Sunday, April 25, 2010

GOLD TO GO TO USD 1500? WHAT TO DO WITH PORTFOLIO ALLOCATIONS?

The website Seeking Alpha is a nice one. It contains a mix of articles, some with a more scientific background and others trading-oriented. In the attached contribution the author, Jordan Roy-Byrne, wonders what Gold investments will do during the next months.

In this contribution the development of the gold price during the most recent 10 years is studied in a more technical fashion, comparing it also to the ratio Gold/S&P500. In and of itself there is no reason whatsoever why this ratio should make sense: the spot price for a precious metal, i.e. an important commodity, compared with the index value of a basket of US stocks. Sure, the bulk of the firms in the S&P operates internationally and is therefore to quite some extent exposed to globalization trends in the world. But on the other hand: the gold price is by definition 'made' in international markets between international traders. And the bulk of supplies is not from the US but from countries elsewhere in the world (e.g. South Africa, China, Russia, Australia and Peru).


The red bar chart in the graph, representing Gold/S&P is therefore not more or less stable (with movements back and forth around some equilibrium level). It shows an upward trend. However, and that is what we like about the representation: it does show clearly that gold should be analyzed in an intermarket setting. International investment strategies are more and more about understanding the portfolio allocations of large players. The time that herds of private investors dominate the market are gone.

It is only during extreme periods (exuberance or crises) that decision takers in institutional investment entities seem to suffer from habits that we also see in private investors, namely 'greed' (when things are going above average and fear for risks is pressed to the back of people's minds) and 'fear' (bad periods when most people are paralyzed when it comes to investing, although they should actually consider a contrarian strategy!).

Gold did quite well during the crisis years. To some extent logical. First, gold prices do have a kind of support level based on the fact that it is on the one hand used in industrial applications and on the other in demand by growing numbers of middle classes in developing countries (for jewelries). When people don't trust stocks anymore, real estate prices are at peak level and collapsing due to the mortgage-related aspects of the Global Crisis, and interest rates are very low with governments and central banks pushing rates to the lowest possible levels so as to stimulate sluggish economic growth, we know that gold is a natural alternative. In other words: when markets are doing bad, gold is reasonably OK. And that was especially true this time round with demand from Emerging Markets providing an extra demand-pull factor.

But the author does understand that trees won't grow into the sky forever. Stocks are getting more attractive now, especially because quite a few of them were now available at dividend yields level that made stocks a great alternative for Fixed Income within portfolios. And obviously, in the longer run stocks represent shares in hopefully profitable firms that can expand their profit base internationally. The demand for gold in industrial processes is relatively limited and in many cases it can be replaced by alternatives. When looking at the demand for precious metals for jewelry by middle classes in Emerging Markets we do recognize that this demand will continue to grow at a rate higher than the already high growth rate of the economy in those countries.

But, we should also take into account that gold traders in financial markets were speculating on this to happen for years already. In other words: the investment demand for gold did already incorporate quite a bit of this trend. Actually: only EXCESS demand vis-a-vis those expectations will lead to further increases.

Another aspect: international gold prices are in US Dollars. And the Dollar has appreciated quite a bit compared to the Euro and some other major currencies. Only the Chinese Yuan is now under pressure from international governments who believe that China should revaluate it compared to the Euro and USD. But the likelihood of Gold Prices increasing further from its current level of approximately USD 1100 to USD 1500 is not that high. First, we see that the trend of the ratio Gold/S&P500 is going down, which is another way of saying that investors found their way back to the stock market. Second: with gold being a commodity in international trade between traders in various currency zones, an appreciation of the USD is already a price increase even when the dollar price remains flat for foreign traders.

Does that mean that we should reduce exposure to gold in particular and commodities in general? 

LMG believes that one should also be careful to do that. For a couple of reasons:
1) Commodities have always played a great role in portfolio diversification and globalization trends and the rise of Emerging Markets have further strengthened this role
2) Fixed Income is - with increased inflation tendencies and low current rate levels - not a fantastic alternative; and
3) Western nations are still struggling with the aftermath of the Global Crisis. Their growth rates will remain relatively low.

We would therefore plea for a commodity allocation of 5-10 percent of your portfolio. Those who have generated good profits on gold could cash in on them. With stock market trends now not being too bad, one could also consider a mixed strategy with gold/commodity exposure now transposed from holding financial securities directly related to the underlying commodity to indirect stakes in the market through mining firms.

When comparing Gold to other commodities, we believe that metals like Aluminum, Copper and even Steel may also provide a good alternative. These less 'sexy' alternatives do at least have a relatively stronger demand-pull due to industrial development in Emerging nations that need them for their expanding industries. But here again: consider some kind of mixed allocation with part of your allocation going directly to the commodities component of your portfolio and another part through listed holdings of metals/mining giants in Western and Emerging nations.

Click here for the link to Roy-Byrne's article on Seeking Alpha.

Click here for more fundamental background information on Gold (from Wikipedia).


1 comment:

  1. Gold prices gain as on speculation debts in Europe will lead to more demand for the metal as a haven from possible losses in other assets.

    ReplyDelete