Gold is not compatible with traditional investing principles. In large part, this is because gold cannot be analyzed under the same fundamental criteria that stocks, bonds, and real estate can. Unlike these traditional investments, gold does not and cannot generate cash flow. It does not produce earnings, dividends, or interest payments. As a result, how do you determine the value of gold relative to its price? Why might an investor consider investing in gold if this cannot be done?
The simple answer is diversification, specifically gold’s unique ability to hedge against investments in financial assets like stocks and bonds when either of these may falter. The more complex answer is that gold can enjoy the occasional extreme bull market that can both enhance an investor’s portfolio returns and limit a portfolio’s volatility and risk.
Meb Faber’s Global Asset Allocation book is worth looking at closely in this regard. Faber took pains to examine how several buy-and-hold portfolios performed over a span of four decades, from 1973-2013. All of these portfolios primarily held stocks and bonds, and all experienced large losses, or “drawdowns,” during bear markets for stocks. But the portfolios that allocated to gold, as well as to traditional investments, managed to achieve lower volatility and drawdowns overall.
If you zoom in on gold and look at its performance at during different periods, it begins to make sense to take a tactical approach to investing in gold, not simply to buy it and hold it. For instance, we know that gold enjoyed an enormous bull market in the 1970s, particularly at the end of the decade when the price of gold more than doubled between November 1979 and March 1980, reaching an all-time high of $800/ounce. It was no accident that inflation in the U.S. had reached an extreme, as gold tends to rise in value during periods of inflation or economic uncertainty.
We also know that the price of gold crashed in the 1980s and 1990s, a period when financial assets like stocks and bonds enjoyed big gains. The boom in commodities and real assets like gold and oil that had occurred in the 1970s reversed sharply for nearly the next 20 years. In this way, the fluctuating price of gold reminds us that investing so often means dealing with extreme situations over time.
But then gold started a new bull market in the early 2000s that continued through the Great Financial Crisis of 2008-2009, peaking in 2011 at around $1800/ounce. The dollar plunged in value during this time as the short-term Fed Funds rate dropped to an unprecedented 1%, where it remained for one year in the early 2000s. Later, after the Great Financial Crisis blew up portfolios around the world with extreme drawdowns, the Fed Funds rate dropped to nearly zero for years, which prompted gold’s rise to its all-time high in 2011. Investors feared inflation would dominate the world, as it did in the 1970s.
But the inflationary fears that investors had worried about for the prior two years did not materialize. Indeed, deflation appeared the bigger risk. For the next several years, gold saw another bear market, bottoming at the end of 2015 at around $1000/ounce.
From 2016 to mid-2019, gold traded in a range from $1150 to $1400, and investors were wise to stand aside. But once prices exceeded this range for good in July 2019, a new bull market had begun. Since then, gold has risen to just under $1650/ounce, less than 10% from its all-time highs. Assuming the price of gold reaches a new all-time high in the next several weeks to months, look for the media to report it extensively, and more investors will likely pile in.
But how to capitalize on a bull market in gold? When to buy and when to sell? One of the axioms of index investors is that the markets cannot be timed effectively. As a result, buy-and-hold is the best approach. To this end, some indexers have advocated for a small buy-and-hold position in gold, perhaps 5% of a portfolio.
But momentum and trend-following investors see things differently. Simple and reliable methods can determine when a bull market exists for any asset and when one doesn’t. The simplest way is to periodically look back at performance over periods of time investors commonly use when rebalancing their portfolios. The most obvious lookback period is one year, but lookbacks of six months and three months work well, too.
The ticker for the exchange-traded fund (ETF) for physical gold is GLD, and it is worth determining whether GLD has generated gains over these relevant lookback periods. It is also worth determining how GLD has performed over the same time frame relative to more traditional investments like large U.S. stocks (S&P500), long-term U.S. treasuries (7-10 year), real estate investment trusts, and cash (short-term treasuries).
Here are the absolute returns for these asset classes over the past twelve months:
While the S&P500 and real estate have been very strong over this time frame, GLD has outperformed all of them.
Here are the absolute returns for these asset classes over the past six and three months:
Real estate and large-cap U.S. stocks have the edge over GLD with the six-month lookback, but GLD performed strongly over this time frame, too, and GLD is again the top performer over the past three months of all of these assets.
It is true that last week GLD had among its strongest weeks of performance since gold prices rose above the $1400 level. But even discounting this strong week would not deny GLD’s strong performance over these time frames.
Placing GLD in your portfolio based on its strong performance over these lookback period, and holding it from at least one month to one quarter, is a good way to get exposure to a bull market in gold with less risk. If GLD’s performance slips below that of cash over these time frames, or underperforms in relation to these other asset classes, selling some or all of the position makes sense, until the next evaluation period occurs. Allocating anywhere from 5%-30% would makes sense.
Why is the price of gold on the rise? Is inflation on the way? No one really knows until after the fact. But more than four decades of gold prices tell us that gold is in a bull market now, and that investors can benefit.