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"Gold always shines bright"  and "Commodities rulez" strategies

1. Introduction
2. Popular 401K investors delusions
3. Fashionable mutual funds mix
4. Follow the leader
5. Naive siegelism
6. "Financial alchemist" strategy
7. Stable value only or "Depression might start tomorrow" strategy.
8. Bonds-based strategy
9. "Gold always shines bright"  and "Commodities rulez" strategies
10. Lifecycle strategies
11. Economic cycle based market timing
12. Combination of lifetime strategies with market timing.
13. Conclusions
14. Webliography
15. Old News

This is a strategy which bets on the unstoppable desire of governments to abuse printing press,  with possible replay of stagflation and/or a significant energy or currency crisis.  As recent event had shown it can be a very profitable strategy. The problem is that it is usually is not available to 401K investors. 

Gold and energy stocks are just asset classes but some people, especially those who distrust government, have a tendency to use them as the major part of their portfolio. This approach works only for Roth and IRA (or SEPA) as most 401K plans do not have access to gold or other precious metals ETF and seldom have access to pure energy related mutual funds.

The concern is that  the current world economic landscape have so serious built-in imbalances that debt-based economy is unsustainable "in the long run" and eventually might lead to (or at least contains significant probability of)  a serious economic downturn. Meanwhile the country is expected to enter another stagflation period, the period associated with a significant and lasting pain for those who kept significant portion of assets in stock and bond portfolios. Many in this category of thinkers predict eventual market crash a la 1937. Typical example are so called "gold bugs". 

Still somehow the USA economy is humming forward for the last 35 years since fiat currency was introduced by Nixon's in his landmark 1971 decision to remove the US from gold standard. So far there were no major crisis (recession 2001-2002 was pretty mild; but that can probably be explained by rapid expansion into former USSR region that occurred at this time as well as dollarization of this part of the globe).

Actually any particular year you can find extremely plausible and convincing predictions of the major crises that looms directly in frond of us.  Some optimism can serve as a useful antidote to this strategy.

Nevertheless the key assumption might be valid: the US currency is a fiat currency and the temptation to abuse fiat currency by the government  historically proved to be irresistible. While excesses of Greenspan era and Bush's tax cuts are two recent examples this became more plausible. With Iraq war this became even more probably: generally wars were/are the most powerful causes of inflation. It is unclear if Iraq war can  serve this role due to its limited scope and availability of Iraq oil to offset costs: government tries to provide both guns and butter and can do this only by unleashing the money press.

But from this point of view the idea of confiscation of existing 401K accounts by Fed looks a realistic option (notes that CPI currently understates inflation): if you gradually sink the dollar then the deficit problem is much easier to handle. Assuming 40% sinking in 10 years and the fact that holders of 401K accounts have very limited options of hedging against inflation the only realistic countermove is owning a real estate. 

But against this view is the fact that long term Treasury interest rate is around  5% which suggests that institutional investors have little worry about the problem of sinking dollar. If you think about it  China and other Asian countries are one huge deflation factor: currently and in the next ten-twenty years they have nowhere else to sell all the products they make.

Gold is not always a good choice for 401K investors and should be used sparingly even if it is assessable in 401K or (more commonly) Roth account. The most important question is not whether to own or not to own gold but what should be your gold weighting in your portfolio. It seems rational to view holding of gold as insurance. When purchasing insurance one doesn’t dwell on the opportunity cost or holding cost.  People buy health insurance because the possibility of a catastrophic loss however hard to define is always present.

I think that it should be approximately 5%-10% (weighting similar to TIPs) and that gold should be bought only on dips, not as cost averaging basis as the cost of carrying a gold balance is actually negative (gold does not produce any dividends, so the only source of income is price appreciation).  Other concerns about holding gold are governments’ sensitivities to its use as a fiat currency alternative as well as the effect of hedging and Central Bank sales. Still long term appreciation of gold should be comparable with appreciation of bond index even if inflation will not strike. The wild card in gold  – China – is accumulating gold and quietly and not so quietly moving away from the dollar.

