(MONEY Magazine) – Few investments have ever experienced the total meltdown that gold has suffered lately. The precious metal has dropped nearly $75 an ounce over the past year to trade in January at $278, its lowest level in 18 years. After hitting that low, gold recovered slightly to $299, but that price is still fully 65% below its $850 peak in 1980. Then there's the carnage in the 30 or so mutual funds that specialize in gold-mining stocks. They plummeted 42.5% in 1997, beating out even Asian emerging markets stock funds for the dubious honor of worst-performing fund group of the year. True, falling gold prices may translate to better deals on fine jewelry later this year (see Newsline on page 24). But the prolonged slump certainly hasn't won gold any fans among investors. "Gold is the most hated investment today," says Jean-Marie Eveillard, the renowned manager of the $4.1 billion SoGen International Fund. Eveillard, who also runs the $30 million SoGen Gold portfolio, is so discouraged that he's ready to give up on gold. Because SoGen Gold's returns have been dismal--the fund is down 18.3% since its inception in August 1993--he has vowed to ask shareholders for permission to shut down the fund if gold hasn't rebounded to $320 to $350 an ounce within the next year.

But making contrarian plays in hated investments is a time-honored way to prosper. And if you've got a stomach for risk, now may be an ideal moment to bet on gold. Be warned, however: We're talking about a short-term trading opportunity, not a long-term investment. Thus this story will not rehash the traditional advice of sticking 5% of your portfolio in gold stocks or funds as a hedge against inflation. Almost no one foresees a return to the kind of double-digit price spiral that sent gold prices soaring in the 1970s. Similarly, we won't recommend gold as a safe harbor in times of crisis. Today the crowd looking for shelter is more likely to buy U.S. dollars than bullion.

What we offer instead is the chance to profit from a brief gold spike. Gold's dismal 17-year slump has been interrupted by occasional short, sharp rallies that were highly profitable for investors smart or lucky enough to have bought in at low prices. The beauty of this play-the-bounce approach is that you don't need a major revival in gold prices to make some real money. Even a tiny blip upward in the price of bullion can translate into a big move in the value of gold-mining stocks and funds. That's because the extra revenue mining companies earn when gold prices climb above the production costs is gravy that flows directly to the bottom line. "The rule of thumb," says Todd Hinrichs, an analyst at ABN Amro Securities in Chicago, "is that gold-mining stock prices rise 2% to 5% for every 1% increase in the price of gold." In 1993, for instance, when gold prices climbed 18% to $392 an ounce, the typical gold-mining stock in Standard & Poor's 500 index jumped 83%.

The key to this strategy is that you must be willing to buy gold shares when other investors loathe them--as is the case today--and be willing to jettison them when others love them. If you are slow to pull the trigger, you could see your profits evaporate. When gold prices leaped 13% in 1989, for example, gold shares gained 45%. But investors who didn't unload their shares were in for rough years in 1990 through 1992--losses of 12%, 19% and 7%--until gold prices surged again in 1993, pushing mining shares up 83%.

So what would it take to ignite a gold rally? One spark could come from even a scintilla of evidence contradicting the widespread view that inflation is under control. "Part of the reason that gold prices have fallen so dramatically over the past four months is that there is a feeling that inflation will remain dormant because of the Asian currency crisis," says Douglas Cohen, an analyst at Morgan Stanley Dean Witter Discover & Co. in New York City. Investors expect a flood of increasingly cheap imports from Asia to hold down the prices of many consumer goods. Yet there is always the chance that the consensus is wrong or that economic currents could shift. For example, Cohen believes that forecasters are overlooking the possibility that, with the unemployment rate hitting lows not seen since 1973, U.S. companies may have to raise wages to attract employees. Such competition for workers could cause inflation to heat up. Indeed, a colleague of Cohen's, Morgan Stanley Dean Witter Discover chief economist Stephen Roach, believes continuing economic growth will cause the inflation rate to climb from 1997's 1.7% to 3.1% this year. "An uptick in inflation of that magnitude could catch people by surprise and help launch a gold rally," says Cohen.

The mere fact that the price of gold has fallen so low may also be setting the stage for a comeback, largely by cutting production of the precious metal. "At today's prices, many gold producers aren't making money," says Michael Bradshaw, an assistant portfolio manager of the $28 million Pioneer Gold Shares fund. "Some of them will reduce production and others will go out of business." Bradshaw notes, for example, that 25% of the world's output comes from mines with production costs close to or exceeding $300 an ounce, which means at today's gold prices it's not worthwhile for them to dig for ore.

