Category Archives: Precious Metals

The Enigma that is Gold

Gold is by far the most controversial investment, always eliciting strong feelings on both sides. One of Warren Buffett’s most often repeated missives on gold is: “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” (source). Now I consider Warren Buffett the foremost capital allocator of our time and deserves deep admiration. I also think under the folksy, cherry-coke-drinking persona is one of the shrewdest businessman alive. He plays the part of a benevolent capitalist to the hilt to curry favor with the government for the lightest regulation and oversight possible – skillfully, legally, and to the benefit of $BRK shareholders. As for those who would substitute Buffett’s professed thought on gold for their own, they should at least be aware of what he did with silver (Google Buffett and silver). Remember: everything he says about gold should apply to silver – with the exception of having to dig a bigger hole.

There are plenty of straw-man arguments against gold. They typically go like this: people buy gold for inflation protection (false premise but since when has that stopped a good argument?), but gold did poorly last time inflation was high, therefore gold wasn’t really an inflation hedge, therefore you shouldn’t buy gold. For real insight into what gold is and is not read this instead. Author Charlie Bielello did a great job dissecting whether gold is currency/commodity/inflation hedge/safe haven based on annual return data from 1972. The conclusion is that gold does not fit into any of these categories. In other words, gold is unique and in a class of its own. I’m totally fine with that – to me there are only two valid reasons for owning gold: 1) as a portfolio diversifier; 2) because it’s in a (long-term) uptrend (well, there is a third reason but I don’t really want to conjure up the image of Mr. T).

Portfolio Diversifier

The Permanent Portfolio (PP) – equal weight of Stocks/long term treasuries/gold/cash – was introduced by Harry Brown as a portfolio that works in all economic conditions: prosperity, deflation, recession and inflation. It’s had a huge influence on me and there will be no shortage of future posts on both the PP and portfolio construction in general. For now I’ll simply point out the main difference between the PP and the traditional stock/bond portfolio: gold. If we look at the correlations between these assets:

pp_correlation_20161001

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The 1-3 year treasury ETF $SHY is being used as a cash proxy and as expected has minimal volatility. Gold, or $GLD as a proxy, has low correlation (by low I generally want to see < 0.3) with both stocks and long term treasuries thus providing a diversification benefit. In general, asset returns are volatile and difficult to forecast, but volatilities and correlations are more stable. The exact amount of diversification benefit depends on realized returns for each asset, but its existence a mathematical fact not a function of back-testing.

That said we can’t eat mathematical derivations, unlike actual returns. Countless hours have been spent (wasted?) on arguing about gold’s position in one’s portfolio. My own view is that even if the long term return of gold is only keeping up with inflation, I would still keep a position but at a proportion much less than 25%, perhaps about 10%. I see prosperity as the more dominant economic condition based on my previously stated view that KNOWLEDGE, which is at the core of human progress, is still being expanded, disseminated and leveraged for growth, and it’s hard to see that trend reversing. One way to express that view is through the Golden Butterfly portfolio proposed by Tyler at the excellent site PortfolioCharts.com. The Golden Butterfly is composed of 20% large cap blend stocks, 20% small cap value stocks, 20% long term treasuries, 20% short term treasuries, and 20% gold. So about twice equity as other assets and some slice-and-dice to boot. My own passive portfolio is not too dissimilar: a different slice-and-dice in the equity portion; if you count REIT as real assets then that’s 20% of the portfolio including 15% PM; the fixed income portion takes advantage of stable value funds. In broad strokes, both can be described as 40% equity/40% fixed income/20% real assets.

The Current Multi-Year Trend in Gold

As disclosed in the first post on this site, I currently have a 16% allocation to PMs overall. That figure includes silver as well as mining company shares, both are highly leveraged to gold prices.

gld_gdx_correlation_20161001

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In particular, the unhedged gold miner index HUI/$GDX is leveraged about 4:1 to gold. 40% of my PM allocation is in mining stocks, in essence expressing a directional view that the bottom has been put in Dec’15. Could I be wrong? Sure, I reckon there’s a 25% chance that we’ll see a lower low from here, but the longer term trend should be up so the consequences of being wrong are not as severe. Some corroborating evidence for the bottom being in can be seen in this article. My current target price for gold this cycle is about $3500-5000 per oz.

My opinion on gold is based on my (admittedly limited) understanding of monetary history, but it is my own understanding nonetheless. It’s a fact that there are gold advocates who hold world views that some may find unsavory. Perhaps that’s why debates about gold as an investment option are often so heated and emotional. Personally I’m tired of a binary view of the world where there are only two camps of people and sharing a single trait or view with one camp automatically pigeonholes you into that camp with all other traits and views. I’ll leave it at that. Lastly it should be clear by now that I intend to time gold, albeit in a multi-year time frame. For my views on market timing please refer to Guilty as Charged.