How not to Invest in Gold!

Inflation Reality

Gold may be one of the most misunderstood assets, but if we assume Inflation to be real and interest rates will reach double-digit rates, a lot of misunderstanding around Gold should resolve itself. Gold is an essential investment. It is a commodity leader, it is more stable compared to other commodities, it’s popular, and it has a history as a currency.

Gold vs. Oil

Gold is a commodity leader more important than oil, as oil cannot replace money but gold can. Gold and oil are two commodities with different characteristics and drivers. The precious metal has a relatively stable supply, with most of the world’s supply already mined and above ground, while the supply of oil is constantly changing as new reserves are discovered and production levels fluctuate. Gold’s demand is driven by jewelry, investment, and central bank purchases, while oil is primarily used for transportation and energy needs. During times of economic uncertainty, gold is often seen as a safe-haven asset, while oil is closely tied to economic growth. Both gold and oil can be influenced by geopolitical events, but gold is often seen as a more stable investment. Research suggests that gold provides a hedge against inflation, while oil provides a hedge against geopolitical risk.

Gold vs. Stocks

Gold delivered nearly 10% annualized returns since 2000 while S&P500 delivered 6% annualized returns for the same period. Why is gold an underappreciated asset despite its outperformance? Is it because it is not news-generating? Or is it because Google delivered nearly 40% annualized return for the respective period? Or is it because many $ 1 T companies beat gold during this period? The excitement of individual stocks will always be more in a bull market and overshadow the double-digit return of gold. In some ways, gold behaves like a value stock, and hence it underperforms.

Gold’s Under-representation

Gold has about $ 11 T estimated value of mined gold in the world. Out of this about $ 1.9 T is held by sovereign funds. There is about $ 200 B in ETFs backed by gold. However, the distribution of yellow mental is clustered in specific regions. Hence there is an under-representation of gold. On average institutional and individual investors’ portfolios hold less than 0.1% gold in their portfolios. Nothing in comparison to an exaggerated over-representation of global wealth of more than 50% in real estate, which is bleeding because of high mortgages, and a fall in asset value, owing to the legacy of zero cost of money after 40 years of fall in interest rates.

34-Year Cycle And Exception To The Rule

The 34-year gold cycle guides liquidity flow from equity to Gold, as money shifts from paper to hard assets. Peter Cogan mentioned the Gold crisis cycle of 34 years in his article on predetermined periodic cycles of optimism and pessimism. The 1967-68 Gold crises, which climaxed with the end of the Bretton Woods system followed the 1933-34 Gold crisis. The article written in the 1969 issue of Cycles was visionary and is the only reference in nearly 70 years of Cycles literature. But the more interesting part is that the Cycle is still valid and working. After the gold crisis of 1967-68, we saw the crisis of 2000, where people believed in technology stocks and the paper dreams they offered compared to hard assets.

We took the historical prices and looked at lows to reconcile the 34-year lows. Economic cycles or long-term time cycles are defined by lows not by highs because greed highs are not as precise as fear lows. Teaching machines long-term trends begins by depicting long-term data and then training them about cycle biases, referred to as translation. A 34-year cycle that started in 2000 may not symmetrically push into 2017 highs but may translate (bias) into the early 2020s. This is how intuitively a time cyclist may think.

But for non-intuitive thinking, we need an economic historian, who might explain to you that historically more cycles have failed than succeeded just like the extinction of species. Just like the Nile cycle, which worked till the Egyptians made a dam on the Nile. A statistician trained in economic history and economic cycles will point to Campbell and Goodhart’s law of failure and reiterate that cycles are like indicators, destined to fail. The confirmation of a pattern does not eliminate the probability of its failure. Fear and loss of confidence in paper money can overcome the current peaking long-term cycle of gold and instead of topping and reversing, it could persist to new highs. And even if it indeed peaks and comes lower, remember it is a small part of the your overall allocation, which if your inflation assumption is correct might anyway warrant a longer term holding.

Gold’s Statistical Characteristics

Teaching Machines Gold Investing begins with understanding the existing statistical characteristics of Gold. Which of course as we mentioned is hindsight bias but still essential history to assimilate. Gold has a relatively lower and more robust serial correlation compared to Oil and S&P500. This makes gold relatively more stationary than the comparative assets in the discussion. Gold’s value classification which works against its popularity has a flip-side advantage as a great diversifying asset that can reduce overall risk in the portfolio.

How Not To Invest In Gold!

Jack Sauers, a Gold cyclist wrote about Gold linkage with market sectors and inflation in 1977. From the investor’s point of view, gold and gold stocks are looked at as being counter-cyclical. That is why when the stock market peaks out and reverses the trend, there is usually a rush to buy gold and gold stocks with investor funds obtained when industrial stocks are sold off as Dow Jones drops. There is thus a strong tendency to drive gold prices and gold stocks even higher. After the low of business cycles is reached and recovery starts again, gold and gold stocks are sold off and funds reinvested. Jack also explained why gold sometimes ignores the inflation trend of other commodities on the rising portion of the business cycle. As far as the average business cycle of 41 months is concerned, copper and silver rise as the cycle increases due to industrial demand, and gold decreases.

All this intermarket sector cyclicality may or may not work. And it’s possible that indicators may continue to work, but historically speaking taking exposure to Gold using gold miners (GDX) has been wealth destroying.

Gold miners are a weak proxy for gold prices. Since its launch in 2006 while GDX lost 50% of its value, Gold more than doubled in that period. GDX has underperformed an annualized 17% vs. Gold. There is a lot of economic explanation for this drag, but the simplest one is that commodity prices are one variable in a gold miners’ business model. The spread between a commodity stock vs. a commodity has a lot of noise, and that noise has historically worked dramatically against gold miners.

Even if our machines can predict inefficiency in the spread, we would rather use them to focus on more stable assets than focus on forecasting poorly designed ETF discounts vs. their underlying commodity. These ETFs also charge annual fees for delivering secular underperformance for more stationary ( losesly defined as mean reverting) assets that could just move up and down for years, not going anywhere, generating cashflow for the ETF manufacturer not the naive buyer of the ETF. Other ETFs package Industrial and Precious metals, but anything not physically backed is limited utility. Why would you want to buy tangible, real commodities, by buying paper not backed by collateral?

New Age Commodity ETFs

AlphaBlock is in the business of new-age ETFs. Commodity ETFs should focus on physically backed assets, should be designed to improve on the design flaws of market capitalized commodity benchmarks which like their equity counterparts are concentrated and risky. They should charge only on performance above conventional market cap benchmarks. And their underlying AI should be trained to work with slow-moving market regimes that assume conventional market patterns are ephemeral, visible today, and gone tomorrow.