Thoughts on the Role of Gold in an Investment Portfolio

  • There are many arguments describing the role of gold
    Some investors view gold as a hedge to stock market fluctuations. Others point to the role of gold as an alternative to fiat currencies, and yet others view gold as the ultimate store of value.
  • These roles change over time and in importance
  • The value of gold may be its ability to play multiple roles
    As global capital markets are yet again dominated by extreme macro-economic uncertainty, gold appears to be behaving as a hedge against extreme equity market movements, a store of value and alternative to fiat currencies.

Given its performance superiority over plain vanilla equities since 2000, gold has become a very popular investment vehicle in the last ten years. But back in the late 1990s, few investors had any need for gold in their portfolios. Gold mutual funds were liquidated (as I witnessed at Pioneer in 1999), with- out a peep from a financial press mostly preoccupied with “asset light” investments. Even the Swiss Central Bank sold gold (along with their Australian and English counterparts). The bursting of the TMT bubble in early 2000 led investors to refocus on hard asset strategies, including gold. Investor interest since then has continued unabated, no doubt fueled by attractive returns year after year (the last negative calendar year return was in 2000, see Figure 1 below), and the advent of easy to trade and inexpensive commodity exchange traded funds (the largest of which, GLD, launched in November 2004).

Gold is sometimes described as the ultimate “post-rationalization” investment. When asked why people hold gold, the answers run the gamut depending on the mood of the markets at the moment. Fre- quent rationales for owning gold include: a hedge against extreme stock market volatility, downside protection should there be an economic and stock market collapse, a store of value or inflation protection, and as an alternative to fiat currencies such as the U.S. dollar. Gold has also been referred to as a “sentiment” asset, given its limited industrial uses and its lack of associated cash flow attributes, which is Warren Buffet’s main argument for disliking gold as an investment.

Let’s look at the correlation of daily gold spot returns to that of:

  1. U.S. stocks (the diversification and downward protection rationale implying negative return co- movement),
  2. the U.S. dollar (the alternative currency argument implying a negative correlation), and
  3. U.S. TIPS inflation breakeven rates (the store of value hedge implying a positive relationship
    between gold prices and changes in inflationary expectations).

Figure 2 shows the correlation coefficients using daily data since the rebirth of the popularity of gold (2000 forward) as an investment vehicle.

The correlation between gold and stock returns is negative, but it’s statistically indistinguishable from zero, leading us to conclude that the hedging argument for owning gold to protect against stock market declines is, on average, not supported by the data. Daily gold returns seem almost completely independent of stock market returns.

When looking at the Gold/USD relationship the coefficient is negative and marginally statistically significant (at the 90% level). This lends empirical support to the argument that gold behaves as an alter- native to fiat currencies.

Finally, the correlation between changes in inflationary expectations (using inflation breakeven rates) and gold prices is, as expected, positive and statistically significant.

  • On the surface it appears that the inflation hedging and currency alternative roles of gold in an in- vestment portfolio carry more empirical merit than the most often cited use of gold as a hedge against stock market movements.

Gold as the ultimate “sentiment” asset may exhibit more distinct and varied roles than implied by these average correlation numbers. In a sense, the value of owning gold can be seen as being derived from its many roles and how they may change over time. For example, at times gold may provide down- side protection against stock market movements, while at other times it may behave as yet another risky asset. The same time-varying relationship may exist for the Gold/USD and Gold/Inflation linkages.

In order to better understand these dynamics, we estimate a 252 day rolling regression with gold re- turns as the dependent variable and the variables of interest (stock returns, USD, breakeven rates) as the independent variables. The coefficients from these regressions can be interpreted as “betas” or measures of response. Figures 3, 4 and 5 illustrate the time evolution of the response or beta estimates. If the pre- viously mentioned arguments for the various roles of gold are valid, we’d expect negative betas for stock returns and the U.S. Dollar, but a positive coefficient for the inflation breakeven rates.


A cursory glance at Figures 3-5 quickly dispels the notion of stability. Gold seems to have a variety of roles, and these roles change over time and in importance. Before 2005, the relationship between gold and stock returns as depicted in Figure 3 seemed nonexistent. In 2006 and 2007 gold behaved more like a risky asset (correlated positively to stocks), but since the Financial Crisis of 2008 it has acted more as a hedge against stock market movements.

Similarly, the role of gold as an alternative to the U.S. dollar is corroborated by the data only since 2010, or since the credibility of monetary authorities has been under consistent attack. Prior to this, gold prices and the U.S. dollar had, for the most part, a weak but positive daily association.

The time series of betas relative to inflationary breakeven rates depicted in Figure 5 shows a mostly positive role for gold as an inflation hedge. However, there are a few periods (mostly late 2005-early 2006) when gold returns are inversely associated with changes in breakeven inflation rates.

One argument investors sometimes make for justifying holding gold in an investment portfolio is protection against significant large negative stock market returns. For example, last Friday’s (June 1st) stock market collapse and the contemporaneous positive 4% return to gold that day provides support for using gold in this manner. Figure 6 illustrates the empirical support for this role when evaluating the re- lationship between gold returns on days when stock market losses exceed –1%. The beta coefficient should be negative if gold investments are to offset extreme daily market losses; for the most part, the evidence is consistent with our expectations. Note the strong negative relationship between gold and extreme S&P 500 losses since 2011.

