Gold And Your Portfolio

Gold and Your Portfolio WSJ says gold is a lousy investment. That might very well turnout to be the case, but the article has nothing useful to convince you about that. In fact, its so poorly researched. For example, consider this: What drives gold prices? It's an alchemist's mixture of fundamentals and fantasy. Gold certainly has industrial uses and it's a hot item for purchasers of jewelry, especially in India. But fundamentals don't support the soaring gold picture of late. As Carl Weinberg, chief economist at High Frequency Economics, a Valhalla, N.Y., research firm, notes: "Industrial demand for gold surely is depressed -- along with demand for other industrial materials -- and jewelry demand must be hard-hit by global recession." One would think he is bringing up the ‘hot item’ in India part to draw a connection to the demand, but he ignores it in the next sentence and goes on to talk about industrial demand. Its sad that an article that talks about gold says nothing about the price of gold being driven up by fears of depreciation of the fiat currency (USD). I can think of two questions that are important to the average investor saving for retirement: 1. How does gold compare with other assets? The reason that question is important is to understand if it has a place in your overall portfolio. It would be silly to sink your entire wealth into gold or for that matter any one asset class. 2. Does anyone know what the difference is between fantasy and fundamentals? For instance at 10,000 is Dow a fantasy or is it based on fundamentals? To answer question 2, I've reproduced Prof Robert Shiller's graph. Do those stock prices look like they are reflecting fundamentals - i.e earnings?

1800

400

1600

350

1400

300

1200

250

1000

Price

200

800

150

600

100

400

50

200

Earnings

0

1870

Real S&P Composite Earnings

450

Real S&P 500 Stock Price Index

2000

1890

1910

1930

1950

1970

1990

0

2010

Year

My point is that asset prices are affected by: 1. Actual fundamentals 2. Perceptions of actual fundamentals and future expectations of fundamentals, and 3. Supply/Demand. It doesn't matter if supply/demand is driven by fact or fantasy - in fact its hard to reliably say which it is, which is why history is among the best guides you have. By no means is it the only one.

In any case, let's take a look at gold and compare it to stocks. The following chart shows growth of $1 invested in gold and stocks. CPI is the proxy for inflation.

Gold, Inflation and Stocks

15 0

5

10

Value

20

25

GOLD CPI S&P Total Return

Feb 1970 Aug 1975 Feb 1981 Aug 1986 Feb 1992 Aug 1997 Feb 2003 Aug 2008

Date

So what are the annual returns - nominal and real? Gold Nom. Return

CPI

S&P

8.84%

4.48%

7.25%

Std Dev

19.92%

1.17%

15.58%

Sharpe Ratio

44.40%

46.53%

Real. Return

4.19%

2.62%

Stocks are marginally better in the long run (in terms of volatility and sharpe ratio), but in real terms gold is much better. The higher volatility of gold is only to be expected - its a commodity and most commodities are volatile because they are real assets with no cash flows. The only thing that determines their prices is supply and demand. Sure, history may not repeat itself, but it does say something about which of these assets has offered better inflation protection in the past!

Let's look at correlations over the entire period from 1970 to now (Oct 2009): GOLD GOLD

CPI

S&P Total Return

100.00%

13.80%

-1.10%

CPI

13.80%

100.00%

-11.67%

S&P Total Return

-1.10%

-11.67%

100.00%

Well, well. At -11.7%, stocks are negatively correlated with inflation (realized) and gold is positively correlated with inflation (14%). These numbers are monthly correlations. So in the aggregate stocks have not protected you adequately in the presence of inflation. My other chart here clearly shows stocks got clobbered during the only seriously inflationary decade the US has seen. See for yourself how your purchasing power would have been protected/suffered with these two asset classes.

Gold (Real) S&P (Real)

4 0

2

Value

6

8

Gold vs Stocks - Real Wealth (since 1970)

Feb 1970 May 1975 Aug 1980 Nov 1985 Feb 1991 May 1996 Aug 2001 Nov 2006

Date

OK, now I admit these figures may suffer from a period bias - that is, these results may be partial to gold given its current price, but they also have the most inflationary period in the history of the US. Let's try to see if rolling performance shows anything. One thing you can tell is that gold is just as much subject to delusions as stocks are except that some of these

"fantasies" appear to be driven by people's expectations of inflation.

Rolling 24 month Perf

0.4 0.2 -0.2

0.0

Annualized Return

0.6

0.8

GOLD CPI S&P Total Return

02/70

05/73

08/76

11/79

02/83

05/86

08/89

11/92

02/96

05/99

08/02

11/05

02/09

So it does deserve a place in a diversified portfolio, especially when you look at its correlation with stocks which ranges from mildly negative to about 50%.

0.0 -1.0

-0.5

Correlation

0.5

1.0

Rolling 24 month Correlations Stocks vs Gold

Jan 1972

Apr 1977

Jul 1982

Jul 1987

Jul 1992

Jul 1997

Jul 2002

Jul 2007

Date

According to Martin Wolf, gold is kind of like VIX for currencies, especially the USD. Its reflects the fear that the currency is depreciating rapidly: Higher prices of gold reflect fear, not fact. This fear is not widely shared. The US government can borrow at 4.2 per cent over 30 years and 3.4 per cent over 10 years. During the crisis, the inflation expectations implied by the gap in yields between conventional and inflation-protected securities collapsed. These have since recovered – yet another sign of policy success. But they are still below where they were before the crisis. The immediate danger, given excess capacity, in the US and the world, is deflation, not inflation. For your cogitating pleasure, here's a table of annual returns on gold and stocks. Stocks are represented by S&P return including dividends. All numbers are in percentages.

1970 1971 1972 1973 1974 1975 1976

GOLD Stocks 7.2 8.4 16.1 10.8 47 15.6 67 -17.4 72.3 -29.7 -23.7 31.5 -4.1 19.1

1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

22.6 37 126.5 15.2 -32.6 14.9 -16.3 -19.2 5.8 19 24.5 -15.3 -2.2 -4.6 -7.7 -5.3 16.8 -1.9 1 -5 -21.4 -0.3 -0.1 -5.5 2.5 24.8 19.4 5.5 17.9 23.2 31 5.8 14.2

-11.5 1.1 12.3 25.8 -9.7 14.8 17.3 1.4 26.3 14.6 2 12.4 27.3 -6.6 26.3 4.5 7.1 -1.5 36.2 22.7 33.4 28.6 21 -9.1 -11.9 -22.1 28.7 10.9 4.9 15.8 5.5 -37 19.3