Economic & Market Report: Good As Gold

February 24, 2023
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By: Pursuit Wealth Management

Summary

  • Gold has a history of adding meaningful diversification in a broad portfolio asset allocation strategy.
  • Gold is historically uncorrelated with other major asset classes such as stocks and bonds.
  • Gold has been in a sustained uptrend dating back to the mid-2010s.
  • The gold-to-S&P 500 ratio continues to trade near its lows over the past two decades.

Capital markets remain turbulent as we make our way through the early months of 2023. Thus, the priority to manage investment risk through broad portfolio diversification remains as important as ever. And gold is an allocation that has distinctive characteristics in this regard.

Doing Its Own Thing. One of the keys that differentiates gold from a portfolio diversification perspective is that it travels its own independent path at any given point in time. This is reflected in the fact that its returns over time are virtually uncorrelated with both of the major asset classes in stocks and bonds.

What exactly is correlation? It measures the mutual relationship between two securities. It is measured across a range from -1.00 to 0.00 to +1.00.

A positive correlation means that the price of two securities move in the same direction at any given point in time. The higher the positive correlation toward +1.00, the stronger the positive relationship in the price movement between two securities. Such positive correlation works well when what you own like stocks are moving higher, but it compounds the pain when your highly correlated securities are all going down at the same time.

Conversely, a negative correlation means that the price of two securities move in the opposite direction at any given point in time. The higher the negative correlation toward -1.00, the stronger the negative relationship. While a security with a strong negative correlation to
stocks may seem like it makes good sense from a portfolio diversification perspective, the key problem is that if what you own is going down when stocks are going up and vice versa, you can end up neutralizing your return.

When it comes to broad portfolio diversification, identifying securities that are uncorrelated with each other ends up being ideal. Why? Because when two securities are uncorrelated, it means that regardless of whether one security is going up or down at any given point in time, the other security will be traveling its own independent path.

With all of this in mind, consider the following correlation table between U.S. stocks as measured by the S&P 500 Index (SPY), long-term U.S. Treasuries as measured by the iShares +20 Year U.S. Treasury Bond (TLT), and gold as measured by the SPDR Gold Shares (GLD).

Gold is not only virtually uncorrelated with U.S. stocks at a very low positive correlation of just +0.08, but it also has a notably low correlation of with U.S. Treasuries at +0.23. Put simply, gold is a security that moves independently from both stocks and bonds at any given point in time, which is ideal from a portfolio diversification standpoint.

Uptrend remains ongoing. While the fact that gold is uncorrelated with both stocks and bonds is a virtue from an asset allocation perspective, the security in isolation still must demonstrate the propensity in isolation to rise in price over time. For as industrial commodities have taught us over the past decade prior to 2022, a low to negative correlation to both stocks and bonds does little good if the price of the asset itself is falling.

The good news for gold is that it has been in a steady uptrend for more than seven years now since bottoming in late 2015. While it is indeed true that gold has been in a sideways pattern since the summer of 2020, this is more a result of the fact that gold had moved so far ahead of trend during the early stages of the COVID crisis. As a result, it has effectively spent the last two years since consolidating these gains as it reverts back to its long-term trendline.

This raises an important point about the fundamental drivers of the gold price. While the yellow metal is widely regarded as a hedge against inflation, it is often less than effective in this regard in practice. This is due to the fact that gold as a highly liquid asset is sensitive to the broader market liquidity environment at any given point in time. Put more simply, if inflation is rising, gold investors recognize that the U.S. Federal Reserve is likely to intervene by tightening monetary policy and draining liquidity from financial markets, thus putting pressure on the gold price.

So when does gold typically perform best? During periods of heightened economic, market, and/or geopolitical stress. This includes episodes like the Great Financial Crisis, the COVID pandemic, and yes, the hyperinflationary period of the late 1970s when the Fed was repeatedly too easy in trying to tame the pricing beast through much of the decade.

And while gold may get a bad rap relative to owning stocks over long-term periods of time, we can see from the chart below that gold has been no slouch relative to U.S. stocks from a cumulative return perspective over the past two decades. In fact, it has outperformed by fifty percentage points in the last twenty years. And both stocks and gold have performed well overall during this time period despite traveling distinctly different paths to reach this destination.

At what price? An important question comes into play when considering acquiring gold as part of broad asset allocation portfolio. How can we determine what is a fair price for gold? After all, the barbarous relic does not generate a cash flow, so how then can we assign an intrinsic value to its worth?

While it is indeed true that gold presents challenges to value in isolation, we have a long and extensive price history that we can use to evaluate its price relative to other key assets such as the U.S. stock market. And when considering the gold price relative to the closing price of the S&P 500 Index, we see that despite its steady uptrend over the past seven years, it continues to trade near twenty year lows on the gold-to-S&P 500 price ratio.

Bottom line. The economic, market, and geopolitical environment remains turbulent and uncertain as we make our way through 2023. Thus, managing investment portfolio risk remains a priority. And gold is a distinctly differentiated investment category that had historically generated uncorrelated returns relative to other major asset classes that has provided such a diversification benefit in the broader portfolio asset allocation process.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. Great Valley Advisor Group and Stonebridge Wealth Management are separate entities.

This is not intended to be used as tax or legal advice. Please consult a tax or legal professional for specific information and advice. Third party posts found on this profile do not reflect the views of GVA and have not been reviewed by GVA as to accuracy or completeness.


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