New Exchange Traded Gold Fund Is All The Rage

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
November 30, 2004

IN THIS ISSUE:

1.  The New Exchange Traded Gold Fund

2.  ETF Is A Better Way To Invest In Gold 

3.  Gold ETF Advantages & Disadvantages 

4.  Should You Buy Gold Now At $450/Ounce? 

5.  Pro & Con Cases For Gold At This Time

6.  Conclusion:  I Would Not Buy Gold Today

Introduction

On Monday, November 29th, December gold futures broke the $450 per ounce mark for the first time since 1988.  Gold’s recent strength, coupled with the dollar’s continued weakness, is driving many investors to evaluate gold as a potential investment.  This week, I will discuss one of the newest ways to invest in gold that is attracting investors in droves.

The lure of gold is nothing new.  In the December 2003 issue of my monthly Forecasts & Trends newsletter, I discussed the pros and cons of investing in gold, and also mentioned a new way to invest in gold that had been submitted to the Securities and Exchange Commission for approval.  Recently, the SEC approved the new Gold Exchange Traded Fund (ETF) for trading, and it has taken off like wildfire.

While this new gold ETF has several advantages over other ways of owning the yellow metal, there are still serious considerations you should make before jumping on the gold ETF bandwagon.  These include not only the risks of owning gold, but also the risks inherent in this new form of gold ownership.

In this week’s Forecasts & Trends E-Letter, I will discuss the pros and cons of the new gold ETF that is now available to investors.  But then there is the question of: 1) whether this new way to invest in gold is right for you; and 2) more importantly, is now the time to be investing in gold at all?

Before we jump in, I realize that some of my readers may not be familiar with the term “Exchange Trade Fund,” or “ETF.” Unfortunately, space will not allow me to go into all of the characteristics, advantages and disadvantages of this relatively new form of investment vehicle.  If you want to know more about ETFs, refer to the following Internet article after reading this week’s E-Letter: http://moneycentral.msn.com/content/Investing/Mutualfunds/P72736.asp.

The New Gold ETF – A Better Way To Own Gold?

The SEC recently approved the sale of a new form of gold ownership.  This new investment vehicle is known as the StreetTracks Gold Trust (NYSE: GLD), and it has taken the market by storm.  In its market debut on November 18th, the Gold Trust ETF raked in over $550 million in new investment from investors eager to participate in gold ownership without the hassles of physical possession of the yellow metal.

The StreetTracks Gold Trust is sponsored by the World Gold Council, and is marketed by Boston-based State Street Global Markets.  The major difference in this investment and other gold-related “paper investments” is that each share represents a physical quantity of gold being held in a custodial account in the London vault of HSBC Bank, USA.  The Gold Trust invests virtually all of its assets in physical gold bullion.  As the fund grows in size, more and more physical gold is purchased, and vice-versa if the fund declines in size.  I will discuss more about this below.

The Gold Trust is structured as an exchange traded fund, or ETF for short.  In a nutshell, an ETF is a basket of securities (or other assets) that tracks a specific market and can be traded all day on a stock exchange, much like individual stocks.  While most ETFs are geared toward mimicking the major market indexes, the Gold Trust holds physical gold, and its share price should closely follow the spot price of gold.  Shares of the Gold Trust are priced at 10% of the spot price of gold, less expenses of the Trust, currently around $45 per share.

A second gold ETF has been submitted to the SEC for approval by Barclays Global Investors.  Their product will be known as the iShares Comex Gold Trust and will be listed on the American Stock Exchange under the symbol “IAU.”  Like the StreetTracks Gold Trust, the iShares Trust’s share price will be equal to 10% of the spot price of one ounce of gold.

While the gold ETF is a brand new entry in the United States, several similar programs have been available on exchanges in England, Australia, and South Africa for some time.

Gold ETF Advantages And Disadvantages

One of the most obvious advantages of the new gold ETF is that it solves the shipping, insurance and storage problems associated with investments in physical gold bullion or coins.  Some of the other advantages of this new way to own gold are as follows:

1. Dealer markup is no longer a problem, in that there is no spread between bid and ask prices.  There may be transaction costs associated with purchasing and selling the ETF, but there is no premium to be paid.

2.  The gold ETF is listed on the New York Stock Exchange, so it is liquid and can be traded any time the market is open.  In addition, the new gold ETF may be “shorted” if an investor believes the price of gold will fall.

3.  Some institutional investors were precluded from owning gold because of the costs related to buying, selling, and storing the physical gold.  The new gold ETF allows these investors to have an undivided interest in gold, but without all the hassles.

4.  Gold mining stocks, a popular way to play the gold market, are often significantly overvalued or undervalued, relative to the price of gold for various reasons, and are typically extremely volatile.  Because the gold ETF closely tracks the price of gold over time, it is becoming a popular alternative to gold mining stocks.

Unfortunately, there are still some disadvantages to investing in the new gold ETF.  Perhaps the most obvious is that it is not physical gold.   For those investors who want to own gold as a store of value in case of international chaos, having an undivided interest in gold sitting in a London vault will provide no comfort.  Those investors who want to run their fingers through their gold hoard will still have to buy physical gold, and deal with the storage and other hassles involved.

