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Gold Loses Luster as War Premium Dissipates


They call it yellow metal. And investors are just mad about its enormous returns in the last two years. But the bull market for gold could be in jeopardy now that a clear path to war has been determined and the U.S. has begun its air assault on Baghdad.

Gold has long been considered a safe haven for investors in times of political and economic strife, serving as a more sensible alternative to buying stocks or hoarding cash under the mattress. Given the string of negative events the economy has weathered - the bursting of the technology bubble, the wave of corporate scandals, the collapse of the World Trade Center and the looming war investors were sent running for cover. Desperately seeking shelter from the storm, investors fled to government bonds and gold.

Mutual funds that specialize in precious metals have been some of the few profitable places for investors during the bear market, besting all other stock fund categories over the past three years with a three-year annualized return of nearly 18%, according to Morningstar. During 2002, the average gold fund soared 62%, the Philadelphia Gold/Silver Index gained 43% and the S&P Gold Index rose roughly 27%. Meanwhile, the S&P 500, a proxy for the broader market, dropped 22.1% and the tech-laden Nasdaq plummeted 31.5%, according to Standard and Poor's.

And within that universe, no fund has fared better than the First Eagle SoGen Gold Fund, managed by Jean-Marie Eveillard since 1993. The French skipper has consistently turned in a stellar performance, besting all international stock funds over the one-, three- and five-year periods. Another standout performer is the Gabelli Gold Fund, managed by Caesar Bryan since 1994, which has beat all but two of its peers in the three- and five-year stretches. Recently, Bryan's no-load fund has taken its lumps, however, down nearly 11% year to date.

But with President Bush giving Saddam Hussein a stiff ultimatum last Monday to relinquish control of Iraq or suffer fatal consequences, it appears that even the top gold funds are losing some of their lustrous appeal. Indeed the average gold fund is down 11.3% year to date. And investors who placed speculative bets in that arena in recent months with the hopes of a continued winning streak are second-guessing themselves.

Essentially, a quick resolution to the conflict in Iraq would be deemed a positive sign for equity markets in that it would restore investor confidence and prompt a flow of cash back into equities. At least that's the prevailing theory. Forty-three percent of investors believe stocks will rise modestly if things go smoothly in Iraq, according to a poll conducted by CNNMoney.com. Another 34% think the market will move sharply higher once Saddam has been removed.

Some industry experts believe that gold will behave as it did during the Persian Gulf War. At that time, the price of gold dropped more than $40 to $366 an ounce once U.S. troops began to oust the Iraqi army from Kuwait, thus eliminating the risk premium. By the time the war ended in March 1991, the S&P 500 jumped 18%. Given the historical parallels between then and now, momentum traders are shorting their positions in both gold and oil.

In that situation, however, there was no period of uncertainty that led up to the event because Iraq's invasion of Kuwait in 1990 was largely a surprise and therefore not anticipated by the market. "It was not a war risk premium because the surge in prices reflected the actual breakout of war," wrote Frederic Lasserre, an economist at France's Societe Generale, in a research note. "Markets have been anticipating the conflict practically since the beginning of [last year] when President Bush clearly expressed his intentions in the State of the Union Address in January.

"I think the war premium just came out of it," said Leo Larkin, an equities metals analyst at Standard & Poor's, when asked about gold's recent slide. "Gold peaked back in February," he said. He went on to say that while the gold market is due for a breather after a spirited run the last two years, it is not set for a precipitous decline.

"Long-term, the bull market for gold is still intact, [but ] short-term, it is going to drop" A recovery in equities would not necessarily spell doom for gold but rather temper the enthusiasm surrounding it, he said. Other factors that bolster demand for gold include weakness in the dollar and consolidation in the mining industry.

Investing in gold can be tricky, as it often is marked by high volatility and can potentially burn investors if they miss out on that big sharp move. In fact, Standard & Poor's cautioned investors earlier this month that volatility could have an adverse effect on gold funds once greater geopolitical and economic clarity is obtained.

Noting gold's high expense ratios and volatility, Phil Edwards, director of Standard & Poor's global funds research unit, said, "If you are basing your long-term investment decision on the past two-year performance of gold funds, and you plan on making this investment a significant part of your portfolio, you might be putting your long-term goals in peril."

Chasing short-term performance is always an ill-advised move with mutual funds as this year's winners are next year's losers more often than not. Still, an interesting data point to consider is that from the end of 1997 to the end of 2002, gold rose 19.6% while the stock market declined 9.1%, a period that includes the robust gains in technology.

"I think gold earned some respectability as an alternative asset [and] a portfolio stabilizer," Larkin said. "Overall, the investment demand is going to increase over the coming years."

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