The outlook for precious metals is bright, but the risks are still there.

    Gold bugs began beating the tom-toms when the price of gold hit $500 an ounce last December. It should be no surprise that, after enduring two bleak decades, these folks say that the economics signal higher gold prices due to strong demand in relation to the short supply of the metal.
    But can gold and precious metals mutual funds continue their stellar performance after a few years of outstanding returns? Some analysts believe the price of gold could hit $800 an ounce, as it did in the 1980s.
    In the next few years, the price of gold could approach the record price reached on January 21, 1980, of $850 per ounce, says Rob Lutts, chief investment officer at Cabot Money Management in Salem, Mass.
    Like many observers, Lutts believes that commodities in general should be a top market performer for the next five to seven years and provide value in a stock market that will be stuck in a trading range.
    The reason for Lutts' optimism: Jewelry demand from the emerging markets of India and China is strong. India consumption is up 47% over 2004. China consumption is up 11%. These countries have a strong demand for gold jewelry as they build new wealth.
    Gold production has been constrained and is not expected to rise substantially. Producers have curtailed production over the past ten years when prices were low. Even though gold prices are rising, increases in production should be limited.
    Investment demand is rising. StreetTRACKS Gold Shares, an exchange-traded fund launched through a partnership between State Street Global Advisors and a subsidiary of the World Gold Council, has attracted $3.6 billion in assets, primarily from institutional investors, since its November 2004 launch.

    Frank Holmes, CEO and Chief Investment Officer of U.S. Global Investors in San Antonio, believes gold could go to $700 per ounce once U.S. investors start buying. "We are not seeing a commitment by U.S. investors like we did in previous cycles," Holmes says. "I don't know when that will take place."
    Besides a favorable supply and demand situation, Holmes believes a number of other unique factors could propel gold prices. The fear of a slowing U.S. Gross Domestic Product (GDP) could result in negative real interest rates. When the return on bonds is lower than inflation, gold becomes attractive. Oil exporting countries, flush with cash, are increasing their gold reserves; so are Asian countries. Plus, demand for gold coins and jewelry is on the rise.
    Mark Skousen, economist and editor of Forecasts & Strategies in New York, recommends buying precious metals if there is a sharp slowdown in foreign purchases of U.S. debt. The reason: This will force the U.S. Treasury to raise interest rates to keep foreign governments from unloading Treasury bonds. To avoid U.S. bond market losses, central banks from China to Argentina quietly are shifting into gold and precious metals to diversify their portfolios. "Buy gold, and especially silver and palladium stocks," Skousen says. "Palladium is the cheapest of all precious metals; it has fallen 80% in value since 2000, but is now staging a comeback."
    Not all money managers are raving bulls. Shanquan Li, manager of the Oppenheimer Gold & Special Minerals Fund, cites problems after you strip away all the hype about gold. As a result, he invested in well-capitalized senior and intermediate producers and has 10% of his portfolio in other minerals.
    Here's the rub: The cost of mining gold has shot up dramatically over the past five years, from about $250 per ounce to more than $360 per ounce. Without huge investor demand driving gold prices, mining company profits are not as attractive. The costs of fuel, cement to build facilities and steel used in construction are rising dramatically. Financial costs also are rising. But over the longer term, increasing supplies of gold should temper gold prices.
    Li concentrates on core holdings of well-capitalized producers, and takes a market weighting approach on exploration and small-capitalized companies. The holdings of gold-related shares should be more stable because of his emphasis on senior and intermediate producers with lower cash cost and highly liquid shares. "The rally in gold is supporting the industry," he says. "But most companies don't make money. My portfolio is invested in safer plays." 
    Li's largest holdings include Glamis Gold Ltd., a lower-cost producer with proven reserves in North America, Central America and Latin America. The company has several new projects in the pipeline that should be highly profitable at current gold prices.
    He also owns large South African producers, like AngloGold Ashanti Ltd. and Gold Fields Ltd. The stocks have not performed well due to the strength of the South African Rand. But they are undervalued relative to non-South African companies. South African mining stocks, he believes, should perform well when the Rand weakens against the dollar. Li also has a stake in NovaGold Resources Inc., a small exploration and development company, which has discovered almost 17 million ounces of gold deposits in Alaska and Canada. The company, though, has not begun mining. Li has cut back on his large position in Newmount Mining. The company wants to acquire Placer Dome Inc., a large U.S. competitor. The acquisition, he argues, is too costly. 
    Investing in gold makes a compelling story-particularly during periods of worldwide uncertainty about inflation and political turmoil. Nevertheless, gold is risky and volatile. For example, in periods ending in 2001, the average precious metals fund lost 3.2% annually over the prior 10 years and 11.7% annually over the prior five years. Gold bullion prices slumped over the same ten-year period, losing 2.6% annually. Gold has performed so poorly over the past 20 years that Lutts, of Cabot Money Management, says investors have forsaken gold as a way to diversify equity and bond portfolios.
    Today, though, it's a different ball game. The average precious metals fund grew at a 29.4% annual rate in the three years ending last November. Gold bullion prices increased a total of more than 33% since 2002.
    However, Holmes, of U.S. Global Investors, says the recent run-up in gold bullion prices could be followed by a 20% correction, but then might gain another 40%. If central banks accelerate or increase gold sales, prices should decline. But as long as the real return on bonds is low, gold should remain attractive, he says.
    Lutts says jewelry demand in the emerging markets is a major force driving up gold prices, and greater institutional and U.S. retail investor demand might push prices to about $700 per ounce.
    Every 1% increase in the price of gold typically results in a 3% increase in the price of mining stocks, Holmes notes. The reason: operating leverage. Many mining companies are highly profitable when the price of gold is $500 per ounce because the average cost of mining ore runs about $150 per ounce less. Holmes says his World Precious Metals Fund is invested in small and mid-size mining companies, most with proven reserves. They are expected to increase production and have strong cash flow and profit margins.
    The returns on smaller mining outfits lagged larger companies in 2005. But Holmes says earnings are growing and merger and acquisition activity is heating up. He expects Northern Orion Resources, the fund's largest holding, to be acquired. The company mines both copper and gold, and is benefiting from rising prices of both metals. Another play on both copper and gold is Freeport-McMoRan Copper & Gold Inc. Holmes also likes Silver Wheaton Corp. Like gold, silver prices are moving higher. The company, with high profit margins, collects 2% royalties from financing silver mining operations.
    The fund's other large holdings: Gold Corp., Bolivar Gold, Lundin Mining, Meridian Gold and Newmount Mining. Holmes is avoiding large South African companies due to the strength of the Rand. He believes revenues of South African companies should only improve when the Rand weakens against the dollar.
    Although the outlook for mining stocks looks favorable, gold bullion also is attractive. Unlike paper assets, like mining stocks, which can decline in value to zero, gold has a price floor that reflects the cost of mining.
    Gold bullion and mining stock prices take turns leading and lagging one another at various intervals. As a result, a mix of both is less volatile than a 100% stake in mining stocks. "Gold prices typically run ahead of gold stocks, Holmes says. "But there is a mean reversion, so owning both makes sense.