Other disadvantages of the new gold ETF are:

1.  As I have written a number of times, the price of gold is very volatile and can move suddenly and without warning.  The gold ETF will not change this characteristic of gold, but it does offer a way to quickly trade out of a gold position without the hassles of selling physical coins or bars.

2.  The success of the new gold ETF may be a self-fulfilling prophecy, at least for a while.  The demand for the gold ETF is strong, requiring the Trust to purchase more and more gold on the open market.  This buying has contributed to the upward pressure on the price of gold, and may continue to do so, as long as the gold Trust continues to grow in size.

To illustrate, in anticipation of the launch of the Gold Bullion Securities ETF on the London exchange on March 31, 2004, the price of gold spiked to over $420 per ounce partly as a result of increased demand.  However, only five weeks later, the price of gold was back down to $375 per ounce.  A similar spike and subsequent decline occurred in 2003, shortly after the launch of the Australian gold ETF. 

Some believe that the latest price spike to $450 is largely due to the wave of gold-hungry investors gobbling up the new gold ETF, and that prices will fall, perhaps sharply, once the initial feeding frenzy is over.  I would not be surprised.

3.  While the expenses of the gold ETF will be kept to a low 0.4%, the Trust will have to sell part of its gold stores to pay these expenses.  Thus, over time, the fractional amount of physical gold represented by each share will decrease.

4.  While the form of the gold ETF investment will be similar to a stock, the IRS will still classify these shares as a “collectible” for tax purposes.  This means that long-term gains will be taxed at a higher 28% rate reserved for collectibles, rather than the 15% rate for other types of investments.

Is It Time To Buy Gold?

With the recent breakout over $450 per ounce, gold has become an even hotter topic among individual investors.  As long-time clients and readers of my monthly newsletter will recall, I have not been a big fan of gold since the late 1970s.  Since the price of gold skyrocketed to above $800 briefly in late 1979, the price trended lower for the next 20 years, reaching a low near $250 per ounce in 1999.

In early 2002, when gold was in the $300 range, we produced a SPECIAL REPORT entitled “Should I Invest In Gold?”  In that Special report, we discussed many of the supply and demand factors in the gold market, and we concluded:

“As discussed in this Special Report, there are some very encouraging signs that gold prices will trend higher in the next few years.  We actually “think” that is what will happen, barring any new bearish developments.”

Our timing was good.  Since then, the US dollar price of gold has been in a steady climb, reaching $450 per ounce on Monday of this week for the first time since 1988.  Gold is up almost 80% from the low in 1999. 

Gold is definitely in a bull market.  As I discussed in my November 2 issue of Forecasts & Trends E-Letter, The Bank Credit Analyst now predicts a multi-year bull market in gold and other resource commodities.

But the question is, should you buy gold NOW?  Now, after an 80% jump in prices?  Now that the latest gold ETF has contributed to the latest spike to $450?  I will answer that question below, but first let’s quickly review the pros and cons for gold today.

Reasons To Be Bullish On Gold

As we pointed out in our Special Report in early 2002, there is still no shortage of reasons to be bullish about the price of gold.  Just a few good reasons include the following:

1.  Gold is a good store of value during times of uncertainty, and there is definitely no shortage of uncertainty in the world today.

2.  Gold is a hedge against inflation.  If you believe, as I do, that the economy will continue to do well and possibly lead to a rise in the rate of inflation, then gold may hedge that risk. 

3.  Although I do not believe that gold reacts to supply and demand in exactly the same way that other commodities do (see #4 below for more about this), you cannot discount the fact that exploration was down during the period of low gold prices and gold mining companies are now having to play catch-up.  This could lead to a supply/demand squeeze and push up the price of gold.

4.  As I have written before, another reason why gold does not always react to supply and demand forces the same way that other commodities do is because gold has a hybrid nature.  While it is a commodity used by many industries, it is also a currency maintained in vast reserves by many countries, central banks and individual investors.  As a result, the price of gold is often dictated more by its relative value to currencies rather than on a strict supply/demand basis.

Accordingly, the recent slide in the value of the US dollar has been very bullish for the price of gold.  For those who believe that the economic recovery can’t last and we’re eventually going back into the abyss, this would mean an even greater decline in the dollar, and thus additional upside potential for gold.

Actually, there are many, including BCA, that believe the US dollar will continue to fall even if the economy continues to expand. Recent comments by Alan Greenspan seem to support this view, and the Bush administration’s apparent policy of “benign neglect” in relation to the dollar seems to add even more support for this argument.

Obviously, these are not all of the reasons to be bullish on gold, but they are some of the major factors that I keep on my radar screen in relation to the yellow metal, in addition to the supply/demand fundamentals.  The point is that there are many factors that are favorable for a continued increase in the price of gold.

Reasons To Be Cautious

Just as there are reasons to be bullish about the price of gold, there are equally valid reasons to be cautious about running headlong into a major gold investment at this point in time.

