When we last checked in on gold nearly a year ago, it had recently suffered a two-day decline of more than 13%, dropping in price from $1,560/oz. to $1,350/oz. While gold prices would continue to decline all the way to the $1,200 range, it has since recovered to the mid-$1,300s. Our thinking on gold has evolved somewhat in recent years, so we thought an update was in order.
One reason we haven't written more on gold over the years is it tends to be a subjective and speculative subject. Here's what we mean by that. With stocks and bonds (and most other investments that relate to a specific business), objective measures of profitability can be used that lead to a reasonable estimate of the value of a company. That valuation can then be used to determine appropriate values for a company's stocks and bonds. Yes, there's some opinion involved (for example, are revenue and earnings likely to accelerate or slow?), but the basis is objective data. The company earned X dollars last year, it has Y shares outstanding, therefore a reasonable estimate of the value of a share is Z.
To an extent, the stock market collectively can be evaluated this way as well, which is why you're constantly bombarded with analysis as to whether the market as a whole is over- or under-valued.
With gold, on the other hand, none of these objective standards exist. Gold doesn't earn anything, and it isn't particularly useful in and of itself. Sure, there are always numerous arguments as to why its value should be higher or lower than at present. But for the most part, the same arguments for/against gold's value today were the same arguments in play when gold was selling for $1,900 in late 2011. When an asset can swing in price nearly 40% while retaining most of the same talking points for/against it, those arguments likely aren't based on objective measuring sticks. They're opinions, and SMI tries not to ply our trade there.
Gold can play two very different roles within an investment portfolio, depending on the reason it's being acquired. Let's look at each role, and how we suggest investing in each case.
As “insurance” against high inflation and a weak U.S. dollar
In this case, gold is typically held for the long-term to serve as an "investment of last resort." The idea is to protect oneself against worst-case scenarios that could wipe out the value of many other conventional investments.
In this day and age, gold might be thought of as "Central Bank Insurance" — protecting to some degree against the unintended consequences of the seemingly unlimited printing of money by the Federal Reserve under the guise of "stimulus." Realistically, this insurance function has a low probability of being needed, but an extremely high payoff if it is. If the U.S. experiences hyperinflation or the dollar is ever replaced with another type of currency (hard as it is to imagine), it's likely that physical gold would retain its value through that transition while most other kinds of investments would suffer.
In this role, physical gold is the preferred investment. The "paper gold" options, such as the GLD exchange-traded fund, wouldn't be as desirable due to questions about the convertability of those assets into actual gold. Because of this, long-term accumulators of gold focus their energy on buying non-numismatic gold coins or bars, often dollar-cost-averaging over time or buying during periods of gold-price weakness.
For gold coins, SMI has recommended buying South African Kruggerands as they tend to sell with low premiums. But any pure bullion coin (American Eagle, Canadian Maple Leaf) will work for this purpose. For gold bars, we have found GoldMoney.com to offer storage, safeguarding, and convenient features at reasonable commissions. The firm offers a savings-like account where you can buy, store, and sell your gold.
As a capital-gains play
The second role gold can play in a portfolio is more speculative, as an investor tries to capitalize on the significant swings in gold prices that occur over time. This usually leads to holding gold for shorter periods. Prior to 2010, this was an area SMI tended to shy away from due to the inherent difficulty of timing
However, in the immediate aftermath of the 2007-2009 financial crisis, we introduced a portfolio of Optional Inflation Hedges (OIH) that included gold-mining companies as one of four permanent components. This new optional portfolio was created in response to the concern many investors had that Federal Reserve money-printing was going to lead to higher inflation. With the Fed now withdrawing much of this stimulus, concerns about an imminent inflation spike have diminished, though not completely disappeared.
Our view of the gold holding in OIH has changed over the past year. First, the economic environment has improved and the inflation risk seems to have been reduced. Second, and more importantly, we now have the Dynamic Asset Allocation strategy, introduced at the beginning of 2013. Prior to DAA, including an allocation to gold-mining stocks in OIH seemed like a reasonable way to hedge the inflation risk — as gold prices rise, the value of mining stocks has historically risen even faster.
However, we now believe that DAA can provide similar inflation protection, but only on an "as needed" basis. Whereas the gold component in OIH is a permanent feature of that portfolio, gold is only held in DAA when gold momentum is upward.
DAA includes two asset classes that are designed to respond to rising inflation — gold and real estate. But DAA allows us to own those only when conditions call for them, allowing our money to work in other asset classes the rest of the time. That's a huge benefit. Last year was a great example of this. OIH's gold component of precious-metals mining stocks lost a sickening 50% of its value in 2013. (Gold itself was down about 28%. Just as mining shares "overreact" on the upside when gold prices are rising, they do the same on the downside when prices are falling.)
DAA, on the other hand, was out of gold all of 2013. Instead, the portfolio was focused primarily on the booming stock market. In fact, our backtesting shows that DAA would have exited gold in 2012 when its price was over $1,650 and not owned it since. When OIH was introduced, DAA hadn't yet been created. But now that we have DAA, we think it's the better tool for investors who use gold to play a shorter-term speculative role rather than a long-term insurance role.
For the time being, we will continue publishing the OIH recommendations, perhaps refining the strategy as we go forward. If gold initiates a new uptrend, the gold-mining funds in OIH should do well. The OIH portfolio also includes recommendations in real estate (as does DAA) as well as energy and emerging markets (which DAA does not).
Pulling it all together
For those desiring "currency insurance," SMI still believes that owning a small amount of physical gold as part of a well-diversified portfolio is a reasonable (though certainly not mandatory) stance. This can provide peace of mind, and if the worst-case scenarios ever do play out, physical gold will be extremely helpful. However, for most readers, we recommend limiting this allocation to 5-10% of the total portfolio.
Of course, readers allocating a significant portion of their portfolio to DAA will find their overall gold allocation rising sharply on occasion due to the additional gold exposure built in to DAA. When gold is moving higher, DAA has the ability to shift one-third of its portfolio into gold. Granted, this is the "paper gold" ETF rather than coins or a bar in your home safe. But, in anything shy of outright disaster, it will respond to changes in gold's price in roughly the same way as physical gold. DAA would have boosted portfolio profits dramatically throughout gold's long run during the last decade, and it would have been easily liquidated once gold began to fall in recent years.
For most readers, relying primarily on DAA for gold exposure is likely sufficient. DAA offers a strategy that can accurately value gold relative to other investment options on an ongoing basis. Hopefully, its inclusion in our toolbox will allow you to put your gold investing on autopilot, simplifying your decision-making while simultaneously making your gold investments more profitable.