9/29/2016 12:30:00 PM

Drew Mason

Investors are enjoying a stock market that is 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 fifteen 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 may be more “ledge funds” than many investors realize. Compounding these issues is the reality that Dodd Frank has largely vaporized the liquidity present fifteen years ago as previewed by the recent implosion of oil prices. However overshadowing the aforementioned issues, the world’s financial system may be even more 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 viable when the balance sheets of the leading sovereigns look as they do today? Yet against this backdrop, Wall Street continues to aggressively talk down the benefits of physical gold with client portfolios. This reality is manifest with near-ubiquitous 0% physical allocations in client accounts. Today the mere suggestion of using physical gold brings ridicule in the US as an “Armageddon allocation”. One investment professional at one of the nation’s most prestigious universities said that to suggest gold among decision makers today invites career risk.


Yet in China, (not to mention the rest of Asia, the Mideast, Russia and most of the developing world), the view towards gold is very different. Is it simply that Asia’s leading investors and its most powerful governments are simply ignorant of the financial insights gleaned from any financial tabloid at the supermarket checkout counter? Or perhaps Asians know something Americans do not? Perhaps the age-old rule about changing fundamentals now applies to American investors: Those who have benefitted the most in a financial paradigm will be the last to recognize its decay?


Unquestionably US 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 American investors should welcome a rational conversation on the real benefit of gold as foreigners understand: namely that gold it 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.


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, retired hedge fund manager.)
If an investor allocates 10% 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) ~0% allocations in western accounts 2) declining production 3) likelihood inflation rises from multi century lows 4) underweighting in emerging market reserves 5) network effect without credible alternatives. How much higher could gold trade? Taking a stab at that, if we consider the 40+ years that gold has traded freely in the modern era as a guidepost there are several notable metrics that triangulate around $6,000. Three of these include: 1) If gold’s move from trough to peak in this cycle compares 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 that point towards similar levels. Using that history let us consider two scenarios.


In the first scenario let’s contemplate that gold moves to the $6,000 mark. If one invests 10% of a portfolio into gold today at $1,175 per ounce and gold goes to $6,000, then the 10% of your net worth in gold today would expand to 50% of your current net worth.


If such a cycle were to play out, let’s just guesstimate that the other 90% of your current wealth not in gold may decrease in value by 50%. Bear in mind such a suggestion is not an Armageddon scenario – just a 1% move higher in interest rates reduces the value of a long bond by 18%. 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 another strong gold, “non-Armageddon” period). Even modeling for such a draconian market scenario, with just 10% of one’s current net worth diversified into gold, an investor would have preserved 100% of his current net worth.


Now let’s consider the opposite scenario and that the gold price falls by 50% from $1175 to $587.50. This would put gold well below its current cash costs let alone its fully loaded extraction costs when financing, government compliance, mine closures, etc. are included.


If gold moves from $1175 to $587.50 investors with a 10% allocation to gold would lose 5% of their current net worth …but that would likely indicate that something truly wonderful has happened in the world. For example since gold has been allowed to trade freely in America, there have been two periods where gold traded 50% 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% and in the second period the S&P rose 4.75x (Again, think about how attractively uncorrelated gold proves to be to these assets!) So if we consider the precedence of such equity performance during periods of intense gold stress, it may be conservative to believe that the 90% of one’s wealth invested away from gold would probably appreciate by at least 25% from today’s levels. Using that potential framework, the net portfolio would have appreciated in value by nearly 20% despite gold’s theoretical 50% haircut.


The point of this exercise is not to predict exact price levels of gold and equities. It is inaccurate to even say that the lack of correlation these assets have shown in past cycle must continue in this cycle. It is however relevant to consider how attractively uncorrelated gold continues to be to virtually all asset classes, particularly given current market levels and how gold allocations have impacted portfolios historically.


Rational investors buy home insurance, auto insurance, health insurance and life insurance each year - even though the statistical tables strongly suggest the buyer will have nothing to show for their investment at year’s end. This is obviously because the cost of a major setback makes the price of insurance bearable. On the flip side, the statistical tables whisper that there is strong probability that dollar investors and market participants need to future proof their net worth with uncorrelated gold given equity valuations, real estate IRRs and real bond yields. 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 ~0% gold allocation is enlightened … or complacent as it was in 1999 and 2008? There is value in true diversification … and peace of mind as Asia will tell Americans.


This article represents the opinion of the author. Gold is not guaranteed and may lose value. All numbers are for illustrative purposes only.