Gold Bullion: The Ultimate Hedge To Insure Your Portfolio

Gold performs the best during times of currency debasement. This is a real concern today, as governments around the world continue to spend a lot of money and print more in an effort to avoid deflation.

— Yiannis Mostrous, Silk Road Investor

A couple weeks ago, I wrote about 13F filings detailing the buys and sells of some of my favorite investors. I can’t get it out of my mind. The reason? John Paulson and George Soros are two of the smartest investors on the planet and both remain heavily invested in gold bullion and gold stocks. Paulson’ portfolio is weighted more than 30% in the shiny metal and Soros’ portfolio is more than 12%.

Please Let Me in on the Secret!

Why is gold attractive? I’ve always been ambivalent about gold because I don’t really see the value of the darn stuff. Sure, it’s pretty to look it (my wedding ring is made of the white variety), but it doesn’t pay dividends or generate cash flow of any kind, and in large quantities it costs money to store. The only way to make a profit on gold is for somebody else to buy it from you at a higher price. I don’t want to rely on other people’s opinions for my financial success; I want my investments to generate their cash independently of what anyone may think.

Difference Between an Investment and a Speculation

Value investor extraordinaire Seth Klarman, in his out-of-print investment classic Margin of Safety, distinguishes between investments (which he likes) and speculations (which he doesn’t) this way:

Assets and securities can often be characterized as either investments or speculations. The distinction is not clear to most people. Both investments and speculations can be bought and sold. Both typically fluctuate in price and can thus appear to generate investment returns. But there is one critical difference: investments throw off cash flow for the benefit of the owners; speculations do not. The return to the owners of speculations depends exclusively on the vagaries of the resale market.

The only cash speculations generate is from their eventual sale. The value of speculations, therefore, fluctuates solely with supply and demand. Speculations have not historically been recognized as stores of value, thus their prices depend on the vagaries of taste, which are certainly subject to change. The apparent value of speculations is based on circular reasoning: people buy because others have recently bought. This has the effect of bidding up prices, which attracts publicity and creates the illusion of attractive returns. Such logic can fail at any time.

Hmmm….since gold does not generate cash flow, is it nothing more than a rank speculation? Based on Klarman’s reasoning, one could certainly reach the conclusion that all commodities are speculations. But he hints at an exception to the cash-flow definition of investments – something called “stores of value.” What does that mean?

Gold is More than a Speculation, But Less than an Investment

Wait; there is a footnote at the end of the chapter which says:

The only possible exceptions to this cash flow test are precious metals, such as gold, which is a widely recognized store of value; throughout history, for instance, the value of an ounce of gold has been roughly equivalent to the cost of a fine men’s suit.

Now we’re getting somewhere! It seems that gold can be considered more like an investment than a speculation because it has a permanence of value independent of temporary and fickle public tastes. It’s amazing to think that the same amount of gold can purchase the same amount of consumer goods now as it did hundreds or even thousands of years ago. Paper money certainly can’t make such a claim. 

Purchasing Power Protector!

One analyst describes the value of gold this way:

Gold’s primary purpose is to preserve your purchasing power. Whether it is roaring inflation, or dollar debasement, or economic upheaval, or out-of-control government spending, it has been the absolute best form of protection throughout the history of mankind.

Furthermore, he correctly notes that gold, unlike other commodities, is easily preserved indefinitely. It cannot be destroyed by fire (will only melt), water (won’t rust or tarnish), or time.

The Lightbulb in my Head Finally Turns on

There, you have it.  Now I understand why Paulson and Soros own gold and why I was wrong to dismiss it. Gold is a form of permanent insurance against economic problems and that is valuable.

Insurance, by definition, protects against losses. As I demonstrated in The Great Investment Truth, the greatest impediment to wealth generation is “the big loss.” By adding gold to your portfolio, you have something that goes up when your stocks go down and that is a huge benefit to your long-term wealth. In my free report on asset allocation, I explain how adding together assets with low correlations to each other reduces downward volatility, thus improving the wealth generation ability of your investment portfolio.

Gold’s Negative Correlation Benefits Asset Allocation

Based on the insurance attributes of gold, one would expect gold to have a very low correlation with other investments like stocks. And, in fact, it does have an extremely low correlation. A 2009 study of gold found it to have a negative correlation with U.S., U.K., and German stocks.  Negative correlations are rare and extremely valuable to an investment portfolio. A recent study by investment firm U.S. Global Investors found that between 1971 and 2009 a 10% allocation to gold generated an annual return that was 63 basis points greater than a 100% stock portfolio and did so “while adding virtually zero risk.”  Might not sound like much improvement, but after 25 years the portfolio with gold would be worth 15.5% more than the all-stock portfolio. 

How Much Gold?

What percentage of your portfolio should be in gold?  The rule of thumb is 10%.  Ironically, even the late Louis Rukeyser, who coined the disparaging term “gold bugs” to describe fanatical “world is ending” gold bulls, admitted that gold may deserve up to a 15% allocation in the typical investor portfolio as a hedge against the debasement of paper money (i.e., inflation).