CONCLUSIONS

Holding gold in an investment portfolio has become extremely popular in the last decade, only part- ly due to its price resurgence since the lows at the end of the last millennium. There are many “post- rationalization” arguments describing the role of gold. Some investors view gold as a hedge to stock market fluctuations. Others point to the role of gold as an alternative to fiat currencies and yet others view gold as the ultimate store of value. Using daily data since 2000, we find that while all of these ar- guments have empirical support, the role of gold and how it acts varies tremendously over time.

Aside from the difficulty in valuing the ultimate “sentiment” asset, investors should carefully evalu- ate the role they wish gold to play in their portfolios and whether there are more direct vehicles designed to address their investment concerns. TIPS may offer a more direct hedge against inflationary develop- ments. Other hard asset strategies - such as timber - may offer steady streams of cash flow in addition to inflation protection which are not available from gold investments. Similarly, investing in a VIX-linked instrument could provide a more direct and effective hedge against extreme adverse stock market movements.

At the end of the day, just like drafting a basketball player who effectively plays multiple positions but does not excel at any one, the value of gold in an investment portfolio may be its ability to effec- tively play multiple roles.

Whether such flexibility is required in a portfolio is highly dependent on the market environment. At this time, as global capital markets have yet again become dominated by extreme macro-economic uncertainty, gold appears to be behaving as not only a hedge against extreme equity market movements, but as a store of value and alternative to fiat currencies as well.

DISCLOSURES

The Leuthold Group, LLC provides research to institutional investors. It is also a registered investment advisor that uses its own re- search, along with other data, in making investment decisions for its managed accounts. As a result, The Leuthold Group, LLC may have executed transactions for its managed accounts in securities mentioned prior to this publication.

The information contained in The Leuthold Group, LLC research is not, without additional data and analysis, sufficient to form the basis of an investment decision regarding any one security. The research reflects The Leuthold Group, LLC’s views as of the date of publication, which are subject to change without notice. The Leuthold Group, LLC does not undertake to give notice of any change in its views regarding a particular industry prior to publication of their next research report covering that industry in the normal course of business. The Leuthold Group, LLC may make investment decisions for its managed accounts that are inconsistent with, or contrary to, the views expressed in current Leuthold Group, LLC reports.

As with any investment, there can be no assurance that any of the funds’ investment objectives will be achieved or that an investor will not lose a portion or all of his or her investment in a fund. Limited Partnerships may offer limited liquidity, may engage in speculative investment practices, may offer limited valuation information to investors and will not be registered. A prospective investor should consult its own tax advisor regarding tax consequences of an investment in a fund.

This report does not constitute an offer or a solicitation of an offer to buy a security. Any offer of solicitation for Limited Partnerships must be made only by means of a delivery of a definitive private offering memorandum. The Partnership’s performance data have not been compiled, reviewed or audited by an independent accountant, and data for recent periods may be adjusted as a result of a subse- quent audit of the year of which those periods are a part.

Because the views expressed in Leuthold Group, LLC research relate to industry groups rather than individual securities, industry group ratings cannot be assumed to apply to each individual security within a group. Thus, if industry group “A” is ranked “Attractive,” The Leuthold Group, LLC may still decide to sell one or more of the component securities in group “A.”

Weeden Investors, L.P., Weeden & Co., L.P.'s parent company, owns 22% of Leuthold Group’s voting securities. An Executive Man- aging Director of Weeden & Co., L.P. is a member of The Leuthold Group, LLC board of directors.

Weeden & Co., L.P. makes a market in AAPL, ABCO, ALGT, ALXN, AMAT, AMKR, AMTD, AMZN, APKT, ARBA, ARUN, ATVI, AZPN, BIDU, BIIB, BRKS, CACC, CATM, CAVM, CELG, CERN, CHKP, CIEN, CLMT, COST, CRAY, CREE, CSCO, CSGP, DELL, DLLR, DLTR, EFII, EZPW, FFBC, FISV, FITB, FULT, GHDX, GPRO, HA, HBAN, HGSI, HMIN, IMAX, INTC, IPGP, IPHS, ISIL, JAZZ, JDSU, JKHY, KALU, LBTYA, LSTR, MAT, MDCO, MGLN, MSCC, MSFT, NFLX, NIHD, NTAP, NXTM, ONNN, OZRK, PACW, PDLI, PRXL, PSMT, QLGC, QSII, RVBD, SATS, SCHN, SCHW, SFLY, SINA, SLAB, SMCI, SNDK, SPLS, STLD, STX, SUSQ, TEVA, TQNT, TRMB, TTWO, UHAL, UMPQ, VMED, VOD, VPHM, VRTX, WBMD, WERN, WRLD and ZBRA.

Weeden & Co., L.P. Member FINRA, NASDAQ, and SIPC.

© 2015 Leuthold Weeden Capital Management
Not FDIC Insured. No Bank Guarantee. May Lose Value
Mutual Fund Distributor: Rafferty Capital Markets, LLC, Garden City, NY 11530