Precious metals have always been intriguing to investors because they tend to hold their value. In times of geopolitical crisis or currency devaluation, for example, the value of paper money might fluctuate, but a hard asset will always be worth something. As a result, historically, precious metals have been considered a “safe haven” in times of economic and financial instability.

That brings us to why gold is on a tear today. It declined in 2008 and early 2009 as panicked investors rushed into cash in an attempt to weather the financial crisis. But sometime in the middle on 2009, when investors began to move their money from the sidelines, gold started to rally. It returned 32.59% through the third quarter of 2009, vs. 19.26% for stocks.

The question is, where can we expect gold to go from here? In order to predict whether gold prices will skyrocket or come crashing down, it’s important to understand the principal factors that affect the price of any commodity: supply and demand.

The supply side of the equation is not particularly relevant in regard to gold because gold supplies remain fairly constant. That’s because production has not significantly increased due to a lack of new mining sites. Should supplies increase, however, investors may want to be cautious.

The demand side of the equation, then, is the one gold investors must look at. And as we noted above, demand for gold tends to increase when investors have a lack of confidence in the U.S. economy and financial markets.

That’s certainly the case today. In fact, we see two factors, that could lead gold to outperform in the near future: inflation and currency devaluation. In response to the financial crisis of 2008 and 2009, the Federal Reserve injected massive amounts of liquidity into the money markets. Ultimately, that increase in the money supply could devalue the U.S. dollar and lead to inflation. In fact, the U.S. dollar is already shockingly low. On October 14, 2009, it fell to a 14-month low against the euro, hitting $1.4947, the weakest since August 2008, according to Bloomberg. And while inflation is not yet a problem, economists are on the lookout for it.

These conditions led Standard & Poor’s (S&P) to raise its gold price assumption for 2010 from $750 per ounce to $800 per ounce. “Investors seeking a hedge against inflation risks and uncertainty in the financial markets continue to support gold prices,” the S&P analysts write. “The metal’s properties as a safe haven, and to a lesser extent the demand for jewelry, also support its longer-term price prospects.”

S&P’s estimate, however, may be on the low side. As of November 2009, gold was trading at more than $1,000 per ounce. And since gold exceeded $1,000 per ounce level, the price has been extremely resilient, with no meaningful pullback seen. There have been periods of profit-taking, but increased demand quickly appears on any weakness in price.

In sum, then, good old-fashioned gold fever is back—and investors who are looking for a promising trend may want to consider investing in it and other precious metals.

But don’t consider gold an investment only for troubled times. One of the greatest advantages of precious metals exists regardless of economic and market conditions. Precious metals tend to perform differently from other assets. As a result, investing in precious metals may be a good diversification strategy for a portfolio comprised mainly of stocks, bonds and real estate—in all environments.

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So now that gold has made a second major run – shooting from $600 an ounce to $900 an ounce after punching through the $1,000 plateau last year – is the “yellow metal” still a prudent profit play, or is it an investment that’s already played out?

To answer that question, we must first ask another: Is the global monetary mirage going to keep inflating, or are we already on a sound monetary footing?

Let’s find out.

The global financial crisis has all the world’s major currencies (the U.S. dollar, the euro and the Japanese yen) racing to devalue against each other. This phenomenon of competitive devaluations occurs when inefficiencies in one country weigh down its economy. Devaluing the currency is an old macroeconomic trick to quickly attain competitiveness against other trading partners. It’s a way of borrowing growth from a neighbor, taxing imports and subsidizing exports.

But this newfound competitiveness is short-lived if the devaluing country does not fix the underlying reasons that gave rise to the currency devaluation in the first place. Devaluing the currency makes imports more expensive, especially commodities. And higher commodity prices and less competition from imported goods gradually feed inflationary pressures into the system.

Those inflationary pressures eventually “eat up” the value of the devaluation. And at the end of this cycle, you are left not where you began, but poorer, because you have made the income and monetary savings of your population less valuable.

The U.S. Economy’s Uphill Climb

No doubt, we are facing a unique set of circumstances in the markets. We are facing a global recession that actually teetered on the brink of a depression.

While some might think that just recapitalizing the banks will allow the lenders to get back into the business of aiding growth by providing credit, the reality is that the financial blowup is a symptom of structural conditions that keep generating these imbalances over time.

Let me be more specific.

There are three important structural conditions afflicting the long-term economic health of America:

• The U.S. auto industry has fallen to international competitors.
• Huge Social Security imbalances and an out-of-control medical care system figure to siphon an increasing amount of capital out of the economy.
• And the onerous and incomprehensible U.S. corporate tax system will cause enough friction to slow economic growth.

