As the “lazy days of summer” come to a close, investors have been enjoying a stock market near all-time highs. Similarly the bond market has been trading at prices literally not seen since the 17th century following 35 years of rate compression. It has been an extraordinary, if not unique, period in financial history. Yet as we learned twice in the last 15 years, when excesses correct, the price reset can be swift and painful for investors with too much exposure in correlated assets. And while it is true today that alternative allocations are up, many hedge funds have been beaten into submission on the short sides of their portfolios since few shorts have worked well in this QE environment. As a result, even alternative allocations and investingin gold may be more “ledge funds” than many investors realize.
Compounding these issues is the reality that the suffocating regulatory changes from Dodd Frank have largely vaporized the liquidity present 15 years ago as Wall Street’s tradition liquidity providers have left the business. An early preview of this new reality was seen in last fall’s implosion of oil prices. However overshadowing all these, the world’s financial system may be particularly vulnerable to sovereign debts, an issue that today seems to be viewed as a financial cancer permanently in remission post injections of QE therapy.
But if there truly was an easy solution to the global debt crisis, don’t you think it would have been tried by a host of governments already? And if the solution to excess debt was indeed QE, wouldn’t Ancient Rome, which practiced a version of QE, still be standing? Since when has issuing new debt to cover up old debt problems ever been a viable solution when balance sheets look as they do today for the leading sovereigns? Yet against this backdrop, Wall Street continues to aggressively talk down the benefits of physical gold. This reality is manifest with near-ubiquitous zero percent physical allocations in client accounts. Today the mere suggestion of using physical gold brings ridicule in the U.S. as an “Armageddon allocation.”
Yet in China, (not to mention the rest of Asia, the Mideast, Russia and most of the developing world), the view toward gold is very different. Perhaps Asians know something Americans do not? Perhaps the age-old rule about changing fundamentals now applies to American investors: Those who have benefited the most in a financial paradigm will be the last to recognize its decay?
Unquestionably, U.S. investors have enjoyed an unprecedented advantage over foreign investors with the sole reserve status of our currency and the dominant position American capital markets have displayed over the last century. So perhaps instead of quickly lumping gold into the category “for Neanderthals only,” wealthy Americans should welcome a rational conversation on the real benefit of gold as foreigners understand: namely that gold is beautifully uncorrelated to the dollar. This is tough to argue against, as not even Wall Street’s biggest bull would suggest the dollar will go on in its current supreme state forever – after all, nearly 100 countries are now trading outside of the dollar, a tell-tale sign when a sole reserve currency is in decay as we have seen on numerous occasions in global finance already.
And if the extraordinary benefit of gold as dollar diversification were not enough for Americans, an added benefit of gold is that gold is also attractively uncorrelated to stocks and bonds in the modern era, noteworthy in itself with those widely owned asset classes at historic highs.
Let’s consider some numbers and perhaps what foreigners understand may become clearer to American investors. (Credit for this perspective originates with Barry Kitt, the extraordinarily successful and now retired hedge fund manager.)
If a hypothetical investor allocates 10 percent of his net worth to gold at $1175, there are a plethora of reasons to see it going higher in the years ahead. These reasons include: 1) zero percent allocations in western accounts today 2) declining production 3) likelihood inflation rises from multi-Century lows 4) underweighting in emerging market reserves 5) network effect without credible alternatives. This near perfect setup begs the question:
Let’s consider two possibilities: First let’s contemplate why gold may simply return to its nominal high price around $2,000. Realize that is the level where gold traded in September 2011, when the European Union’s debts dominated financial headlines. With the status of Greece as it is today, a repeat of that macro is not necessarily far-fetched. Similarly, it is not unreasonable to envision that if such a macro again reared its head that financial markets could quickly trade down 15 percent. If 15 percent sounds overly dramatic, given our recent equity elevation, remember that is the pullback observed as gold moved toward $1900 in 2011, when the S&P corrected 16.5 percent from July to September alone.
Should such a scenario repeat, investors with a 10 percent allocation to gold would buffer such a market swoon notably better, hypothetically still retaining 94 percent of their original portfolio value with just a 10 percent allocation to physical gold.
The flip side to this first market scenario would be to see the gold market and the equity markets continue as they have for the past two years. Shrugging off any concerns during 2013-2014, gold fell 30 percent and equity markets rose 45 percent. Should such a scenario repeat, seemingly discounting a global economic and political renaissance, the same investor with a 90 percent allocation to equities and 10 percent allocation to gold would still see his or her portfolio rise by 35 percent.
