Striking Portfolio Balance with Gold Stocks
By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors
It wasn’t a pretty week for gold prices. The eurozone’s epic endeavor to conquer its sovereign debt issues forced some institutional investors to liquidate profitable gold positions to meet a rising need for liquidity.
In addition, falling confidence in the euro and other global currencies pushed investors tumbling toward the relative safety of the U.S. dollar. As we outlined for you last week, the key phrase is “relative safety” because we know that it could only take a slight breeze to blow the dollar’s house down.
Back on August 22, I wrote that gold was due for a correction and that it would be a non-event to see a 10 percent drop in gold. I wrote, “This would actually be a healthy development for markets by shaking out the short-term speculators.”
This morning’s gold price of $1,590 is about 15 percent from the high, which is a little greater than predicted, but a non-event just the same. I believe the long-term story remains on solid ground.
In a report this week, Credit Suisse reiterated the bull market for gold is not over, saying, “We do not believe the key fundamental drivers of the [gold] bull market have dissipated. While there are risks, in our opinion gold is getting close to attractive levels for new longs to be initiated.”
Gold Stocks vs. the Federal Budget
This chart, which we’ve highlighted several times, shows the size of the surplus or deficit in the federal budget. When the federal government is spending more than it takes in, gold and gold stocks tend to outperform the broader market. It’s important to point out that it’s the political policies, not political parties, that drive this phenomenon. During the 1990s, when President Clinton was in office, there was a budget surplus and investors could earn more on Treasury bills (about 3 percent) than the inflationary rate (about 2 percent). This gave investors little incentive to embrace commodities such as gold, and prices hovered around $250 an ounce.
Since 2001, increased regulation in all aspects of life, negative real interest rates, welfare and entitlement expansion funded with increased deficit spending have created an imbalance in America’s economic system. It’s this disequilibrium between fiscal and monetary policies that drives gold to outperform in a country’s currency. The Federal Reserve capped interest rates near zero back in 2008 and the federal budget deficit ballooned to $1.4 trillion. In fact, both the deficit as a percentage of GDP (negative 11 percent) and federal government debt as a percentage of GDP (nearly 65 percent) are at the highest levels since 1950. This has helped fuel gold’s rise through $1,000 and $1,500 an ounce.
Striking Portfolio Balance with Gold Stocks
Gold stocks have historically ranked among some of the most volatile asset classes. Over any given one-year period, it is a non-event for gold stocks to move plus or minus 38 percent. This DNA of volatility is about three times that of gold bullion, which carries an annual volatility around 13 percent.
Despite this volatility, our research shows that investors can use gold stocks to enhance returns without adding risk to the portfolio.
In 1989, Wharton School finance professor Jeffrey Jaffe completed an academic study that illustrated the effects of portfolio diversification into gold stocks. Jaffe’s original study covered the period from September 1971, just after President Nixon ended convertibility between gold and the dollar, to June 1987.
