The goldbugs are riled up. Some experts believe gold could hit $2,000 an ounce this year as investors demand safe havens and inflation hedges.

"There's been a lot of safe-haven buying over the past year," says Natalie Dempster, investment chief of the World Gold Council in New York. "There is a record level of gold bar and coin sales." Gold, she says, has no credit risk, and is helping to allay concerns that the U.S. budget deficit is inflationary.

Nations worldwide are devaluing currencies and pumping money into their economies to jump-start the worst recession since the Great Depression, Dempster says. And those fiscal and monetary stimuli are sparking demand for gold from both individuals and institutional investors. The reason: There's often a lack of correlation between the returns on gold and those of other commodities and financial assets because of gold's accessible aboveground supply.

"Zero interest rates, the budget deficit impact on the dollar and fiscal stimulus could create the perfect storm for inflation down the line," Dempster says.

The only thing that could stop gold prices in their tracks is the strengthening of the U.S. dollar, though she believes that's unlikely. Through February, gold bullion prices were up nearly 8% in 2009. And over the past three years, ending in 2008, the price of gold was up a total of 59.48%, according to the World Gold Council.

Precious metals mutual funds, however, have not fared so well. In 2009, the average fund in this category was up just 6% through February and gained a total of 25% over the past three years, ending in 2008, according to Morningstar Inc., Chicago (see Figure 1).
There is no free lunch when it comes to investing in gold bullion and legal tender coins or precious metals mining stocks. It makes for a

compelling story-particularly during periods of worldwide uncertainty about inflation and political turmoil. Nevertheless, gold is risky and volatile. For example, in the ten years ended in 2001, gold bullion prices declined at a rate of 2.6% annually, while precious metals mutual funds lost 3.2%. Gold performed so poorly that reports indicated both individuals and institutional investors gave up on it as a way to diversify portfolios.

Also, its price is cyclical. Gold tends to post seasonal bottoms in late July or early August. After that, demand picks up for a couple of reasons: Jewelers stock up ahead of wedding season, particularly in India. Also, investors returning from summer vacations often buy gold, according to the Commodity Traders Almanac (published by Wiley). In addition, gold prices are subject to spikes in demand from investors in search of a hedge or protection from inflation and economic instability. In the longer term, the almanac says cyclical forces can "dramatically impact the seasonal price moves."

Joe Sterling, co-manager of the American Century Global Gold Fund, says the benefits of lower energy prices, the discovery of new gold deposits and easier access to the capital markets has already been factored into gold prices. Going forward, he does not envision a "gold gone wild" market.

"Gold prices will hang in there," he says. "I'm not sure we will get some big spikes unless there is a complete devaluation of the euro or a monetary failure. I see prices remaining buoyant, but not going haywire."

Another caveat in an otherwise rosy scenario: Shorter-term inflation is not currently a threat. Plus, once the economy rebounds, the Fed is expected to remove money from the economy by selling shares of companies it helped, negating the oversupply of U.S. dollars.

The "deflationary worries and a strong dollar could weigh on price early in the year," according to a report by Morgan Stanley. Meanwhile, UBS analyst John Reid says in another report that if the banking sector stabilizes, gold prices may not rise dramatically. Prices will soar only if investors substantially increase gold holdings.

Jewelry demand plays a major role in how gold performs. Nearly three-quarters of gold demand is due to jewelry sales. But it is uncertain how much impact jewelry demand will have on gold prices this year. Demand for gold is still strong in India, Dempster says, but has declined in the United States and Europe. Central banks are selling it, and its industrial use is dropping.

Some investment advisors take a cautiously optimistic attitude toward gold. Don McCoy, president of Planners Financial Services, a Minneapolis-based broker-dealer and investment advisory firm, has kept 5% of client assets in a precious metals mutual fund since 2003. If inflation heats up, he may increase his allocation to 8%. Nevertheless, he believes that if the United States does not come out of the recession this year or next, gold may not perform well.

"If the global recession continues to sputter and contract and not expand, we could be looking at global deflation," McCoy says. "If that happens, gold will not be attractive."

Edward Yardeni, of Yardeni Research in Great Neck, N.Y., says gold may be stuck in a trading range for some time. "It may continue to trade sideways in expectations that the Obama administration will end the financial crisis and revive economic growth," he says.

But all bets are off if foreign investors in U.S. government bonds reduce their investments, which are financing the U.S. deficit. "The Fed would be forced to buy Treasurys," he says. "This could raise inflationary concerns that the government is resorting to the printing press. That would be very bullish for gold."

Last year was a particularly bad year for precious metal mining mutual funds. The average precious metals fund lost nearly 30%, Morningstar says.

In 2008, mining stocks and gold bullion prices decoupled for several reasons. Since last fall, credit tightening and high energy costs hurt mining stocks, according to Rachel Benepe, co-manager of the First Eagle Gold Fund. However, now mining companies have greater access to the capital markets. In mid-February, she reported that mining companies had raised $3.2 billion in capital to fund their operations over the previous couple of months. Plus, mining companies were more profitable because of lower oil prices, rising gold prices and declining mining costs.

Published reports indicate that if oil prices stay at today's level of about $40 per barrel, mining company costs will decline 10% to 15%. Gold bullion and mining stock prices typically take turns leading and lagging one another at various intervals.

Late in the fourth quarter of 2008, for example, mining companies benefited from gold's rise and the softening U.S. dollar, says Sterling at American Century. The American Century Global Gold fund mostly owns large gold mining companies that can pull ore out of the ground for less than the average cost of $550 per ounce. Companies such as Goldcorp Inc., Barrick Gold Corp., Newmont Mining Corp. and Kinross Gold Corp. make up 36% of the fund's portfolio.

"We have been a little heavy on our cash positions," Sterling says. "We are looking to buy some midcap companies that show growth of profits and have maintained costs." Overall, the fund tracks the NYSE Arca Gold Miners index.

Sterling says the fund typically avoids investing in mining companies that are hedging the price of gold in the futures market. That's because unhedged companies show greater earnings growth when the price of gold is rising because of fixed mining costs. On average, every $10 increase in the price of one ounce of gold results in a 30% growth of earnings. The fund's average holding is expected to grow earnings at 27%.

First Eagle Gold Fund, Benepe says, always has a position in gold bullion in addition to mining company holdings. The fund was recently keeping 28% in bullion, 62% in stocks and the rest in cash and bonds. First Eagle uses a proprietary model that looks at the spot gold price, company fundamentals and financials to determine its asset allocation and investment candidates.

The fund's typical mining company is a lower-cost producer with long-life mines and large aboveground supplies. For example, the fund invests in Fresnillo, a Mexican silver and gold producer that mines ore at below-average costs.

"We don't take a view on the outlook for gold," Benepe says. "We have always owned it because it is an insurance policy and is the only asset out of the credit system."

The fund is geographically diversified and sports an average market capitalization of $5.8 billion. Its largest holdings include Randgold Resources Ltd., Royal Gold Inc., Kinross Gold Corp. and Newmont Mining. But it also invests about one-third of the portfolio in midcap and small-cap companies that can show strong upside in earnings when the price of gold is rising.