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Latest Bullish Sign for Gold: Central Banks Are Big Buyers

Gold prices, which have already soared to record levels in recent weeks, could get a further boost from a new investor: central banks.

Several central banks are joining average investors in betting that weak currencies—particularly the US dollar—could be a friend to the gold trade for quite some time.

Gold Bars
AP
Gold Bars

After a weak summer, gold has rallied strongly over the past three months on the belief that that the dollar will continue to fall until the US economic recovery is on more solid footing.

For Rob Lutts, CIO of Cabot Management in Salem, Mass., bull markets such as gold's run in three stages—denial, acceptance and love affair.

The market as he sees it is in the second stage now, so until the love affair commences and the trade gets too frothy, he believes investors can't loose with gold.

"I think we've moved a little more into the acceptance phase," Lutts says. "Eventually asset allocation models like those that come out of big brokerage houses will be increasing their allocation to gold and making it more of a permanent sort of recommendation."

While the weak dollar has been fueling retail investor interest in the metal, it's been only in recent weeks that global central banks—for two decades net sellers of gold—have gotten in on the act as well.

"The big spenders are coming to the table," says Sean Brodrick, natural resources analyst for Weiss Research's Uncommon Wisdom Daily newsletter. "Central banks are buying and they are buying big time. If central banks are buying, that's the biggest money around and I want to be on their side of the bet."

Most recently, the Reserve Bank of India said it will buy 200 metric tons from the International Monetary Fund, half what the IMF is selling.

That's been the trend around the world as Mexico, Russia, the Philippines and Mexico all have increased their gold holdings this year.

The trend is expected to hold up and make global central banks net buyers of gold for the first time since 1988, Evy Hambro, who runs two commodities funds for BlackRock, recently told a media briefing in Australia.

"Gold's role is gathering a lot more attention in terms of risk diversification," Hambro said.

As that trade becomes more global in nature, it presents varying opportunities for investors.

While Brodrick believes gold is on its way to $1,300 an ounce, he said investors could do just as well with gold miner stocks as with the metal itself. He sees consolidation coming in the industry as mining becomes more and more the domain of large companies that can afford to look for a metal that is becoming increasingly scarce in terms of new discoveries.

"Despite the fact that gold has been marching higher for years, global gold mine production is actually going down. The reason is they aren't finding these big elephant-sized deposits," Brodrick says. "There's a real squeeze coming on. If we're not at peak gold, we might be approaching it."

One way investors can tap the mining consolidation trend is through the Market Vectors Gold Miners exchange-traded fund. The fund seeks to mimic the performance of the AMEX Gold Miners index.

"The beauty of that is you can have some awful surprises that send your (gold) investment into the tank," Brodrick says. "Sure (the ETF) could go lower, but it's not going to get one of those hits that knocks it for a loop."

To be sure, there are analysts who worry that gold's rally—up about 24 percent for the year and 19 percent since the March stock market lows—could be getting overheated.

The warnings are similar to those bracing for a severe stock market correction that hasn't happened, but they nonetheless remain.

"While a golden rule in the current precious metals market is, 'Never stand in the way of a raging bull,' invesors should also note the other adage of 'Caveat Emptor' or 'Buyer Beware,'" Jeffrey Nichols, senior economic advisor at Rosland Capital, wrote in an analysis.

Dips Could Be Buying Opportunities

Nichols notes that large mining companies like Barrick Gold are buying back previous sales so shareholders can continue to get exposure. He also echoed comments of other advisors who feel gold dips have been treated as buying opportunities.

"However, if these players stand aside for any reason, gold prices could drop precipitously, and this would be an opportunity for investors to establish or augment their own positions," he wrote.

Potential for sudden moves in gold's price, though, is scaring off some investors who worry that the gold run can only go as long as conditions such as dollar debasement stay ideal.

"The downside with gold is that it has a volatility that is a whole lot greater than bonds and even greater than stocks," says Tim Courtney, chief investment officer at Burns Advisory Group in Oklahoma City, Okla.

Past gold rallies have always preceded inflation, says Courtney, who believes that with inflation being almost wholly discounted as a threat, gold probably has hit its peak.

Nonetheless, he understands why investors want it in their portfolios.

"If you want to have a small piece of your portfolio invested in gold, go ahead but I would not rely on gold being a stable contributor over long periods of time," Courtney says. "History has shown it does not offer the kinds of returns that you need to grow your wealth, based on the amount of inherent volatility that gold has."

That hasn't deterred gold bugs, though, who see the metal benefiting not just weakness in US dollar but also currencies around the globe. Numerous developed nations are allowing their currencies to devalue as a way of making goods cheaper to buy and thus reflating their economy.

Cabot Management's Lutts thinks $2,000 gold is a strong possibility for 2010, though he acknowledges there will be bumps and bruises along the way.

"It's not going to be a straight line," he says. "There's going to be periods of concern and people are going to be selling. But it's very clear to me that investment dollars out there in the world today have a very high regard for things that can protect their value against deteroirating currencies.

Investors should allocate about 15 to 20 percent of their portfolios towards gold, says Lutts, who advocates gold-based ETFs including the GDX miners' fund as well as the SPDR Gold Shares, which holds physical gold; as well as the lightly traded PowerShares Global Gold and Precious Metals, which seeks to replicate the Nasdaq Global Gold and Precious Metals index.

Only when the gold bull market hits the love-affair stage and too many buyers step in will Lutts think about getting out.

"I would probably cut my positions significantly (then), take profits and try to judge then the love affair," he says. "You'll know you're in the love affair phase when you go to Thanksgiving dinner and everybody tells you how much gold they're buying."