When to Overweight Gold (a.k.a. Market Timing 101)

Gold, like any asset class, performs better in some economic environments than in others.  While a permanent allocation of 5% or 10% to gold makes sense, it would be useful to know under what conditions one should consider buying even more gold. A 2005 study attempts to answer this question. It concludes that an overweight position in gold of 20% is warranted when the “Fed Model” indicates that the stock market is 15% or more undervalued. In fact, during such times, an 80% stock/ 20% gold portfolio beats an all-stock portfolio by more than 10 percentage points annualized!

The Fed Model compares the yield on a 10-year BBB corporate bond with the earnings yield (i.e., estimated forward annual earnings divided by index price) of the S&P 500. If the earnings yield is higher than the bond yield, the market is said to be undervalued. According to Bloomberg, the S&P 500’s earnings per share for 2010 will be $81 and the current yield on 10-year BBB corporate bonds is 5.27%. Dividing $81 by 5.27% results in a fair-value estimate for the S&P of 1,539. With the S&P currently trading at 1068, the Fed Model says that the market is 31% undervalued. Consequently, a 20% overweight position in gold may be warranted at this time.

You may be wondering why gold should outperform stocks at times when the model considers stocks to be undervalued and primed for a bounce back. The study’s author conjectures that stocks aren’t actually undervalued at such times, but instead their low price reflects a fear of increasing inflation and negative real returns. Such fear is the perfect environment for investors to switch from stocks to gold.

Dow-to-Gold Ratio is Trending Down

The paper also looks at the ratio between the Dow Jones Industrial Average and gold. With the Dow currently trading at 11,092 and gold at $1,375 per Troy ounce, the ratio is currently 8.1.

Source: Bloomberg

The ratio has been in almost a constant downtrend since it peaked in 2000 at 43.7. Historically, once a downtrend in the ratio has been established, it doesn’t bottom until the ratio hits 3 or 4.  Let’s be conservative and assume it will bottom at 4.  That means that the ratio will fall by half in the coming years. This can happen either by the Dow falling by 50% or gold doubling in price. Under either scenario, an overweight to gold looks good right now.

Negative Real Interest Rates are Bullish for Gold

A third test looks at real interest rates (i.e., nominal interest rates minus the inflation rate).  When real interest rates are negative, investors switch from bonds to gold and gold prices rise. As one analyst puts it:

Real interest rates are the only metric that is correlated with the gold price. If you can hold U.S. dollars via Treasury bills, notes or bonds and they are paying a positive real interest rate that is not being inflated away, then why hold gold that doesn’t pay anything?

Gold prices tend to significantly increase only if real rates become negative. The current bull market in gold that started in 2001 corresponds to U.S. three-month Treasury bill real rates falling below 0%. However the gold price really takes off when 10-year real rates go negative. That’s what happened in 1979 and very briefly at the end of 2007. The 10-year real rate is positive right now. As the three-month rate is negative, it’s positive for the gold price but if the 10-year real rate goes negative and stays in negative territory, look out. The gold price could really spike. 

The consumer price index (CPI) is currently running at an 1.2% annual pace, with the core CPI (excluding food and energy) at 0.6%, the lowest annual rate in the history of the core CPI (since 1957). According to Bloomberg, the 3-month U.S. Treasury bill yields only 0.15%, so the 3-month real interest rate is negative 1.05% (0.15-1.20). The 10-year bond yields 2.81%, so its real rate remains positive at 1.61% (2.81-1.20).  Consequently, gold’s price currently has a slightly bullish bias, but won’t really take off until the CPI starts to rise.

Silk Road Investor is Initiating Metals Coverage!

Yiannis Mostrous, natural resources expert and editor of Silk Road Investor, the market-beating emerging markets investment service, is very bullish on gold.  Just last month, he wrote the following about gold:

A structurally weaker dollar and a shift in the global financial system away from the dollar toward a multiple-currency structure is now a distinct possibility. Such a transition would make gold universally accepted as the ultimate store of value.

Investors should remain bullish on gold, regardless of short-term gyrations in value. The price of gold could reach USD1,500 per ounce in the medium term as central banks maintain loose monetary policies.

But even more interesting is Yiannis’ opinion on other metals. He’s extremely bullish on metals in general for three reasons: (1) quantitative easing in developed markets and loose monetary policy in the rest of the world; (2) strong demand for infrastructure upgrades in emerging markets such as India and China; and (3) tight supply of hard assets.

In fact, he is so excited that last week he told Silk Road Investor subscribers that he was initiating coverage of metals stocks for the first time:

As the metals story is inseparable from the overarching theme of economic growth in Asia and other emerging markets, we have decided to incorporate our metals coverage in Silk Road Investor.

Once a month you will receive an in-depth analysis of one sector of the broad metals industry along with our investment recommendations. Additionally, we’ve initiated a new model Portfolio for metals with five key stocks. You will also receive alerts instructing you to buy or sell selected metals stocks as we adjust and expand our Portfolio.

I can’t tell you his top three metals markets for 2011 except to say that gold is not among them. To find out the names of the three metals markets ready to skyrocket next year, as well as the five key metals stocks every investors should own now, give Silk Road Investor a try today!