Good as gold
Gold prices are no longer setting records. Special parties are no longer being held where people can sell their gold jewelry at spectacular prices. The Midas touch for gold has faded.
Gold was selling for as little as $256 an ounce in 2002 and soared to nearly $2,000 an ounce in 2011. An investment of $1,000 in 2002 would have been worth about $7,800 in 2011. In May 2013, though, gold was back down to $1,343 an ounce.
The Federal Reserve Board’s bond-buying program known as "quantitative easing" not only distorted the prices of stocks and bonds, it also sent gold prices soaring for several reasons:
Record-low interest rates. As an investment, gold earns no interest so when interest rates rise, gold typically drops in value. Conversely, when interest rates fall, the price of gold typically increases, although there have been times when gold prices hit record highs while interest rates were rising.
Currency devaluation. The Fed’s easy money policy also weakened the dollar. When the supply of anything increases, assuming demand remains the same, its value will decrease. That’s why the dollar loses value when the money supply increases.
When the dollar weakens, gold becomes a more attractive alternative, so demand causes its price to increase.
Hedging. Gold is often used as a hedge against inflation and sometimes as a hedge against deflation. While the inflation rate has remained low, increasing inflation has been a stated goal of the Fed.
The weaker the dollar becomes, the less it is worth. That should cause inflation because when the dollar weakens it takes more dollars to buy the same goods. However, when the economy is weak, prices remain stable and sometimes even drop.
While deflation has been a concern of The Fed, the inflation rate is now about 1.8%. If the economy improves, the inflation rate could quickly go much higher.
Why gold is still relevant
The price of gold could continue falling if the economy strengthens and interest rates continue to rise.
However, the economy does not appear to be strengthening – and if it is, it is strengthening at a very slow rate. The Federal Reserve Board had forecast growth in gross domestic product of 2.3 percent to 2.6 percent for 2013, but recently cut its estimate to 1.4 percent. Growth of 1.4 percent is negligible. In recent history, the U.S. economy has grown at an average rate of 3.3 percent a year.
Unemployment remains high, Europe is still in turmoil and economic doldrums continue in much of the world.
In addition, if returns on bonds, stocks and other investments fail to adequately compensate for risk and inflation, demand for gold typically increases, causing its price to increase.
Rising interest rates are already resulting in a sell-off of bonds, and there are plenty of signs that stocks are overvalued. Recently, the S&P 500 was up 25 percent from a year earlier, while corporate profits were up only 1 percent over the same period, which shows that there is currently a disconnect between stock values and market performance.