Published: October 11, 2010

The late-1970s was witness to one of the most remarkable gold rallies in history. From a low of $100 per troy ounce in 1976, prices rose to a then-record $873 by 1980.

The culprit? Double-digit rates of inflation.

Indeed, the inflation in this period was so dramatic that the price of goods and services in the United States economy doubled during a nine year period between 1973 and 1981. That’s an average inflation rate of 8.8%, while in the year of gold’s peak in 1980, prices rose a sizzling +13.5%.

In response to the out of control prices, the Federal Reserve, led by Chairman Paul Volcker, ratcheted up interest rates to extreme levels, with the benchmark federal funds rate reaching a high of 20% during the middle of 1981. The Fed’s efforts paid off, but they also triggered a painful recession that lasted for more than a year. Nevertheless, by 1982, inflation had declined to 6.2% and in 1983, it was down to a much more manageable 3.2%

As inflation cooled, so too did gold prices, with the precious metal falling back under $300 in 1982.

Fast forward to today: another remarkable rally has sent gold prices back to record levels, now above $1300, but only this time inflation is nearly nonexistent. In fact, in recent weeks Fed officials have been expressing concern that inflation may actually be too low for their liking. Thus, we have record gold prices and low inflation. How do we reconcile this situation?

There are many plausible theories one can point to in order to explain gold’s most recent advance. Some of the most popular have to do with the potential for high inflation down the road either due to the unprecedented monetary easing during the depths of the 2008/2009 economic meltdown, or future easing as governments grapple with surging levels of public debt, opting to monetize their obligations rather than raise taxes or cut spending.

Other theories speculate that inflation readings offered to us by the government, such as the consumer price index (CPI), are understated and that actual inflation is much higher. As the methodology for calculating CPI has been revised numerous times in the past couple decades, proponents of this theory argue that inflation readings would be much higher using the older, unrevised methods.

Finally, some point to the fact that gold remains well below the record inflation-adjusted price notched back in 1980 as evidence that the metal is cheap and that much upside remains. In today’s dollars, gold would have to surpass $2400 to reach a new inflation-adjusted high.

A common theme between all of the theories attributed to gold’s rise is a distinct loss of faith in fiat, or “paper” currencies. Gold’s history as money -- a medium of exchange, a store of value and a unit of account -- spans thousands of years. As confidence in paper currencies declines, more and more people are turning to gold as an alternative currency, or at least an alternative store of value -- a perception that is fueling the relentless climb in gold prices.

But just as important as why gold is being bought is how gold is being bought.

Consider that the latest bull market in gold began all the way back in 2002. Then consider that it was about this time that the first gold exchange-traded-funds (ETFs) began to hit the market. This is no coincidence.

Gold ETFs are backed by physical gold holdings and are a convenient way for investors or traders to gain exposure to the precious metal. Buying gold is now as simple as purchasing a stock or mutual fund in your brokerage account. The result has been that billions of dollars that would have flowed into other assets is now flowing into gold.

Recall that the first gold ETFs entered the market around 2002, thus gold demand from these products was zero prior to that period. By 2009, demand from gold ETFs totaled an incredible 617 metric tons, or nearly 20 million troy ounces, compared to a total demand of 3,455 metric tons.

The combination of demand from ETFs and other investment demand for gold through retail channels totaled 1,323 metric tons in 2009, or 38% of total demand. In 2002, investment demand (almost all of which was retail) was only 10% of total demand. In that same 2002-2009 time period, gold demand for jewelry fabrication fell from 80% of demand to 50%.
 

What these eye-opening figures suggest is that in the market for gold, investors have been outbidding traditional consumers, which has led to prices marching relentlessly higher.

Action to Take --> The biggest risk to gold prices is if investor appetite for gold wanes, particularly appetite for gold ETFs. If ETF investors were to liquidate a portion of their 2,100 metric tons (67.4 million troy ounces) of gold holdings, prices would likely fall. Moreover, because investors in these funds can sell with a mere click of a button, enormous amounts of gold holdings could be liquidated in a very short period of time, leading to potentially huge price declines.

Moreover, while the arguments in favor of gold -- including the potential for future inflation and the fact that the metal remains well below its record inflation-adjusted highs -- have merit, there are just too many unknowns to make gold a compelling investment. Prices could rise to $2,000, just as they could fall to $500. There is no way to tell.

You should consider limiting the portion of your portfolio allocated to gold, including gold ETFs such as the SPDR Gold Shares Trust (NYSE: GLD). Instead of speculating on the direction of prices, consider gold a hedge against inflation, dedicating only a single-digit percentage of risk capital to the metal.

 --Sumit Roy
Contributor
StreetAuthority

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