFMS, a research consultancy owned by Thomson Reuters, as the mine lives of older projects are expanded so companies can take full advantage of a higher gold price and as more recent projects ramp up to full capacity. Mine production is hard to rely on, however, as there are many technical setbacks and geopolitical issues that can delay mining. In the meantime China is in the market buying gold. The country imported 427 tons of gold in 2011 and consumed 787 tons. Demand can ebb and flow from the country, but overall it's the rise of the middle class that is leading consumption. By 2015, 44% of china's population will be middle class. The average minimum wage has soared 20% from 2009 to 2010, household income is growing 9% a year while consumption is growing 11%. The story in India is relatively similar, although China is quickly playing catch up, having deregulated its gold market only a decade ago while Indian demand has had more time to moderate. Indian bar demand rose to a fresh record of 282 tons in 2011 and accounted for nearly a quarter of world physical bar investment, according to GFMS, despite the fact that jewelry demand in the country fell 3% in 2011 to 970 tons. The World Gold Council said that jewelry demand in the country tanked 28% in the third quarter. From July to December gold prices in rupee terms were up 25% as the dollar appreciated against the local currency and as inflation ballooned to 10% making gold too expensive to buy. "There is a huge amount of strategy that goes into Indian buying," says Neil Meader, research director at Thomson Reuters GFMS, who thinks if gold prices can stabilize and the rupee can gain ground against the dollar then buying could pick back up. "You do quite often see very good buying on the dip." One of the biggest recent drivers of gold has also been currency devaluation. Gold tends to move inversely to the U.S. dollar as the stronger the currency gets the more expensive gold is to buy in other currencies and vice versa. As Buffett acknowledges, the dollar has fallen 86% in value since 1965 when he took over management of Berkshire, while gold prices have risen 4,900%. "Does anyone really believe in the long term strength of the U.S. dollar?" said Frank Holmes, CEO of U.S. Global Investors. Holmes thinks gold prices could double to $3,600 an ounce in 5 years. All of this being said, it doesn't mean the gold price will rise to infinity. In fact many experts are predicting a top sometime next year. GFMS believes that gold prices could peak at the end of 2012 or beginning of 2013. "We think the peak would be towards the end of this year or maybe in the first half of next year," says Neil Meader, research director at Thomson Reuters GFMS. The end to gold's 10-year bull run would come with a renewed faith in currencies as the structural imbalances that have impeded paper money slowly start to fade. "One overt trigger that is worth looking for is the start of a serious ratcheting up in interest rates, because for gold investment to be popular you do need very low interest rates," says Meader.
Low interest rates and higher inflation, as central banks respond to this period of deleveraging and disinflation by pumping money into the system, lead to negative real interest rates where money in the bank loses value while gold doesn't. Jon Nadler, senior analyst at Kitco.com, however, thinks gold prices will more likely see $1,000 an ounce before $2,000 an ounce. "The question will remain for 2012 to what extent will investment demand be able to remain the principle driver and continue to attract interest from speculators and investors," a shaky prospect after last week's carnage. Nadler thinks gold might need a significant period of consolidation, perhaps 2-3 years, to regroup. The shakeout of speculators is a scary thing for gold prices, no doubt, and often result in many proclaiming "the bubble has burst." ETF and futures demand fell off a cliff in 2011. Speculative net long positions on the Comex are currently at three year lows after shedding 90,000 contracts in 2011. Global ETFs added 154 tons of gold in 2011 but that was down 57% from a year earlier. "A strained net investment position means the price could go up that much more quickly if those investors choose to come back to the market in force," says Meader, but investors have to want to come back into the market first. "If you wanted to see the ETF players come back and the Comex
we need some kind of resolution to the Eurozone. As soon as that becomes old news ... and then people start shifting to what it might all mean in an American context in terms of funding the deficit, I think that's when the market could really turn and you'll start moving ahead." Any kind of monetary easing from central banks and increasing worries about future inflation would also spur more buying. So far this rebuilding of positions has started to happen. In the latest Commitment of Traders report speculative long positions rose by 24,000 contracts in the week ending January 31st. The SPDR Gold Shares ( GLD - Get Report) holds 1,277 tons of gold as investors have come back into the market. Buffett isn't the only big named investor skeptical on gold, but he may be missing out on the trade nonetheless. George Soros took a lot of heat for trimming his position in the GLD in the second quarter, although he added to his position in the third. John Paulson, whose main fund, Advantage Plus Fund, sunk 44% in the first three quarters of the year, still owns more than 20 million shares of the GLD although he did dump a third of his position in the third quarter. -- Written by Alix Steel in New York. >To contact the writer of this article, click here: Alix Steel.