The gold rush is still on

By Michael Brush

Gold bugs have seen their precious metal tarnish this summer.

Devotees of the yellow metal -- which they believe protects their wealth against everything from inflation to Armageddon -- have watched in horror as gold has slumped 19% in a month to $790 an ounce.

Not even Russia's invasion of Georgia could rouse bullion, which normally shoots up in times of geopolitical crisis.

The apparent cause of gold's drop: Many investors are changing a course that saw them buying commodities while betting against financial stocks and the dollar. A global economic slowdown has raised doubts about sustained demand, and U.S. policymakers have gotten more serious about bailing out banks.

This reversal has sent the whole commodities sector down, including gold, which flirted with $1,000 an ounce as recently as March (as I had predicted in "Why gold's going straight to $1,000").

Gold bugs are about to get some relief. The truth is, despite this pullback, the fundamentals that drove gold higher haven't changed.

4 reasons gold will rebound

The near-term catalyst for the next move up could be as simple as holidays that call for giving gold as a gift, including Diwali (the Hindu "Festival of Light"), Christmas and the Chinese new year. Demand for gold to produce jewelry should soon kick in.

In fact, looking back over the past three decades, it's really no surprise that gold is weak right now. "Gold is always a dog in August. Always," says Frank Holmes, the chief investment officer at U.S. Global Investors (GROW, news, msgs), which offers the Gold and Precious Metals Fund (USERX). Then the price climbs as the holiday season approaches, Holmes says.

Most importantly, several factors that supported higher prices (and that led me to be bullish in "5 reasons gold is headed to $1,500") haven't gone away. "The key underlying trends are intact," says Tom Winmill, who manages the Midas Fund (MIDSX).

Over the next six months, gold could move up $100 to trade in the $850-to-$900 range, Holmes believes.

• Video: A golden opportunity in gold?

Longer term, Citigroup (C, news, msgs) gold analyst John Hill says, gold will trade around an average of $950 an ounce next year and $1,000 an ounce in 2010.

If they are right, that will be good for mutual funds investing in gold, as well as exchange-traded funds, or ETFs, that track gold, like SPDR Gold Shares (GLD, news, msgs). Mining stocks are riskier but could do even better because they have fallen even more than bullion has. I offer five picks below.

But first, here four reasons gold will rebound:

No. 1: Limited supply compared with demand

The reason demand for gold jewelry can have an impact on prices is that supply and demand are already tight.

"The easy deposits have been found and mined," says Doug Groh, a senior analyst with Tocqueville Asset Management, which runs the Tocqueville Gold Fund (TGLDX). "There is limited supply, and it is very expensive and increasingly more expensive to access that supply."

Overall production from gold mines slipped 4% in the second quarter as fresh investments in new mines failed to offset dwindling output from mature mines, Citigroup's Hill says.

Meanwhile, demand for gold as an investment has stepped up over the past few years because of the creation of gold ETFs, Groh says. Gold ETFs were recently backed by about 930 tons of bullion, or around 125 days of mine output, according to Tocqueville Asset Management.

Here's the big picture: The world will see 3,275 metric tons of supply from mining and scrap in 2008. Demand for jewelry and other fabrication will be 3,210 metric tons, and investment demand will call for 365 tons, for an overall shortfall of 300 tons, predicts Lehman Bros. (LEH, news, msgs) analyst Peter Ward. He's projecting even bigger shortfalls for 2009 through 2012.

No. 2: Inflation

At 5% a year in the U.S., consumer price inflation seems pretty high. But consider that the price of raw materials for manufacturing was recently advancing around 40% a year, says the Midas Fund's Winmill.

The retreat of oil prices to about $115 a barrel won't help much because oil is still historically very costly.

High inflation also means that investors are losing 2.6% a year in traditional "safe" investments such as two-year Treasurys, which now yield just 2.4% after inflation.

When prices rise and investors lose money in what are supposed to be safe debt instruments, many turn to gold, Winmill says.

No. 3: An uncertain future

We're not out of the woods yet with the credit crunch. That will keep putting a constraint on lending, the raw fuel of capitalism. Problems in the housing sector will continue to weigh on U.S. consumers, whose spending drives economic growth. Meanwhile, the potential for big changes in tax and spending policies in Washington, D.C., if the Democrats take the White House, has investors feeling uncertain about the future.

Again, this cloud will have investors turning to safe-haven gold.

Continued: Bearish on gold

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