Gold has been considered a currency, commodity and investment for thousands of years. Sought after for both its beauty and worth, gold continues its rally to reach new daily highs. There is speculation among anxious investors about just how high gold could go. While no one knows for certain, there is a strong argument in favor of gold climbing even higher. (For more on investing with gold, check out Getting Into The Gold Market.)
TUTORIAL: Your Guide To Commodities
First, let's look at the factors that drive gold prices.
Central Bank Reserves
Central banks keep paper currency and gold in reserve. For the first time in decades, central banks have begun buying more gold than they are selling, according to the World Gold Council (www.gold.org). As these banks move away from paper currencies and towards gold, they in effect remove a significant of supply from the international gold market, driving the price of gold higher.
U.S. Dollar Value
Gold and the U.S. dollar have an inverse relationship. As the dollar gains strength, the price of gold drops; when the dollar weakens, the price of gold rises. This correlation is due to investor habits. When the dollar is strong, investors will trade in dollars; when the dollar is weak and during times of economic uncertainty, more investors look to gold as a safe haven for their investment activity. This wealth protection measure is used as a hedge against currency devaluation, inflation or deflation.
The worldwide demand for gold for jewelry and industrial purposes affects the price of the precious metal. Jewelry is the end product for about 78% of newly mined or recycled gold each year, with 12% of demand attributed to medical and industrial uses. With higher incomes in emerging markets sparking a greater interest in gold, the world has seen a dramatic increase in both demand and prices for gold.
Rising oil prices, political unrest and the threat of violence, such as that seen recently in the Middle East and North Africa (MENA) region, can ignite investor fears about worldwide economic stability. The uncertainty can lead to increased interest in gold as a secure investment, further driving up the price of gold. (To learn more about gold and other metals, see Forex Investing: How To Capture Commodity Fluctuations.)
Can Gold Go Higher?
Gold continues to reach new highs as investors use it as a hedge against inflation concerns and worldwide economic and political uncertainty. As with any investment that has enjoyed an extended rally, investors may be getting nervous that gold's bubble is about to burst. Though these fears may seem logical (what goes up must come down), they are challenged by compelling arguments indicating that gold could indeed go higher. (To read more about the importance of gold, see Why Gold Matters.)
Continued Economic and Political Uncertainty
On April 18, 2011, Standard & Poor's downgraded its credit outlook for the United States, stating in a press release, "Because the U.S. has, relative to its 'AAA' peers, what we consider to be very large budget deficits and rising government indebtedness, and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable." S&P indicated that there is a 33% chance that it would cut long-term ratings within the next two years for the United States. In addition to worldwide instability, this particular downgrade, coupled with the threat of further ratings cuts, will likely increase gold's attractiveness to already skittish investors. (For more information on international investing and instability, check out Why Country Funds Are So Risky.)
Price Still Within 0.7 Standard Deviations
Despite gold's rise from less than $1,000 an ounce to nearly $1,500 per ounce in the last six months ending April 2011, this represents only a 0.7 standard deviation in gold prices, according to Credit Suisse (NYSE:CS). What this means is that, while gold prices have certainly increased, the price has not strayed far from its statistical mean. Compare this to gold's 180% move in 1979, which represented a 10.3 standard deviation. (To read more on indicators, see 3 Technical Tools To Improve Your Trading.)
Globally Recognized as Wealth Protection
Investors worldwide seek gold as a means to protect wealth and hedge against uncertainty. Interest in gold as an investment is not limited to physical holdings such as gold bars and coins, but also includes investment instruments with gold as the underlying asset, such as SPDR Gold Shares (NYSE:GLD), a popular exchange traded fund with more than 15 million in average daily trading volume. (For more information on gold ETF, see The Gold Showdown: ETFs Versus Futures.)
Impact of Emerging Markets
As economies develop and salaries increase in emerging markets, the demand for gold is expected to increase. 2010 saw record demand for gold. India, for example, the largest gold jewelry market in the world, saw a 25% increase in demand in the last decade, with gold purchases in India accounting for 32% of the global total in 2010. Research performed by the World Gold Council shows that cumulative annual demand for gold in India will increase to an excess of 1200 tons by 2020; in 2010, that total was 963.1 tons. (To find more reason to own gold, check out 8 Reasons To Own Gold.)
Better Late Than Never?
With gold approaching $1,500 an ounce, many investors may wonder if it's too late to hop on board. Gold is still far from its January 1980 inflation-adjusted high of $2,300 per ounce, indicating that it can undoubtedly go higher. Also, the fact that gold has been a solid performer over the past decade does not automatically guarantee its near-term failure: gold is not necessarily in a bubble that is about to pop; rather, it could very well continue for some time to reach new highs. How long is not known, but today's economic and political environment, coupled with increased demand in emerging markets, points to gold's continued rise. (Check out, Gold: The Other Currency.)
This article is not intended to be construed as investment advice and does not make any investing recommendations. The author does not currently hold any positions in any of the mentioned trading instruments.