Five Reasons to Avoid the Gold Rush

By Guest Author - September 9th, 2009, 8:30AM Vitaliy N. Katsenelson presents the counterpoint for the gold argument:

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The reasons why one should sell the cat, pawn the mother-in-law, and use the proceeds to buy gold are well known: the Fed is printing money faster than you can read this, which will result in inflation; the government is borrowing like a drunken monkey, so the dollar will be devalued; this will debase all currencies, so the only thing that will save you is the shiny metal.

However, here are some arguments why one should think twice before jumping in bed with gold bugs, or at least remain sober while determining gold’s weight in the portfolio .

1. For investors (not speculators) it is very hard to own gold, because you cannot attach a logical value to it. Unlike stocks or bonds, gold has no cash flow and has a negative cost of carry – it costs you money to hold it. It is only worth what people perceive it to be worth right now. The argument I commonly hear is, “What about all those Enrons, Lehmans, Citigroups, etc. that either went bankrupt or got near it? What was the value of those?” If the lesson learned is not to own stocks but to own gold, it is the wrong lesson. The lesson should be: own companies you can analyze (the aforementioned companies were unanalyzable) and diversify – don’t put your all net worth into one stock.

2. The gold ETF SPDR Gold Shares (GLD) is the seventh largest holder of physical gold in the world. If its holders decide to sell (or are forced to sell; think of hedge-fund liquidations), who will they sell it to? This is extremely important, as the presence of GLD changes the dynamics of the gold price, both to the upside and downside. If gold keeps climbing, the ease of buying will drive gold prices higher than in GLD’s absence. In the event of a significant sell-off, there are not enough natural buyers of physical gold. It is a bit like a roach motel – easy to get in, hard to get out.

3. In the past, gold had a monopoly on the inflation and fear trade. Not anymore. Now you have competition from Treasury Inflation-Protected Securities (TIPS), currency ETFs, short US Treasury ETFs, government guaranteed/insured FDIC checking accounts, etc. TIPS suffer from the flaw of the CPI being measured and reported by the US government, which has an inherent bias to understate inflation; returns of commodity ETFs are skewed by price differentials between financial derivatives and spot prices of underlying commodities; returns of leveraged ETFs diverge significantly over the intermediate and long run from the underlying index; FDIC reserves are being depleted with the every-Friday-night bank bailout (but believe you me, the US government will not let FDIC go bankrupt, even if it means it has to raise taxes and impose draconian fees on the banking sector).

The bottom line here is this: none of these investment vehicles are perfect, in fact many have significant flaws; but despite their flaws they attract money away from gold, thus undermining gold’s monopoly on the fear/inflation/currency debasement trade. (I’ve discussed it in greater detail in my book).

4. If, because of points 2 or 3 above, gold fails to perform as expected, the perception of what gold is worth may change dramatically.

5. Over the last 200 years, gold was really not a good investment. It may have a day in the sun, but it may not. And the cost of being wrong is fairly high.

Though gold bugs make it sound as such, gold is not the only and not the best alternative if the worst fears come to pass. The best way to deal with the risks of dollar devaluation and high inflation – with a much lower cost to being wrong – is, instead, to own stocks of companies that have pricing power of their product. When inflation hits, they will be able to raise prices and thus maintain their profitability. Also, companies that generate a large portion of their sales from outside the US will benefit from the declining dollar.

Gold bugs look at gold as a currency, but it is not one and unlikely to be one in our lifetime. Here is why: there is not enough of it around, so even if world government were to adopt a fractional system (currency in circulation as a multiple of gold reserves), they will never go for it, because central banks and governments will never give up their monetary tools – inflation is a very addictive tool to fight growing monetary obligations.

There is a wild card in the price of gold, though: China (John Burbank made that argument at the Value Investor Congress in Pasadena). If it decides to switch partially from owning US Treasuries to owning gold, the price of gold will skyrocket.

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Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.