This is the fifth piece in Seeking Alpha's Positioning for 2013 series. This year we have taken a slightly different approach, asking experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond. As always, the focus is on an overall approach to portfolio construction.
Eric Parnell is the Founder & Director of Gerring Wealth Management, a Registered Investment Advisor based in Chester County, Pennsylvania and serving clients nationwide. Eric founded Gerring Wealth Management in 2005 with the mission to provide clients with personalized investment services at a low cost.
In addition to his work with Gerring Wealth Management, Eric serves as a professor in the Economics and Finance Department at West Chester University teaching courses in Finance, Economics and Statistics. He is a CFA charter-holder. Prior to starting Gerring Wealth Management, Eric served as the Director of Investment Communications for SEI Investments and as an Economist for Moody's Analytics.
Seeking Alpha's Jonathan Liss recently spoke with Eric to find out how his views on gold and silver were shaping up heading into the new year - and how he planned to put those views into action in client portfolios.
Jonathan Liss (JL): How would you describe your investing style/philosophy?
Eric Parnell (EP): My investment philosophy is an absolute return focused strategy. The priority when managing client accounts is to first limit the risk of loss. In other words, I seek to minimize the potential for a negative absolute return. I then seek to maximize positive returns within this risk-controlled framework with the objective of generating an annualized rate of return in excess of 10% over a long-term horizon.
The implementation of this strategy includes the utilization of a broad range of asset classes including stocks, bonds, commodities and select other asset categories that have low to negative correlations with one another.
EP: I am bullish on global stocks, high yield bonds and industrial commodities, but not for reasons that I would consider healthy or sustainable. In short, all of these categories stand to benefit from the massive liquidity flows entering financial markets as a result of the U.S. Federal Reserve’s latest aggressive balance sheet expanding stimulus program in QE3. As a result, stocks, high yield bonds and industrial commodities all have the potential to enter into another euphoric melt up phase despite the fact that economic and market fundamentals are not only weak but deteriorating in many parts of the world. Without the massively distorting forces of monetary stimulus, I suspect we would see a distinctly different market outcome in the coming year. But such is the environment we are operating in today.
I am bearish on the U.S. Treasury market for the same reason. Despite the fact that the Fed is directly purchasing government bonds as part of their latest stimulus program, post crisis history has repeatedly shown that more capital ends up flowing out of the safety of U.S. Treasuries to chase returns in risk assets than the buying demand coming in from Fed bond purchases.
But of all asset classes, I am most bullish on the precious metals complex including gold and silver for the coming year. The fact that the Fed is set to expand their already massive balance sheet by one third in printing more than $1 trillion over the next 12 months is decidedly positive for hard assets like gold and silver. Moreover, unlike stocks, both gold and silver also provide protection against crisis, which adds to the appeal given the persistent instability that exists both with the debt crisis in Europe and geopolitically in the Middle East. Thus, gold and silver provide the appeal of protecting against both upside and downside risk.
JL: As he has on many occasions in the past, Warren Buffett questioned the sanity of those that view gold as an investment again in 2012, stating that the yellow metal has no real-world utility, pays no dividend and thus isn’t a ‘real’ investment, because it can’t be reasonably valued. Why is Buffett wrong about gold’s utility within a balanced portfolio?
EP: I have great respect for Mr. Buffett and his fundamentally driven investment philosophy. But when it comes to gold as an investment, I believe his views are both misguided and shortsighted. Most investors do not own gold and silver under the expectation for some wild end of the world scenario. Instead, they own these precious metals for the most rational reason in that they provide important thematic and diversification benefits for investment portfolios.
From a thematic standpoint, investors own gold and silver during times of uncertainty about the sustainability of the global fiat currency system. If global central banks are taking actions that raise concerns about whether the currencies backed by nothing other than the full faith and credit of issuing governments will continue to serve as a reasonable store of value into the future, inflationary and hyperinflationary forces have the potential to develop in a meaningful way. Given this risk, investors are prudent to seek an alternative currency that can serve as an effective store of value. And both gold and silver have a long history of serving this role well. This is why these precious metals are often referred to as alternative reserve currencies that stand on their own as a store of value, unit of account and medium of exchange in worldwide markets.
On this very point, it is reasonable to question why Mr. Buffett himself does not actually hold a meaningful allocation to gold and silver. For at the same time that Mr. Buffett has dismissed gold for its lack of productive value, he has conceded the fact that investors in gold "have a correct basic premise that paper money will be worth less in the coming years". Given that he is widely known to hold sizeable positions in cash for extended periods of time to acquire productive assets in the future, it could be argued that Mr. Buffett is acting irrationally by simply conceding that this paper money will be worth less over time when the opportunity exists to hold assets like gold and silver that help insure against this loss of value. Thus, by holding gold and silver, investors are also acting rationally by protecting the value of their money until such time that they wish to deploy this capital for the acquisition of productive assets.
