There's Gold in Them Hills

Dan Shainberg

September 9, 2018

Since QE1 gold bulls have been prognosticating the imminent collapse of the U.S. dollar. It has been a decade and their dire warnings signs have yet to show up in any meaningful manner. Spot gold prices have gone nowhere for the past year and remain stubbornly range bound. Gold currently rests under $1,200/ounce and is down (-7.3%) over the past two months. The U.S. dollar is in fact appreciating relative to Gold and foreign currencies which are under pressure as the Fed raises rates in a steady, predictable manner. 

Are the gold bulls wrong? Will the dollar collapse? What signs can analysts research to determine whether or not the shiny yellow metal is worthy of holding in their portfolio?

The market consensus implies an aggressive Fed with 4-5 rate hikes and a reversal of QE which has a classic money "tightening" effect. For gold to move meaningfully higher the headlines need to "do a 180." The most obvious catalyst for such a reversal would be a change in the perception of Fed policy which could come as a direct result of a weakening economy, declining GDP expectations or reductions to the headline inflation figures. 

There are a number of likely triggers that could cause the required change in market perception. The list below is a consolidated set of common sources from opinions of popular economists. 

(1) Material drop in the stock market

(2) Sudden rise in interest rates 

(3) Widening credit spreads 

(4) Acceleration in price inflation 

(5) Chinese economic slowdown

(6) Reduction in securities based margin

This newsletter is not just an opinion piece on the economy. Our goal as investors is to actually put capital to work. That is a very tough task today should you have any return hurdle rate and/or risk mitigation strategy. Interest rates on traditionally "low-risk" assets are weak and unlikely to beat inflation. Returns on the equity markets are reasonable in a historical context but only if you believe the denominator (EPS) is stable. If the economy turns south and earnings decline, then today's ~20x P/E could easily prove to be overvalued resulting in a devastating dual hit of margin compression and multiple contraction. 

In such a scenario the stock market could see declines of 40-50%, and this is precisely the risks the gold bugs like to highlight. But rather than investing in a shiny yellow metal rock that costs nearly $1,200 per ounce, one can still build a portfolio of value oriented equities that have low correlation to the economy. By building such an equity portfolio, you can avoid the headache and extremely difficult requirement to predict the future and timing of the macroeconomic cycle. 

In order for a gold bug to "win" they would need both a catalyst for a trend reversal and accurate timing for such a catalyst to hit near term. For nearly a decade these gold bugs were proven wrong on at least the timing aspect. But by building a recession resistant portfolio of value oriented stocks, you can continue to generate reasonable returns regardless of the macroeconomic outlook. You likely won't beat the market if we have another super bullish year with growth materially outperforming value, but you should also continue to be rewarded as a patient investor when the economy turns south. 

There are numerous mid-cap value oriented equities with cash flows that yield north of 10% relative to their market capitalization. These companies also often have business models that are minimally correlated to economic cycles. Whether or not the economy improves, falls stagnant or even declines, these Warren Buffet style companies seem to be a much better risk/return for those who do not have strong confidence in a near term market or economic reversal.

It is for this reason that those interested in gold should really question whether or not that high barrier for generating a return in the asset class is truly the best place to invest. 

Dan Shainberg

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#RecessionResister

@DanShainberg