Gold and Your Portfolio

WSJ says gold is a lousy investment. That might very well turnout to be the case, but the article
has nothing useful to convince you about that. In fact, its so poorly researched. For example,
consider this:

What drives gold prices? It's an alchemist's mixture of fundamentals and fantasy. Gold
certainly has industrial uses and it's a hot item for purchasers of jewelry, especially in
India. But fundamentals don't support the soaring gold picture of late. As Carl Weinberg,
chief economist at High Frequency Economics, a Valhalla, N.Y., research firm, notes:
"Industrial demand for gold surely is depressed -- along with demand for other industrial
materials -- and jewelry demand must be hard-hit by global recession."

One would think he is bringing up the ‘hot item’ in India part to draw a connection to the
demand, but he ignores it in the next sentence and goes on to talk about industrial demand. Its
sad that an article that talks about gold says nothing about the price of gold being driven up by
fears of depreciation of the fiat currency (USD).

I can think of two questions that are important to the average investor saving for retirement:

1. How does gold compare with other assets? The reason that question is important is to
understand if it has a place in your overall portfolio. It would be silly to sink your entire wealth
into gold or for that matter any one asset class.
2. Does anyone know what the difference is between fantasy and fundamentals? For instance at
10,000 is Dow a fantasy or is it based on fundamentals?

To answer question 2, I've reproduced Prof Robert Shiller's graph. Do those stock prices look
like they are reflecting fundamentals - i.e earnings?
 2000 450

1800 400
Real S&P 500 Stock Price Index

Real S&P Composite Earnings

1600
350
1400
300
1200
250
1000
Price
200
800
150
600
100
400

200 50

0 Earnings 0
1870 1890 1910 1930 1950 1970 1990 2010

Year

My point is that asset prices are affected by:

1. Actual fundamentals
2. Perceptions of actual fundamentals and future expectations of fundamentals, and
3. Supply/Demand. It doesn't matter if supply/demand is driven by fact or fantasy - in fact its
hard to reliably say which it is, which is why history is among the best guides you have. By no
means is it the only one.
In any case, let's take a look at gold and compare it to stocks. The following chart shows growth
of $1 invested in gold and stocks. CPI is the proxy for inflation.

Gold, Inflation and Stocks

GOLD
CPI
S&P Total Return
25
20
15
Value

10
5
0

Feb 1970 Aug 1975 Feb 1981 Aug 1986 Feb 1992 Aug 1997 Feb 2003 Aug 2008

Date

So what are the annual returns - nominal and real?

Gold CPI S&P
Nom. Return 8.84% 4.48% 7.25%
Std Dev 19.92% 1.17% 15.58%
Sharpe Ratio 44.40% 46.53%
Real. Return 4.19% 2.62%

Stocks are marginally better in the long run (in terms of volatility and sharpe ratio), but in real
terms gold is much better. The higher volatility of gold is only to be expected - its a commodity
and most commodities are volatile because they are real assets with no cash flows. The only
thing that determines their prices is supply and demand.

Sure, history may not repeat itself, but it does say something about which of these assets has
offered better inflation protection in the past!
Let's look at correlations over the entire period from 1970 to now (Oct 2009):
GOLD CPI S&P Total Return
GOLD 100.00% 13.80% -1.10%
CPI 13.80% 100.00% -11.67%
S&P Total Return -1.10% -11.67% 100.00%

Well, well. At -11.7%, stocks are negatively correlated with inflation (realized) and gold is
positively correlated with inflation (14%). These numbers are monthly correlations. So in the
aggregate stocks have not protected you adequately in the presence of inflation. My other chart
here clearly shows stocks got clobbered during the only seriously inflationary decade the US
has seen.

See for yourself how your purchasing power would have been protected/suffered with these two
asset classes.

Gold vs Stocks - Real Wealth (since 1970)

Gold (Real)
8

S&P (Real)
6
Value

4
2
0

Feb 1970 May 1975 Aug 1980 Nov 1985 Feb 1991 May 1996 Aug 2001 Nov 2006

Date

OK, now I admit these figures may suffer from a period bias - that is, these results may be
partial to gold given its current price, but they also have the most inflationary period in the
history of the US. Let's try to see if rolling performance shows anything. One thing you can tell is
that gold is just as much subject to delusions as stocks are except that some of these
"fantasies" appear to be driven by people's expectations of inflation.

Rolling 24 month Perf

GOLD
CPI
S&P Total Return
0.8
0.6
Annualized Return

0.4
0.2
0.0
-0.2

02/70 05/73 08/76 11/79 02/83 05/86 08/89 11/92 02/96 05/99 08/02 11/05 02/09

So it does deserve a place in a diversified portfolio, especially when you look at its correlation
with stocks which ranges from mildly negative to about 50%.
 1.0
0.5
Rolling 24 month Correlations Stocks vs Gold
Correlation

0.0
-0.5
-1.0

Jan 1972 Apr 1977 Jul 1982 Jul 1987 Jul 1992 Jul 1997 Jul 2002 Jul 2007

Date

According to Martin Wolf, gold is kind of like VIX for currencies, especially the USD. Its reflects
the fear that the currency is depreciating rapidly:

Higher prices of gold reflect fear, not fact. This fear is not widely shared. The US
government can borrow at 4.2 per cent over 30 years and 3.4 per cent over 10 years.
During the crisis, the inflation expectations implied by the gap in yields between
conventional and inflation-protected securities collapsed. These have since recovered –
yet another sign of policy success. But they are still below where they were before the
crisis. The immediate danger, given excess capacity, in the US and the world, is
deflation, not inflation.

For your cogitating pleasure, here's a table of annual returns on gold and stocks. Stocks are
represented by S&P return including dividends. All numbers are in percentages.

GOLD Stocks
1970 7.2 8.4
1971 16.1 10.8
1972 47 15.6
1973 67 -17.4
1974 72.3 -29.7
1975 -23.7 31.5
1976 -4.1 19.1
1977 22.6 -11.5
1978 37 1.1
1979 126.5 12.3
1980 15.2 25.8
1981 -32.6 -9.7
1982 14.9 14.8
1983 -16.3 17.3
1984 -19.2 1.4
1985 5.8 26.3
1986 19 14.6
1987 24.5 2
1988 -15.3 12.4
1989 -2.2 27.3
1990 -4.6 -6.6
1991 -7.7 26.3
1992 -5.3 4.5
1993 16.8 7.1
1994 -1.9 -1.5
1995 1 36.2
1996 -5 22.7
1997 -21.4 33.4
1998 -0.3 28.6
1999 -0.1 21
2000 -5.5 -9.1
2001 2.5 -11.9
2002 24.8 -22.1
2003 19.4 28.7
2004 5.5 10.9
2005 17.9 4.9
2006 23.2 15.8
2007 31 5.5
2008 5.8 -37
2009 14.2 19.3