When the United States couldn’t sell cars and other products abroad, it stimulated its internal consumption in order to keep the economy going. The U.S. auto industry barely subsisted while the rest of America subsidized it with abnormally low interest rates and overpriced cars. Foreign carmakers could underprice them – and with better cars to offer – helping them book large profits, even when manufacturing in the United States.

Over time, the falling market share – in an industry where economies of scale are the name of the game – kept increasing the financial pressure on the U.S. car industry, which was technically insolvent by the year 2000. And up until recently, members of the U.S. industry declined to take the hard medicine and restructure their failing business models.

All the government money in the world couldn’t help the U.S. auto industry without a vital restructuring. The end result will be a trimmed-down, leaner industry whose workers will have less purchasing power. That is a strong change that will not be reversed.

Likewise with the banking industry, capital alone won’t do the trick unless the banks remove the cancer that is eating away at the very foundations of this country’s economic system. Therefore, we’ll see a pared-down, de-leveraged financial system that will produce less secular growth, lower profits and lower employment than its inflated predecessor.

In addition, although the industry has been “stabilized” with massive subsidies (zero interest rates, wide open discount windows and U.S. Federal Reserve programs designed to bolster asset values) significant losses are still ahead, which will continue to be painful.

There’s one last problem: The U.S. government has yet to address the elephants in the bazaar: The massive inter-generational Ponzi scheme of Social Security and the massive and unsustainable healthcare system.

If we do not address these two problems seriously, without political pandering and without making the very tough choices we need to make, let the last one leaving the U.S. turn off the lights, because the population pyramid is too narrow at its base to sustain the millions of baby boomers retiring.

The Obama administration is being proactive in addressing these problems, but the measures it is employing are inflationary.

The Government’s Inflationary Arsenal

In order to prevent a widespread economic depression from fully unfolding, the U.S. government and the Federal Reserve have resorted to a battery of very powerful measures.

These measures prevent the normal course that would have followed the blow-up of the huge unsustainable imbalances built over decades in the U.S. car industry, in the U.S. real estate market and more importantly in the Social Security and Medical Care systems.

In short, the Federal Reserve has resorted to:

• Lowering interest rates to near a range of 0%-0.25%. This effectively is a subsidy from savers to the financial institutions.
• And “quantitative easing.” That is, the Fed is buying U.S. Treasuries to drive their rates lower and to increase the money supply.

These are both merely ways of devaluing the dollar. Of course, the justification of engineering inflation is saving the U.S. banking industry and avoiding a dreaded deflationary spiral, a la Japan in the 1990s, which would mire us in 10 years of economic paralysis.

In effect, the U.S. government is trying to put out the fire with gasoline: Spending unconscionable amounts of money that it does not have, and financing that spending with record levels of debt. The short-term results of a boost in activity will be extremely costly.

Under this scenario, with a depression not in the cards, the market is rallying to adjust to mere recession pricing. But are we out of the woods?  The rampant spending and overzealous monetary easing will result in – you guessed it – inflation.

The Fed’s claims that it is ready and willing to act quickly in order to contain inflation when it finally appears just don’t seem realistic at this point. As a central bank that had to resort to such extraordinary measures just to sidestep the death spiral, could you really risk tightening the reins too much and too soon? No way. The Fed will have to be very slow in taking back the liquidity with which it has just flooded the market.

After all, it is much easier to spike rates later to stop inflation than to deal once more with a crumbling financial system.

Monetary management is more of an art than a science. The Fed doesn’t really know how much time – and to what extent – it will take for their measures to impact economic activity. It is driving while looking into its rearview mirror.  And with this amount of financial adrenalin and imbalances being corrected in the system, the likelihood of a monetary “soft landing” is slim to none.

This brings us back to gold.

With this prognosis, we know that the government’s policies will succeed in achieving what it truly intended: Creating inflation.

Therefore, gold is a necessary component of almost any portfolio. The problem is that the iShares SPDR Gold Trust ETF (NYSE: GLD) already has accumulated more gold than the rich countries of Switzerland or China. That means any move from the masses of investors to leave the metal will have a huge downward effect on it.

But, knowing this important technical risk, I would still be ready to invest if gold pulls back to the $800 an ounce level. From there, I’d keep building a prudent position, as we should see a price spike once inflation starts showing up in 12 months to 18 months.

Recommendation: Build a position in iShares SPDR Gold Trust ETF (NYSE: GLD), not to exceed 10% of the portfolio (**). Do so on pullbacks, and with a view of selling later once inflation shows up. That’s when the Fed will start hiking rates and reducing liquidity.

Source: Buy, Sell or Hold: iShares Gold ETF Will Sizzle When U.S. Stimulus Spurs Inflation