The Role Of Gold

 I’ve been a long time skeptic of gold and remain stubbornly bearish regarding its long term outlook.  To my mind the oft cited purposes that give it value are diminishing or gone; it’s use an alternate currency is quickly being replaced bitcoin; the ability to hedge against inflation has been spurious; and using it as store of wealth or a sage asset in case of thermonuclear war seems silly- if that’s my fear I’d rather own farm land with some cows.

But thanks to recent weakness in the dollar and macro political concerns gold has rallied some 5.5% in the past month and is now approaching the top end of a multi-year range.

And if you are to believe the recent bullish boasts and bets made by some of the highest profile money managers such as Stanley Druckenmiller, George Soros, Jeffery Gundlach and Bill Gross it should be going ever higher in the months to come.

The basis for the bull calls vary a bit but they all underpinned that as Druckenmiller stated at Sohn conference last May, “gold has traded for 5000 years and for the first time has a positive carry in many parts of the globe as bankers are now experimenting with the absurd notion of negative interest rates.”   

Bottom line, one of the great knocks against gold was its inert nature and the cost to hold or store it in some fashion. Now with zero to negative rates on bonds which can at best return your original capital, gold with its theoretically unlimited upside looks increasingly attractive.

If gold can break above recent range it could potentially begin a new multi-year bull market.

But what bucket does gold as an “asset” actually fall into and what role can it play in your portfolio? Some of the key determinants were based on how you view gold to begin with; is it a currency, an inflation hedge, a safe haven, a commodity or some combination of all?  A recent article from Pension Partners provided a good overview for each of these labels.

Gold as a Currency

Since the end of the Gold standard in 1972, we see an overall correlation of -0.37 between Gold and the Dollar Index, meaning that on average Gold and the Dollar move in opposite directions.

But on average doesn’t mean always. In looking at calendar year returns, Gold and the Dollar have moved in opposite directions 75% of the time. That means in 1 out of every 4 years they are actually moving either up and down together.

And while Gold and the U.S. Dollar tend to move in opposite directions, the moves are not anything close to proportional. Since 1972, the Dollar Index has fallen 16% (-0.4% annualized) while Gold has risen 2875% (8% annualized). There is clearly more to Gold than just a falling Dollar.

Gold as a Commodity

Is Gold more of a Commodity? Let’s take a look.

Since 1972, the monthly correlation between Gold and the Thomson Reuters Equal Weight Commodity Index (CCI Index) is .39.

While Gold and Commodities tend to move together, they don’t always move together and the cumulative appreciation since 1972 has not been close to proportionate. In 31% of years Gold has moved in the opposite direction to the equal weight commodity index, with an annualized return of 8.0% for Gold versus 3.1% for the CCI Index.

Gold as an Inflation Hedge

How about Gold as an inflation hedge?

Since 1972, Gold’s 2875% advance has far surpassed the cumulative rate of inflation in the US of 480% for the overall CPI and 473% for Core CPI.

Digging in a little deeper, though, reveals that Gold is anything but a constant or proportionate inflation hedge. From 1972 through 1980, Gold surged 1256% versus a 110% increase in the CPI. During the next 20 years (from 1981 through 2000), the CPI rose 101% while Gold fell 54%.

Gold as a Safe Haven

How about Gold as a safe haven?

We know that Gold is uncorrelated to the U.S. stock market, with a monthly correlation of 0.00 since 1972.  Meaning it does provide a nice diversification from stocks but whether it’s any safer is up to debate.

The Enigma that is Gold

The truth is that Gold cannot be simply defined as a currency, commodity, inflation hedge or safe haven. At various times it has been some/all of these things and at other times none of these things.

Gold is not a pure play on any one factor but the sum product of multiple factors. If you believe the U.S. Dollar is going lower, short the U.S. dollar. Gold will likely rise but the inverse Dollar ETF (UDN) is certain to rise. If you believe commodities are going higher, go long a basket of commodities. Gold will likely rise with them but a broad-based commodity exposure (DBC) will have better odds. If you are concerned about inflation Gold may end up protecting you in the long run but as we have seen Gold can be a terrible inflation hedge in the shorter run (see 1981-2000).

Long-term bonds and stocks have actually been a much more consistent hedge against inflation than Gold over the past 40+ years. Finally, if you are seeking a safe haven – Gold may provide such an exposure at times – but the odds of that are not nearly as high as the consistency of Treasury bills/bonds.

Perhaps the most important thing we can say about Gold is that it is truly an enigma. Its behavior is unique in terms of its lack of sensitivity to economic activity and non-correlation to stocks and bonds. That uniqueness, while frustrating to those who need to explain its every move, is what make it an interesting component in a diversified portfolio.  It also makes Gold an effective baseline to which you can compare more economically sensitive commodities such as Lumber.

To extract long-term value from Gold, embrace the enigma. Leave the storytelling to those whose job it is to come up with a reason for its every move.

 

— Steve Smith

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