What of these productive assets in the current environment? This is where the diversification benefit of gold and silver demonstrates its worth. For example, stocks have been mired in a secular bear market dating back to 2000 and the bursting of the technology bubble. In recent days, the stock market as measured by the S&P 500 Index is trading just above 1400, which is the same level that stocks were trading at more than 13 years ago back in July 1999. But over this same time period when stocks have been essentially flat, gold has provided investors with a +15% annualized rate of return. This outcome is not a coincidence, for when examining stocks versus gold in the context of long-term secular market cycles, gold performs well when stocks are not and vice versa. During the previous secular bear market for stocks marked by price instability and slow growth in the 1970s through 1982, gold posted an annualized return of +27% versus just +2% for stocks. And as would be expected during the last secular bull market from 1982 to 2000 that was marked by steady growth, low unemployment, price stability and improving fiscal health, stocks posted an annualized return of +18% versus a -2% decline for gold. In short, stocks and gold exchange leadership over long-term cycles, and gold remains in charge during this ongoing secular bear market period marked by crisis and pricing uncertainty.
So for all of these reasons, I respectfully disagree with Mr. Buffett in his views on gold and silver, as both have tremendous value as investments today.
JL: Many gold bugs claim that impending runaway inflation makes now an ideal time to buy gold. Yet, one look at a gold chart during the 80s shows gold losing over 50% of its value from the start of that decade, and with typical inflation rates that ran into the double digits. Contrast that with gold’s performance since 2002, where it is up roughly 600% alongside nearly non-existent inflation. Why do so many gold bugs continue to insist that gold performs best in inflationary periods, despite overwhelming historical evidence to the contrary? Generally speaking, which economic conditions bode best for gold’s performance and why?
EP: While I believe that now continues to be a good time to buy gold and silver, I believe we are entering the late stages of what has been a more than decade long secular bull market in both metals. It is not necessarily the full-blown outbreak of inflation that makes gold and silver ideal investments. Instead, it is the initial seeds of economic deterioration and pricing instability that, when either left unchecked or even encouraged over long-term periods of time, can ultimately lead to a major inflation outbreak that have made gold and silver attractive investments since the turn of the millennium.
It is no coincidence that the bull market in gold and silver got underway at the very moment when fiscal and monetary policy makers in the United States shifted to weak dollar policies in an effort to generate economic growth. And it is also no coincidence that gold and silver accelerated to the upside not long after the outbreak of the financial crisis when fiscal policy and monetary policy makers launched into unprecedentedly aggressive stimulus and money printing.
Of course, all of these forces over the last decade not only undermine the integrity of the fiat currency system but also have the potential to become inflationary if not hyperinflationary in the future. Thus, it is not the actual outbreak of inflation that makes gold and silver good investments. It is merely the increasing probability of economic turbulence and sustainability rising inflation that is supportive of these precious metals.
EP: I prefer the precious metals themselves over the miners. And within these metals, I prefer gold and silver over platinum and palladium for the following reason. Both gold and silver, particularly gold, are more consistent in their identity as alternative reserve currencies that provide hard asset protection against both pricing instability and crisis. For this reason, gold and silver are generally uncorrelated to stocks. It should be noted that silver has more industrial applications than gold, so silver is somewhat more cyclically sensitive than gold. Platinum and palladium, on the other hand, are much more economically sensitive due to the fact that both of these metals have considerable industrial applications. Most significantly, both are critical inputs in automobile production. As a result, platinum and palladium often behave very differently than gold and silver with a higher correlation to the traditional stock market.
On a different note, diamonds are another investment theme along with gold and silver that has strong appeal in an environment of pricing instability and potential crisis, but it remains difficult to establish a direct exposure today to diamonds in a securities portfolio.
JL: Gold and precious metals funds, or the real thing? And regarding precious metals funds: physical or futures-based?
EP: Holding the physical metal is always ideal when it comes to owning precious metals. But the issue for many investors is that they are not interested in dealing with the added considerations such as storage and insurance associated with taking delivery on the physical metals. Moreover, many investors would rather own gold and silver as part of a securities portfolio to benefit from the liquidity of being able to move quickly and easily in and out of such positions at any given point in time.
