Gold is now trading at its all-time current dollar peak of more than $1400 an ounce, up dramatically from a then multiyear low of $260 in early 2001. Adjusted for inflation, however, it is still well below the roughly $2,350 in present dollars represented by its 1980 peak of $850 an ounce. While that price held for just a few days, gold prices were in the $300s and $400s for most of the 1980s and 1990s, suggesting that the present price level is not excessive: the Dow Jones Industrials are up ten-fold from their 1981 high.

Traditionally, gold was used mostly for jewelry, industry, and hoarding by people who had no other way to save for the future. In recent years, investment has added to the demand for gold, spurred by the creation of the first gold exchange traded fund, SPDR Gold Trust (GLD) in 2004. Several other gold ETFs have been organized, and gold is also held, along with silver, platinum, and palladium, in precious metal funds. These investment vehicles added substantially to the demand for gold in the second quarter of 2010, but they bought very little metal in the September period. They now own around 2,100 metric tons of gold, or a bit over half a year’s supply, worth around $93 billion at gold’s recent price.

Lending support to gold at present are fears that stimulus actions by Britain, Japan and the U.S. Federal Reserve will increase the money supply and lead to high inflation in a few years. There was much talk in this context of possible bad results of the Fed’s second “quantitative easing” (QE2), its plan to buy a further $600 billion of U.S. Treasury securities through June 2011. While that’s a goodly number, though, it still represents well under 10% of the U.S. money supply, so that much more cash in circulation probably will not have much effect, for good or ill.
 Gold can also serve as protection against a currency’s decline and, specifically, against weakness in the U.S. dollar. Most commodities are priced in dollars, so a gold holding may be worthwhile for investors in commodity-exporting countries. Too, gold price movements are virtually uncorrelated with stock prices, so the yellow metal helps balance a portfolio.

Adding to gold’s appeal, the supply of mined gold is unlikely to increase much more than a few percent per year, though people have sold jewelry when gold has jumped in the past and will do so if it spikes again. Central banks sold some gold in the last decade, but central bank action is more likely to be in the other direction now, as nations such as China, India, and Turkey all have less than 8% of their reserves in the yellow metal.

On the other side, inflation is likely to be minimal over the next year or so, the U.S. and the major goods exporting countries may rationalize world trade so as to support the value of the dollar, and investors’ level of anxiety could also decline, putting downward pressure on gold prices. Moreover, major gold producers have bought futures contracts over the past year; this has the effect of slightly lowering supply. Those actions have now ended, removing a minor factor that has supported the price rise.

Despite the present lofty price of gold, it does not appear much overvalued in relation to oil, silver, or stocks. An ounce of gold is now worth about 16 barrels of oil, 52 ounces of silver, and 1.18 times the S&P 500; the long-term averages are 15, 58, and 1.0, respectively.

All told, we think gold is fairly valued at this point and suggest that investors put up to 5% of their portfolios in Keynes’s “barbarous relic”. Beside gold ETFs, investors can take a look at the gold companies in Issue 8 of The Value Line Investment Survey, including Agnico-Eagle (AEM), Barrick Gold (ABX), Goldcorp (GG), and Newmont Mining (NEM). But to obtain the balance offered by gold’s lack of correlation to other assets, investors should hold exchange traded funds, unless they think a bar or a coin would look good on the mantel piece.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.