Thursday, September 15, 2011

Gold Update

Gold has been an outstanding investment over the last decade.  I remember 2000, when the price of gold was about $250 and the Dow Jones Industrial Average roughly 10,000 (or 40 times the price of an ounce of gold).  I said at that point I'd much prefer to hold gold than the Dow Jones, which though not nearly as overpriced as the NASDAQ at the peak of the internet stock mania, had just had an 18-year bull market.  

The probability was for poor returns from the stock market in the coming decade, based on its historic overvaluation and its strong past returns.  After all, when gold last peaked in 1980, the ratio of the Dow Jones to an ounce of gold was roughly 1:1.  I argued in 2000 that the ratio wouldn't necessarily reach 1:1 again, but it was highly likely to move in that direction.   And it has.  Today, the Dow Jones to the price of gold is about 6:1  So might gold rise much more before its bull market is over (or the Dow fall sharply), or is that stretching a historical coincidence too far?

It also seemed that gold was likely to be a good investment, for two perhaps cynical reasons.  Alan Greenspan, who at the time was revered by many, was running a reckless monetary policy (and undermining the value of paper money).  Also, Gordon Brown and the UK government sold its entire gold holding at about $250 per ounce.  (I was not impressed by the savvy of government officials and thought one should go contrary to their financial actions.)

Gold has indeed been an outstanding investment over the past decade (11 years, actually) rising from $250 in 2000 to a recent high of over $1,900.  This sevenfold gain in gold (roughly 20% annualized) over the last 11 years occurred when the U.S. stock market was roughly flat (plus about 2% per year on dividend income).

Throughout the last decade, the policies of Greenspan and Ben Bernanke have been extraordinarily positive for gold.  Gold has historically performed well when real short-term interest rates have been negative (that is, short-term interest rates minus the rate of inflation).  Rates have continued to be negative, and recent upticks in inflation measures in the U.S. and the U.K. solidify this positive indicator for gold.  So for this and other reasons, I think that gold remains in a bull market and that most portfolios warrant even a modest allocation to gold.  I'd suggest a core allocation of 5-10%, with a potential range of 3-20%.

I hesitate to place too much emphasis on seasonal trends or averages, but gold's bull market has, like many bull markets, had periods when the price rise became too sharp and led to a significant pullback.  As gold had risen nearly 50% over the past year and 30% this year, a pullback seemed likely (as I wrote on 8/10 and 8/25).  During previous episodes, the gold price pulled back to close to its 200-day moving average.  In the autumn of 2009, gold rose to about 20% above its 200-day moving average before declining about 15%.  In the autumn of 2010, gold rose to about 15% above its 200-day moving average before declining 10%.  This year, gold recently rose to nearly 30% above its 200-day moving average.  A return to close to the 200-day moving average would result in a decline of about 20% from its recent peak (without necessarily ending its bull market).  The gold price has declined about 6% already, so the odds favor a further pullback of perhaps 10-15%.

For those with more than 20% of their assets in gold, I suggest reducing positions even at current levels.  For those with modest or no positions, I'd wait for a further pullback and make meaningful purchases when the price has fallen further and sentiment measures fall to extraordinarily low levels.

Steve Lehman

Gold:  1777

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