Outlook for Gold
Why do we bother listening to the so called experts when choosing the assets to put in our retirement plan or personal investments? To be frank, an investor who was not risk-averse could have just purchased the market at any point over the last 40 years and made money with a holding period in excess of 7 – 10 years. It’s easy right? The world is full of those who hypothesise and live in the rear-view mirror. The Monday morning quarter-backs preach the virtues of following Warren Buffets advice of holding stocks for the long-term. I agree. You should hold stocks for the long-term. You should also educate yourself around the intrinsic volatility associated with this approach. The reality is that most investors, retirement plans, endowments and family offices don’t have the stomach for this approach. In reality the typical investor sells when they should be buying and buys when they should be selling. Any attempt at trying to identify these precise entry/ exit points is besieged by danger and is folly. The number one rule of investing is to stay in the game. You stay in the game by managing your risk exposure. Rule number 2 [for anyone who cares] is to secure a reasonable entry price. You achieve this be securing intrinsic value and averaging your buying. Rule number 2 can only happen if rule number 1 is observed.
How do we manage risk exposures?
There are two main reasons why I personally invest in a broad allocation of assets. Firstly, I want to maximise my expected returns and secondly I want to manage the choppiness of my own investor journey. There is nothing seductively appealing about marinating in 20% to 60% market losses over a prolonged period. The only way to grow real, sustainable wealth is through a disciplined, repeatable managed process. If we can agree that it makes sense to own a broad range of investible assets that behave differently through the market cycle, then the obvious next question is which assets should I own? Each asset class has its own distinctive characteristics. For example stocks provide superior returns but there is a volatility premium, bonds should offer income but there are inflation, interest rate and credit risks, property is a good long-term investment but liquidity is problematic and commodities are a powerful inflation hedge but underperform for prolonged periods. They do however share one generalist trait; the price you pay at entry does determine the long-term value of the asset. Therefore price matters and outlook matters. It’s not what the asset has done that is important. It is what it is likely to do over the next 5 to 10 years.
Correlation
The correlation coefficient measures how Asset A moves in comparison to Asset B. For example how has gold performed over rolling 10 year periods versus equities since 1960? A correlation coefficient can take values from +1 to -1. Asset A and B are said to be 100% positively correlated if the correlation between the two is +1. Inversely, the correlation is said to be 100% negatively correlated if the correlation registers -1. In reality we never observe such extremes. Put simply, portfolio construction seeks to include assets that offer negative correlation to each other to reduce risk when storm clouds appear. How do we know that these assets are actually negatively correlated? We examine the data generated over investment generations and not just decades. Many fall victim to what is known as naïve diversification. Don’t be misled. Just because you have 30/40 different assets in your portfolio does not mean that you have diversification. Diversity does not equal diversification. Let’s go with another example. It’s September 2008 and you hold a large proportion of developed market equities, high-yield corporate bonds and REITS [Real Estate Investment Trusts]. You might consider yourself fairly well diversified across stocks, bonds and property assets. Unfortunately the common denominator for your portfolio is that you are inextricably linked to a long [positive view] on secular GDP or growth. Once growth and sentiment fade, the assets in your portfolio become positively correlated and fall together. This can be disastrous fuelling a negative mind-set leading to crystallization of enormous losses.
Solution
The good news is that we can take reasonably straightforward steps to protect ourselves from this scenario and I am going to focus on Gold for the duration of this piece. Perhaps outside of the current discussion surrounding crypto currencies, there has never been an asset class to stoke up more debate than gold. Its detractors will be negative on the long-term benefits of gold as an asset class highlighting that real values are lower than they were 35 years ago. This is a weak point in my view. It fails to account for the structural shift in markets arising from policy interventionism and declining confidence in paper currency. Others will point to its low utility in the real economy and the fact that it produces zero income. I would argue that gold does not have to produce income. Its ability to act as a safe haven, store of value offers much more attractiveness in an increasingly concentrated and positively correlated pool of assets. We cannot fully understand the benefits of holding gold in our portfolios without first digressing on the current state of play. We are in unprecedented times and people need to understand the reality of the situation. Successive US administrations have swollen the US FED balance sheet to the point that they may not be able to unwind the interest rate environment without blowing up the entire system. The recent evidence is instructive. We can cast our minds back to the autumn of 2018 when the FED attempted to deleverage their balance sheet and normalise interest rates. The subsequent market implosion forced the FED to reverse course. The problem central banks have around the world is that the debt is a constant. It is not transitory or latent. It is real and going nowhere. So Central Bankers have successfully backed themselves into a corner where they are now unable to normalise [raise] rates. In response, the FED was forced to cut rates and recommence their QE programme. They called it a different name but the dogs on the street knew that it was quantitative easing.
The time really is different
There are many who believe now that the FED has a credibility issue and this confidence trick is about to unwind. In the 1980 stock market correction gold was priced at $800. However interest rates were forced up to nearly 20% to curb inflationary pressures. If the FED cannot raise interest rates without imploding the market, how does it fight inflation? Perhaps it doesn’t. The question, as an investor, that you have to ask yourself in this environment is which asset class I want to have exposure to. The ramifications for the US $ in this scenario are also pretty dire. Covid-19 appears to have exasperated the situation with government interventionism on steroids. US citizens received pay cheques and production has been replaced with consumption. What is the end-point with US national debt? Is it $30trn or $40trn? There is a view that when global confidence in the reserve status of the US dollar crumbles then the barbarous relic [Gold] will be the ultimate beneficiary. It is astounding that the mere contemplation of the US dollar losing its reserve status is being debated at all. However this has not occurred over night. Its origins lie in the infamous August 1971 speech by Richard Nixon when he demolished the gold standard system. If gold was the reserve currency before the dollar then there is a strong likelihood that it will be the reserve currency after the dollar. A return to the gold standard would reinforce discipline on governments in terms of spending, prevent asset bubbles and facilitate trade through the stabilization of currency markets.
So how does this macroeconomic backdrop feed into our structural positive position on Gold? The thesis is that once central bankers around the world realise that the game is up they will be forced to increase their holdings of gold. At the time of writing [May 2021] central banks hold very little gold in relative terms. So who else buys gold? The list is exhaustive but should include Institutional funds, pension funds, endowments, family offices, hedge funds and retail clients. I will finish this note by saying that some of the best investment decisions in history went against the consensus view. When everyone agrees that it’s a good idea then it’s definitely time to get out. When people are laughing openly at these views you should have the strongest conviction. Easier said than done!
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