Why the gold market is an investor's best friend

Considering gold is a traditional 'safe haven' against falling markets, you may be wondering why it's been so volatile of late. Martin Denholm looks at the real reason investors are selling.

They say diamonds are a girl's best friend. For investors right now, I'd change that to the gold market.

Let me kick off with a couple of juicy statistics

Industrial demand for this popular metal hit a record 458 tons in 2006.

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Investment demand soared 45%

Gold supplies fell almost 15% in 2006.

The Lear report says producers in countries like South Africa are simply unable to keep up with the sizzling demand from Asia and the Middle East. The jewelry industry is a mega global business in both regions, with sales hitting $44 billion last year.

Gold market prices have responded, which is good news for investors. Over the past year, gold prices have shot from a low of $560.75 to $694.20. Over the past 30 days alone, prices have climbed from a low of $641.80 per ounce to $684.40 just a few days ago, within touching distance of that 52-week high.

Of course, over the past few days, most major equity markets have endured a wild ride. But considering gold is a traditional 'safe haven' against falling markets and a dropping dollar, as well as rising inflation, you might be wondering why the metal has experienced volatility with the broader market. Don't be fooled

Reasons for gold market volatility

The recent gold price pullback isn't because the bears are about to start ravaging the gold market. One big reason is that investors are using the opportunity to grab the gold profits they've scooped up over the past few months to cover their losses from other areas.

Since the beginning of this year alone, we've seen swings of over $80 an ounce up and down for gold. But it's still trading at almost the same level it was back in January. So what gives? For some clues, I turned to my colleague and former NYMEX floor trader, Lee Lowell, who is the smartest guy I know when it comes to commodities.

Lee says: 'If you look past the major gold market volatility, $650 an ounce seems to be the area that gold is gravitating towards, once it's done making its big moves up and down. Take a look at the daily chart below of the near-month gold futures contract and you can see the wild swings. But the overall slant is bullish. Whenever there's world turmoil or doubt in the equity markets, investors and hedge funds alike move towards hard, physical assets like gold. I don't see the gold market plummeting anytime soon as there's just too much interest on the buy side. There's a lot of talk of $1,000/oz and we could see it.'

And speaking of gold investors, the goalposts are shifting

Gold is moving into uncharted territory

It's not often you hear the phrase 'a gold supply shortage.' But that's changing now. Having socked away vast gold reserves for decades to diversify their holdings, the world's central banks are now changing their tune.

Their collective gold stash is dwindling rapidly, causing them to have less control over the gold market. As a result, private investors are jumping in with a vengeance, confident that less central bank control over buying and selling means less price volatility.

In fact, private investors have gobbled up 7,500 ounces of gold over the past five years - and now control more of the supply than central banks, according to CPM Group. That's huge!

And with gold being a great way to diversify and protect any portfolio, many of these folks are buying gold for the long-term. Not a bad strategy, considering the current geopolitical situation, terrorists on the prowl, and inflation rising.

But there are a couple of other factors giving the gold market a bullish glimmer

Over the past few years, several major central banks (the Fed, European Central Bank, Bank of Japan) have cut interest rates sharply. That means there is much more money washing around the market these days.

So in addition to the inflation you hear about every day (oil, energy, food, gasoline), this 'man-made' situation has also pushed inflation higher. And gold loves inflation.

Of course, no conversation about gold or the gold market would be complete without mentioning the U.S. dollar. Considering that gold is such a good hedge against the dollar, the two have long had an inverse relationship.

And just recently, gold investors couldn't have asked for a better boost. The greenback has slumped to record lows against the euro, 26-year lows against the British pound, and a 16-year low and 20-year low against the Australian and New Zealand dollars respectively. And north of the border, the Canadian dollar is fast approaching parity with the dollar.

While this is making U.S. exports cheaper, it's also cheapening the value of the dollar and making gold more attractive.

Mix this in with a supply shortage and demand spike and you've got a recipe for higher prices - especially considering that it takes several years to explore and develop a gold mine, then get a decent amount of gold from it.

How to take advantage of this gold market breather

While the last few days might signal that the gold market is succumbing to the broader market drop, it's more likely that it's just taking a breather. But whether it's just a consolidation or a more marked pullback will ensue, this gives you a good chance to boost your gold market holdings at a lower price before the supply-demand issues and other factors I mentioned above lead it back up again. Let me give you a couple of ideas

streetTRACKS Gold Shares (NYSE: GLD): This ETF gives you directly exposure to the gold market, without actually having to buy any of it yourself. It tracks the performance of gold prices directly, and because it's an ETF, it trades like a normal stock. On April 20, it hit a 52-week high of $68.73, but the gold selloff over the past few days has resulted in it slipping back almost $3 around $65.45.

Market Vectors Gold Miners (AMEX: GDX): Another gold-based ETF, but this one tracks performance of the stocks in the AMEX Gold Miners Index. This came within 2 cents of setting a new 52-week high ($43.32) earlier this week - a bullish sign. But like GLD, it's slipped back to $39.50.

Investing here means you don't have to spend time looking for individual gold stocks, then increase your risk by buying just one or two - this one tracks the world's top gold producers in one simple investment. And with gold harder to come by at the moment, these firms should reap the reward of the supply-demand situation.

By Martin Denholm, Managing Editor, Mt. Vernon Research for the Smart Profits e-Report, www.smartprofitsreport.com