This theoretical performance through enhanced diversification is itself noteworthy. But is $2,000 gold and a 15 percent market correction really the appropriate way to frame a discussion about proper risk management given the macro and markets today? Granted mainstream media ridicule a broader historical discussion as to the likelihood that $2,000 gold will be only a stepping stone and not a cyclical peak. But even if the media ignore the precedent for a gold price materially higher than $2,000 … should you ignore such a discussion and its historical implications on risk management?
History is clear that $2,000 will likely not prove the cyclical top for gold. What allows us to say that with conviction? Simply put, we are not aware of any other debt cycle in history where gold prices peaked out well before debt consequences matured. Today, any consequences of excessive debt have been papered over by trillions of dollars of QE. So if $2,000 gold is not the peak, where does history suggest gold prices may go?
If we simply consider the 40+ years that gold has traded freely in the modern era there are several notable metrics that triangulate around a similar target – and we don’t need to leave the shores of the USA to observe the case study.
Three converging metrics include: 1) If gold’s move from trough to peak in this cycle compares with that of the prior cycle, 2) if the value of America’s gold reserves relative to America’s fiat money supply returned to prior proportions, and 3) if the price of gold was inflation adjusted from the prior cycle using classic CPI.
Obviously just because gold traded in such a fashion during the last cycle does not mean that it will do so in this cycle – gold carries no guarantees. But this at least gives us three separate quantitative yardsticks to frame a conversation regarding what precedent suggests is ahead. All three quantitative metrics target a gold price north of $6000.
If such a number brings sticker shock, you are not alone in your reaction. But if one were to invest 10 percent of a portfolio into gold today at about $1,100 per ounce and gold were to rise to $6,000, then the 10 percent of your net worth in gold today would expand to 50 percent of your current net worth.
If such a cycle were to play out, let’s just guesstimate that the other 90 percent of your current wealth not in gold may decrease in value by 50 percent. Bear in mind such a suggestion is not an Armageddon scenario – just a one percent move higher in interest rates reduces the value of a “risk free” long bond by 18 percent. Rates would not even need to move to modern averages to see significant fixed income wealth compression. Recall also that in the last inflationary cycle the multiple of the S&P was indeed cut in half (FYI gold enjoyed a 24x move at the same time – happily it was just another one of many strong gold, “non-Armageddon” periods of metals outperformance). Even modeling for such a draconian market scenario, with just 10 percent of one’s current net worth diversified into gold, an investor would have preserved 100 percent of his current net worth.
Now let’s consider an even more ebullient economic renaissance bursts onto the global stage and the gold price falls by 50 percent from, say, $1175 to $587.50. This would put gold well below its current cash costs let alone its fully loaded extraction costs – but it is possible.
If gold moves from $1175 to $587.50, investors with a 10 percent allocation to gold would only lose 5 percent of their current net worth …but that would likely indicate that something truly wonderful has happened in the world. As precedent since gold has been allowed to trade freely in America, there have been two periods where gold traded 50 percent lower. The first was during the period from 1981-1984, and the second was from 1988-2000. During the first period the S&P rose by nearly 25 percent and in the second period the S&P rose 4.75x (Again, think about how attractively uncorrelated gold proves to be relative to paper markets!) So if we consider the data of such equity performance during periods of intense gold stress, it may be conservative to believe that the 90 percent of one’s wealth invested away from gold would probably appreciate by at least 25 percent from today’s levels – but let’s be conservative. Using that potential framework, the net portfolio would have appreciated in value by nearly 20 percent despite gold’s theoretical 50 percent haircut.
The point of this exercise is not to predict exact price levels of gold and equities. According to the research of Dr. Jeffrey Hart, a finance professor at the University of Iowa, it is inaccurate to even say that the statistically significant inverse correlation between these assets that has manifest itself for as long as gold has traded freely in this country must continue. It is however, relevant to consider how attractively uncorrelated gold continues to be to virtually all asset classes, particularly given capital market levels and how gold allocations have impacted portfolios historically.
The durability of gold as an asset providing wealth preservation even when other assets are stressed is why Asia continues to hoard physical gold. Do you think the American portfolio with zero percent gold allocation is enlightened … or complacent as it was in 1999 … and 2008? There is value in the unique diversification physical metals offer today, as Asians are so deftly trying to remind American investors.
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Drew Mason is the Director of Asset Management at Dillon Gage Metals. He worked for 15 years on Wall Street and was a founding partner in the Palos Harbor Fund, a physical gold income fund. He has written about and conducted interviews on the precious metals and optimizing secure metals storage globally via numerous media…
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