STORY OF THE WEEK
GOLD HAS OUTSHINED IN 2020
The price of gold has been on a tear recently, with a year-to-date return of 27.1%. The precious metal is even outpacing the frothy NASDAQ 100 (22.2%) and is trailing only silver (37.3%), which trades like a higher-beta version of gold. Last Friday, gold futures hit a milestone by surpassing its previous all-time high closing price set in September of 2011.
Source: WSJ, data from FactSet
There are several potential reasons for the rally in gold:
- Inflation fear
- U.S. Dollar weakness (currency risk)
- Geo-political risk
- Low nominal yields and negative real yields
- Fear of missing out (FOMO)
The first four catalysts listed above represent common arguments that have historically been used to justify purchasing gold. Each of them applies to today’s environment to some degree. The fifth reason is a behavioral one and relates to the tendency of investors to throw money at recent winners. This has been on full display during the first half of 2020. According to Morningstar data, equity funds have seen over $100 billion in outflows through June, while the top two gold tracking ETFs (GLD/IAU) collectively have taken in about $20 billion.
Although the proponents of gold investing commonly cite the reasons above, studies have shown that traditional stocks and bonds actually do a better job of addressing them. For example, due to the high volatility in the real price of gold, it has only been a reliable inflation hedge over very long periods of time, likely exceeding most investor’s investment horizons.
Since gold became legal for individuals to own (1/1/1975), it has underperformed the return on the S&P 500 index on an annualized basis: 5.4% for gold versus 12.0% for the S&P 500. This likely makes the stock market a superior place to invest for those that are concerned about inflation or want to increase their expected return due to low interest rates. Investors concerned about potential weakness in the U.S. dollar could be better served by diversifying their portfolio globally. Declines in the dollar translate into a gain for U.S. based investors that purchase assets in an appreciating currency. Similar to the U.S. market, international stocks have also outperformed gold since 1975: 9.4% for international stocks versus 5.4% for gold.
Stocks may be better suited than gold to protect against inflation and dollar depreciation. They also offer the potential for returns in a low-to-negative yield world. Similarly, bonds may be better than gold in a flight to quality scenario. When geopolitical fears or other risks surface, investors want to ensure they are sufficiently diversified. Gold can effectively accomplish this task. With a long-term correlation that is effectively zero, the typical ebb and flow of stock prices have no bearing on the price of gold. High-quality Treasury bonds, however, take the diversification benefit a step further. The 10-year correlation of intermediate-term Treasury bonds and the S&P 500 is -0.37. Here, a negative correlation means that when stocks fall, bonds tend to rise. This is a particularly attractive feature during periods of extreme market stress.
The superior returns generated by the stock market arise from the fact that businesses generate cash flow that can be reinvested. Reinvestment allows these companies to expand their operations, which increases their ability to generate even more cash flow, and so on in a virtuous cycle that has been a miracle of wealth creation. Gold, on the other hand, does not generate earnings or anything of similar value. Its ability to deliver a return rests solely on the belief that somebody in the future will be willing to pay you more than what you originally paid.
Warren Buffet shared his thoughts on the subject in the 2011 Berkshire Hathaway shareholder letter. At the time this was published, gold was still trading near its previous peak:
“Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.”
There is nothing to say the price of gold cannot increase significantly from here, particularly with a new crop of retail traders ready to pile into any asset with momentum. The bottom line, however, is that gold should not be counted on to generate long-term wealth as well as stocks or to diversify stocks as well as bonds. There can and will be periods where gold outshines other asset classes, but its inability to produce anything of value ultimately limits its value. Long-term investors are better off sticking with a diversified portfolio of stocks and bonds.
1. Erb, C., and C. Harvey. 2013. “The Golden Dilemma.” Financial Analysts Journal, vol. 69, no. 4 (July/August): 10–42.
2. Source: Stock return from Morningstar Direct, based on the S&P 500 TR USD Index from 1/1/1975 to 7/27/2020 (annualized). Gold return from the St. Louis Fed’s FRED database, based on GOLDPMGBD228NLBM, 1/1/1975 to 7/27/2020 (annualized).
3. Source: Stock return from Morningstar Direct, based on the MSCI EAFE NR Index from 1/1/1975 to 7/27/2020 (annualized). Gold return from the St. Louis Fed’s FRED database, based on GOLDPMGBD228NLBM, 1/1/1975 to 7/27/2020 (annualized).
4. Source: Morningstar Direct. Correlation based on monthly data over the last ten years ending 6/30/20. Stocks represented by the S&P 500 TR USD Index, gold represented by the SPDR Gold Trust (GLD).
5. Source: Morningstar Direct. Correlation based on monthly data over the last ten years ending 6/30/20. Stocks represented by the S&P 500 TR USD Index, Treasury bonds represented by the BBGBarc 3-7 Year Treasury Index.
WEEK IN REVIEW
- Data published yesterday showed that orders for durable goods lasting at least three years saw a strong increase for the second straight month. Orders for new cars and trucks, in particular, increased rapidly (+86%), while aircraft manufacturers posted a large decline. Core orders excluding defense and transportation, a key measure of business investment, increased at 3.3% versus the forecast 2.0%. While this was the second consecutive increase in the orders data, there are concerns that the resurgence in COVID-19 cases could taper further improvement.
- Coming into this week, 26% of the companies in the S&P 500 have reported earnings. The blended earnings growth rate for companies that have reported, combined with the estimates for companies that have not yet reported, has improved to -42.4% (vs. -44.0% last week). A handful of tech giants, including Apple, Amazon and Google, are set to report after the market closes on Thursday. These firms have rallied on the basis that their businesses can continue to thrive in the midst of the pandemic. Their reports will need to justify those gains.
- The Federal Reserve’s Federal Open Market Committee (FOMC) will conclude its monetary policy meeting on Wednesday. At 1 CT, the committee will publish its post-meeting statement, followed by a press conference with Chairmen Jerome Powell at around 1:30 CT (which can be live-streamed on Yahoo Finance). While the market is not expecting any changes to the policy stance, the Fed announced today that they will extend the current lending programs through December (they were originally scheduled to expire in September). In other interest rate news, the national average 30 year fixed mortgage rate hit an all-time low of 2.98% as of July 16th.
- U.S. Manufacturing Sector Regaining Momentum, But Surging Virus Cases Threaten Recovery (CNBC)
- The Tech Bubble Is Slowly Deflating as Earnings Roll In. Here’s Why. (Barron’s)
- The Difficulty of Timing the Market (Kenneth French) Comparing market timing to sports betting (video)
- Flowmageddon: It Time Yet? (Morningstar) Active equity funds are seeing massive outflows
MARKETS AT A GLANCE
Source: Morningstar Direct.
Source: Morningstar Direct.
Source: FRED Database & ICE Benchmark Administration Limited (IBA)
Source: FRED Database & ICE Benchmark Administration Limited (IBA)
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ABOUT THE AUTHOR
JOSH JENKINS, CFA + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH
Josh Jenkins is a Senior Portfolio Manager & Head of Research at Lutz Financial with over nine years of investment experience. He is responsible for assisting clients in the construction, selection, and risk assessment of their investment portfolios. In addition, Josh will provide on-going research and trade support.
AREAS OF FOCUS
- Asset Allocation & Portfolio Management
- Investment & Market Research
AFFILIATIONS AND CREDENTIALS
- Chartered Financial Analyst (CFA)
- Chartered Financial Analyst Institute, Member
- Chartered Financial Analyst Society of Nebraska, Member
- BSBA, University of Nebraska, Lincoln, NE