1.  As noted above, gold prices in the US have risen almost 80% since the low, and prices have moved virtually straight up since September.  That means the market is ripe for a pullback at any time.  Furthermore, gold has heavy overhead resistance (a technical term for selling pressure) from $450 to $500.  Gold prices spiked to near $500 in 1982 and 1987, and both times, the market then cratered.

And that’s another negative.  Gold prices typically fall off a cliff after a sharp run-up, rather than gently trending downward.  This extreme volatility can be disconcerting to many investors.

2.  Most analysts that I respect, including BCA, believe that the US dollar will fall only another 10-15% before it stabilizes.  This expectation is already factored into the price of gold today.  The dollar could reach those levels relatively soon.  This could take a lot of the wind out of gold’s sails.

3.  Another thing to keep in mind is that the recent run-up in gold prices is largely a US phenomenon.  If you look at gold prices in Euros, you will see that European gold prices have been generally flat during the big rise in US gold prices because the Euro has strengthened relative to the dollar.  So, the relative value of gold as an investment sometimes depends in part on what kind of money you have in your pocket.

4.  Contrary Opinion.  More often than not, I am a contrarian, meaning that I don’t like to buy when everyone else is buying (or short when everyone else is shorting).  Right now, the bullish consensus on gold is very high, as evidenced by the stampede into the new gold ETFs.

5.  At prices above $400, gold producers have begun to ramp-up production.  As noted above, they may be playing catch-up at present, but at some point increased supplies will adversely affect gold prices.

6.  As I have written in recent weeks, there is a recession in our future.  While BCA and others believe that the recession will not come until late 2005 or even later, this is a risk that will almost certainly be negative for gold prices.

Given the pros and cons discussed above, I would NOT recommend buying gold today. I would wait for a meaningful correction, which may or may not happen.  Given the recent sharp spike in prices, I consider the risk too high at this point.  On the other hand, if you already own gold at much lower prices, I would hold on for now.  But you might also consider determining a “stop out” point to protect profits.

Be Careful How You Invest, If You Do      

As I have written before, I have concerns regarding the various methods of investing in gold, as they relate to the average investor.  The physical purchase of gold in its various forms (coins, bullion bars, etc.) involve not only significant bid/ask price spreads, but also the additional expenses of insurance and storage, unless you want to risk keeping it at home and hope you are not robbed. 

An example of the bid/ask spread can be found by going to www.kitco.com.  On Monday, for example, the asking price for a one-ounce American Eagle gold coin was just over $478, while the bid price to anyone wanting to sell the same coin gold to Kitco was $450.90.  That’s a lot of ground to make up!  Gold bars have smaller bid/ask spreads, but they are still significant and there is still the matter of storage to be dealt with. 

I have recently received direct-mail ads (also on the Internet) offering a “secret currency” investment that was “outlawed for 41 years,” but is now graciously offered to you.  Hint: whenever you see this kind of hype, look for the trash can!

This particular investment turns out to be nothing more than numismatic gold and silver coins, which can have a value higher than the spot price of the metal based on rarity and condition of the coins.  This investment not only has the normal problems associated with physical gold, but adds the requirement that you be able to identify and evaluate the numismatic qualities that provide the extra value.  Again, my advice is to just say NO to these investments.

When I have written about gold before, I have had readers ask why I didn’t include a new opportunity called “e-gold.”  The reason I didn’t is because this is fairly new and, appears to be more geared toward using gold as a method to conduct business on the Internet than as an investment.  The e-gold website describes it as “an electronic currency” backed by physical gold held in storage, thus making international Internet trade more feasible.

While this might sound like a great new opportunity using the bold new frontier of the Internet, I’m going to reserve judgment for a while.  In my opinion, the new gold exchange traded fund is a much better way to invest than e-gold.

Conclusions

The new gold ETF appears to be an excellent way to participate in the gold market without all the hassles of owning physical gold.  But the question is, should you be buying into this market at this time, after a rise of almost 80% over the last few years? 

Gold has had a very nice run, the strongest uptrend since 1986 to 1987 when prices climbed to $500 per ounce before falling to near $250 over the next 13 years.  Do I think gold will fall back to $250 again?  No, I do not, especially in light of BCA’s latest forecast for a multi-year bull market in resource commodities.

There is certainly the chance that gold will continue to move higher, and it is even possible (maybe likely) that gold will rise above the $500 barrier at some point in the future. 

But there is also a good chance that gold prices will experience a significant downward correction at some point, especially when the ETF buying frenzy subsides.  That indeed was the case following the introductions of other ETFs in London and Australia.

For this and other reasons cited above, I believe the risks in the gold market are too great to be buying at this time.  I would wait for a meaningful pullback, which may or may not happen.  If you already own gold at lower prices, you may want to hang on a bit longer, but consider having a profit stop at some level.  Gold has a nasty habit of falling off a cliff after strong run-ups like we’ve seen recently.

And most of all, don’t believe all the hype that is now out there regarding gold investments.  This always happens in a bull market.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

More on gold ETFs.
http://goldeconomy.com/indexETF.html

World Gold Council – market overview.
http://www.gold.org/value/markets/supply_demand/index.html#1


Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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