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Gold And Stocks: Are Both Dangerously High?

Both bulls and bears make strong cases

By Mark Huffman
ConsumerAffairs.com

October 15, 2009

In addition to the coverage of the market, viewers saw a parade of commercials urging viewers to buy gold. One commercial after another -- sometimes running back to back -- warned of an unstable stock market, a worthless dollar and collapsing economy and promised safety and security if viewers bought gold.

Let's rewind the tape to 2005. There's still a parade of commercials, but instead of gold they're pushing subprime mortgage loans from Countryside or Ditech. As the housing bubble reached the breaking point, the commercials pushing easy mortgage money seemed to come in greater frequency.

Are we witnessing the same thing now, in 2009, with gold?

While the Dow Industrials hit a high for the year on Wednesday, the price of gold hit a new all time high, for the second time in two days, at $1,070.80.

Is it too late to buy gold? If so, what about the stock market? After a nearly 50 percent rise since March, is the market ahead of itself?

On Wall Street, there appears to be no clear consensus. First, let's look at gold.

All that glitters

Gold prices have rallied more than 27 percent over the past year, mainly because the Federal Reserve has been pumping so much money into the banking system. The Fed has been creating new money to compensate for the staggering losses suffered by banks that over invested in mortgage backed securities.

In traders' minds, that not only raises to risk of inflation, but reduces the value of the dollar. As a result, certain commodities like gold, that are purchased with dollars, have risen in price.

But gold is also sold using other currencies and, in those markets, gold prices haven't risen nearly as much. So it seems clear that it's not really gold that's gaining value, but dollars that are losing value.

While you can certainly make a case that if you deal mainly in U.S. dollars, investing in gold will protect the value of your money. That's true, as long as the dollar stays weak. But history has shown that governments tend to manipulate the value of their currencies to achieve short term economic goals. In other words, the dollar may not always remain weak.

If the economy begins to gain strength and inflationary pressures begin to emerge, the Fed is likely to raise interest rates. Higher interest rates could provide a good reason for investors to invest in dollars, and as they do, the dollar gains strength. If you have purchased gold at more than $1000 an ounce, you might see the value of your investment plunge.

One gold advertiser likes to say "gold has never been worth zero," as a selling point. True, but if it were to lose just 10 percent of its value, investors who purchased at the top of the market would be crushed.

On the other hand, if you believe economic conditions will worsen and the dollar will continue to decline, then paying $1000 an ounce for gold might be prudent. But keep in mind that in 2005, hardly anyone thought home prices would ever go down.

Bulls charge

While gold has been climbing, so have U.S. stocks. From its low of 667 in early March, the Dow Jones Industrial Average has regained its level of year ago, when the credit crisis began to worsen. While traders cheered Wednesday's 10,000 breakthrough, it was mostly a celebration of its performance over the last six month. After all, the Dow first broke the 10,000 barrier in 1999, essentially trading sidewise over the last decade.

There are more variables to consider when buying equities than when purchasing commodities like gold. Stocks are pieces of companies that have earnings, providing a way for investors to judge what a stock should be worth.

In the second quarter U.S. companies began to surprise analysts by reporting profits -- some better than expected. But in nearly every case, companies regained profitability by laying off workers, slashing inventories and otherwise cutting operating expenses. Market bears were unimpressed.

What's powered stocks over the last two weeks has been the start of the third quarter earnings season. This time, companies are showing some revenue growth, or at least forecasting it for future quarters in their guidance. This week blow-out earnings reports by CSX Railroad and chip maker Intel ignited optimism.

Market bull Jim Cramer, on his CNBC show Mad Money Wednesday, ridiculed market bears, saying they have offered up nothing but "alibis" as to why the market should go lower instead of higher.

But even Cramer doesn't expect an unabated rally.

"We will probably have a three to five percent pullback," he told viewers. "I think you should be in now, and when that pullback occurs, buy more."

But the bears include New York University Professor Nouriel Roubini, who accurately predicted the financial crisis last year, and billionaire investor George Soros.

Markets have gone up too much, too soon, too fast," Roubini told Bloomberg News in an interview earlier this month, He predicts U.S. stocks may suffer a "major decline" because of what he sees as the slow pace of economic recovery.

Soros, meanwhile, warns the "bankrupt" U.S. banking system will create a huge drag on the economy, producing renewed doubts about the sustainability of the global recovery.

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