Given the current slump in gold prices, J. Clarence Morrison, an analyst at Prudential Securities in New York City, expects world gold production to drop from an estimated 77 million ounces in 1997 to 73 million ounces this year. Meanwhile, gold consumption worldwide is at record levels, thanks to strong jewelry demand in the Middle East and India. Morrison estimates gold consumption at 117 million ounces last year and sees that figure reaching 124 million ounces this year.

Economics 101 tells us that the combination of a drop in the supply of gold in the face of increasing demand virtually guarantees a rising price. But there is another variable in the gold equation: the world's central banks, which hold a third of the world's gold supply. In recent years, central bank sales of gold on the open market have filled the gap between production and consumption, preventing bullion prices from taking off even as the amount of new gold coming out of the ground has declined.

Gold bears fear that European central bankers will boost their sales, especially if Europe goes through with the plan to launch a single currency next year. The nations that are pushing for a unified currency have agreed to have their money supplies governed by a new European central bank. The worry is that this bank will decide to keep a smaller portion of its reserves in gold than the central banks of individual European countries do today. But gold bulls, like Cohen, believe that Germany and France, the two countries that will exert the strongest influence over a new European central bank, won't want to pare gold reserves. "They have been through wars when gold held its value, and those memories haven't been extinguished," says Cohen.

If Cohen is right and central banks don't dump huge amounts of gold on the market within the next year or so, the supply/demand imbalance could help boost prices. How high? Predicting the price of gold is as notoriously difficult as forecasting interest rates, but ABN's Hinrichs believes that if the fear of central bank sales dissipates, we could see gold prices as high as $395 an ounce within the next 12 months.

If you're persuaded by these arguments, the two best ways to buy gold are through mining stocks and the mutual funds that invest in them. For most investors, funds are the best way to go, since you're not risking all your money on a few specific companies. (Remember: If gold prices stay flat or decline, some mining companies will fold.) Mark Wright, senior analyst at Morningstar, recommends Vanguard Specialized Portfolios-Gold & Precious Metals (800-851-4999) and American Century Global Gold Fund (800-345-2021), both of which focus primarily on large North American mining companies. Both have shown that they can provide explosive returns--93% and 81% respectively in 1993--and since they are no-loads, you won't squander money on commissions as you jump in and out of them. You can shoot for even bigger gains, however, with a fund that loads up on South African firms. Since South African mining companies' costs are higher than those of American and Canadian ore producers, they naturally post lower profits than their North American counterparts. But when gold prices climb, each additional dollar of profit represents a far larger percentage increase for South African firms than it does for the more profitable North American firms. As a result, whenever bullion prices head up, the share prices of South African companies often climb the most. For example, Lexington Strategic Investments (800-526-0056), a fund that invests primarily in South Africa, gained a staggering 270% in 1993. But the fund, which has a 5.75% sales charge, is also riskier than most of its peers because South African shares take a bigger hit if gold prices decline. What's more, investors take on the risk that currency fluctuations or political developments in South Africa could erode returns.

You can also profit from a rally in gold prices by buying individual stocks. If you go this route, you want to stick with low-cost producers, since they can weather a prolonged downturn in gold prices. You should also favor large companies that operate mines in different parts of the world, since firms with geographically diversified operations are less apt to have their production cut back if, say, a country toughens its environmental laws. Hinrichs recommends three companies that meet those criteria. Newmont Mining owns 94% of Newmont Gold Co., the biggest U.S. gold producer, which also has large mining operations in Peru and Indonesia. Newmont Gold extracts ore for $187 an ounce, making it one of the world's lowest-cost producers among larger companies. Hinrichs also likes Battle Mountain Gold and Barrick Gold, two large North American gold-mining outfits with competitive costs. In addition, the analyst favors one medium-size ore producer that keeps its costs down, Agnico Eagle Mines.

When buying individual stocks, you should steer clear of high-cost gold producers. As noted above, the share prices of such companies can soar when the value of gold climbs; but mining operations with lofty costs may not be able to stay in business if bullion prices remain at today's depressed levels for a prolonged period.

If you've bought beaten-down gold shares and their prices start to take off, don't get greedy. Instead, sell gradually into the rally so you lock in some profits. For example, Hinrichs says investors should begin selling shares when gold reaches $330 an ounce and that they should have unloaded roughly 70% of their holdings by the time gold prices reach $385. He recommends bailing out completely when gold hits $400 an ounce. One sure sign that a gold rally is on its last legs, says Pioneer's Bradshaw, is when mining companies sell shares to investors in a public offering. "During a three-week period in 1996 when gold prices were above $400," says Bradshaw, "there was a financing by gold-mining companies a couple of times a week." Within seven months, though, prices slipped back to $370 and gold shares fell 18%. So if you see gold-mining firms flogging their shares to the public, you should think sell too--it's probably a good sign that the gold rush is at least temporarily over.