For these reasons, I prefer to establish and maintain these exposures using exchange trade securities that represent ownership of the physical metals. These include the Central GoldTrust (GTU) and Central Fund of Canada (CEF), which consist of 53% gold and 46% silver with the remaining 1% in cash. The Sprott Physical Gold Trust (PHYS) and Sprott Physical Silver Trust (PSLV) are also solid choices, the latter of which is particularly useful for dedicated silver allocations.
JL: Why do you prefer these CEFs above popular physical gold and silver ETFs like GLD, IAU and SLV? Aren’t funds that track the spot price of gold and silver preferable to funds that regularly trade at discounts or premiums to NAV, or is there another consideration here?
EP: This is an excellent question with which many readers and commenters in the Seeking Alpha community are extremely well versed. Closed end fund products like CEF, GTU, PHYS and PSLV are preferable to the more popular physical gold and silver ETFs for several critically important reasons. First, the prospectus language associated with these products clearly describes that they truly hold the physical bullion and do not include the controversial or confusing language found with the ETF products that is rightfully subject to wide-ranging legal interpretation. These closed end fund products also hold their assets in segregated and insured physical bullion and do not lease these holdings out. In addition, they have strict auditing procedures and do not use custodians that may have blatant conflicts of interest and have resided at the center of the banking controversies that have plagued financial markets in recent years. These products also store their bullion in Canada and may offer tax advantages over their ETF counterparts for U.S. investors.
Finally, these closed end fund products also have net asset values that may trade at a premium or discount to the underlying fair value of the physical bullion. This particular characteristic has appeal, for if we were to enter into an environment where investors began to lose confidence in the more popular ETF products for the reasons mentioned here or otherwise, it would likely result in a flow of capital toward these closed end fund products, which would only serve to increase the premiums on these products and subsequently lift the price higher.
In the end, the selection of an investment security to establish a medium-term to long-term allocation to precious metals such as gold and silver is dependent upon trust, and products like CEF, GTU, PHYS and PSLV deliver in this regard where the more popular exchange traded funds do not.
JL: Please elaborate on why you avoid futures-based products in the precious metals space.
EP: It should be noted that precious metals futures certainly have their merits, particularly for those who are active traders with a short-term time horizon and are seeking to incorporate leverage. But for those investors that are seeking to establish a medium-term to long-term allocation to gold or silver, it is best to forgo futures-based products due primarily to rollover risk. In the futures market, particularly in precious metals, the prices of futures contracts are typically higher than the expected spot price at maturity. This is a phenomenon known as contango. Thus, futures based products often need to repeatedly sell their current contracts at a lower price to roll into the next dated contract at a higher price. This results in an increasing drag on performance for futures-based products that can total multiple percentage points in lost returns over time.
JL: What percent of an investor’s portfolio do you feel should be in gold and other precious metals heading into 2013?
EP: For a growth oriented investor with a reasonable time horizon that has conviction in the precious metals theme, an allocation to gold and silver to as much as 15% to 20% of an overall portfolio is reasonable in the current market environment. It should be noted, however, that such allocations to gold and silver are not for the risk averse or the faint of heart, as precious metals can experience wide price swings on any given trading day.
To this point, tilting the weighting between the metals toward gold is prudent at a minimum, as silver tends to be far more volatile with daily price swings greater than +/-2%, a common occurrence on any given trading day. Given this volatility, more conservative accounts should limit precious metals exposures to 5% and may consider allocating only to gold in order to reduce the overall risk associated with any precious metals positions.
Conversely, some may wish to consider allocations beyond the 20% range, but such heavy weightings should be reserved for only those investors that are either highly aggressive or have a deeply founded belief in the precious metals investment thesis, as such strong conviction is required to endure the inherent volatility associated with these metals along the way.
JL: What are your thoughts on the Permanent Portfolio? The allocation to precious metals is seemingly very aggressive at 25% (20% gold and 5% silver), which is above what you suggest for even aggressive, growth-oriented investors, yet the returns have been phenomenal for funds like PRPFX going back to 2000.
In many ways, the foundation to my approach to overall portfolio management has some similarities to Browne’s original core philosophy of a four-part equal weighting to stocks, long-term U.S. Treasuries, gold and cash.
But instead of the derivation followed by the Permanent Portfolio, my approach instead focuses on the following eight components: beta stocks, quality stocks, high yield including real estate, precious metals, TIPS, nominal bonds, long-duration bonds, and cash. These components are not equal weighted and I apply a more dynamic strategy across separate accounts that are subject to change over time depending on market conditions rather than a more static universal allocation. But at the core structural level, I think the underlying philosophy of the Permanent Portfolio certainly has strong merit, although my precious metals allocation is typically lower than 25% due to the inclusion of more model components.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.
To read other pieces from Seeking Alpha's Positioning for 2013 series, click here.