This is the eigth piece in Seeking Alpha's Positioning for 2014 series. This year we have once again asked 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 B. Parnell, CFA is the Founder & Director of Gerring Capital Partners, a Registered Investment Advisor based in Chester County, Pennsylvania and serving clients nationwide. He founded his firm in 2005 to provide high quality, personalized investment solutions for clients at a low cost. Eric is a regular contributor to Seeking Alpha and is widely seen in the media on radio and television. In addition to his work with Gerring Capital Partners, Eric serves as a professor in the Economics and Finance department at West Chester University teaching courses in Finance, Economics and Statistics.
Seeking Alpha's Abby Carmel and Jonathan Liss recently spoke with Eric about his outlook for precious metals in 2014, and how he would advise investors to position portfolios accordingly.
SA Editors (SA): How would you describe your investing style/philosophy?
Eric Parnell (EP): My investment philosophy is best described as an absolute returns approach in that I first seek to protect against the risk of loss and then seek to maximize returns within this risk controlled framework. This investment approach includes the incorporation of the broad range of asset classes that exist beyond the stock market and have a low to negative correlation with one another in order to achieve true portfolio diversification and risk control.
As for my investment philosophy as it relates specifically to the stock market, I am a fundamental value investor that is focused on companies that are trading at a discount to their intrinsic value with a particular emphasis on quality, income and price stability.
(SA): As we approach 2014, are you generally bullish or bearish? If bullish, what are the major catalysts for markets in 2014? If bearish, what are the major risks to markets in 2014?
(EP): As we enter 2014, I am bearish about the current state of capital markets. This bearishness does not mean that I am necessarily bearish on the price performance of the stock market for the coming year. I could easily envision a scenario where stocks could eclipse 2400 on the S&P 500 Index (SPY) before 2014 draws to a close. While this bold projection might imply great optimism at first glance, it is actually a most damning observation, as I could just as easily see a circumstance where the stock market crashes below 1200 in the coming year.
The potential for such wide-ranging stock market outcomes resides at the heart of my concern about markets today. For after five consecutive years of unprecedentedly aggressive stimulus by global policy makers, investment markets across so many asset classes have become so wildly distorted in many cases that what actually represents true equilibrium prices may be vastly different from where securities are currently trading today. And while market volatility has been exceedingly calm as the policy stimulus continues to flow, investors may quickly find themselves becoming acquainted with market turbulence unlike anything they have seen in recent years, either when policy makers finally attempt to stand away from stimulus or markets finally stop responding to the morphine.
If the idea that stock market may no longer rise under the influence of monetary stimulus seems absurd, one has to look no further than the many asset classes that are closely correlated to the stock market that reached the breaking point in the past year. For example, high yield bonds (HYG) have effectively been flat since early May, while REITs (IYR) are down -15% over this same time period. And for all of the talk about the Japanese stock market (EWJ) this past year, it took until the last eight trading days of the year before the Nikkei 225 finally reclaimed its mid May highs. At some point, the U.S. stock market will arrive at a point where it too ceases to respond positively to further monetary stimulus. Liquidity has a preference, and although it leaned heavily toward stocks in 2013, the likelihood that it will seek a new destination is rising as equity valuations become increasingly expensive.
For all of these reasons, I am bearish about the state of capital markets as we enter 2014.
I am bearish that the unintended consequences associated with unprecedentedly aggressive monetary stimulus over the last several years finally begins coming home to roost just as it did in 2000 and 2007.
I am bearish for all of the investors that have only recently been sucked back into the stock market that is already long in the tooth after what has been an unprecedentedly strong rally over the last five years.
I am bearish for the many retirees and people living on fixed incomes that have been forced well beyond their comfort zone on the risk spectrum into highly volatile categories such as emerging market debt (EMB) and master limited partnerships (AMLP) in an overreaching attempt to secure the income necessary to sustain their lifestyles.
And I am bearish that we are currently in a market where stock market capitalization is now in excess of GDP with valuations well above their historical average, margin debt to purchase stocks at record highs, and sentiment indicators at bullish extremes in a still sluggish global economy where corporate sales and earnings have effectively ground to a halt at a less than 3% annualized rate over the last 18 months with profit margins already at historical peaks and corporations already in the process of slashing their forward projections at a feverish pace. Put more simply, even if the economy were to dramatically improve in 2014, which is a huge if, a stock market that has gained 35% over an extended period of less than 3% revenue and earnings growth is already more than reflecting any potential improvement. And what then for the stock market if the economy actually doesn't pick up speed in 2014 as so many are hoping? Suddenly, an S&P 500 trading well below where it finished 2013 is not at all outside the realm of possibility.
(SA): The conventional thinking among the gold crowd was that precious metals were supposed to continue to move higher as long as QE was in full force and the Fed's balance sheet continued to expand. Yet gold and silver have now been selling off since October 2012 in the midst of full QE and an expanding balance sheet. Why do you believe the conventional gold thesis hasn't played out?
(EP): Among the asset classes that typically perform well during periods of aggressively expansionary monetary policy but faltered in 2013, none did so more dramatically than the precious metals complex including gold (GLD) and silver (SLV).
If you were a gold investor, many events played out exactly as you would have hoped heading into the year. The global demand for physical gold soared dramatically while at the same time the global supply declined. Global central banks took their already aggressive monetary stimulus programs up several notches with the U.S. Federal Reserve expanding their balance sheet by more than $1 trillion and the Bank of Japan committing to double the supply of yen by the end of 2014. Global central banks were also once again net buyers of gold. And major vaults were essentially emptied out, as acquirers are increasingly eager to take possession of the metal. Yet despite all of these underlying forces that one would reasonably expect should cause the price of gold to explode higher, we saw gold prices fall by nearly -30%.
What was particularly notable in 2013 was the abrupt disconnect in the relationship between the precious metals and the expansion of the Fed's balance sheet. The correlation between the two had been near perfect from the start of the Fed's daily U.S. Treasury purchases as a part of QE1 back in March 2009 through the end of 2012. The only time they meaningfully deviated was when the Fed briefly stepped away from asset purchases following the end of both QE1 and QE2 and the metals kept rising. Otherwise, they moved almost completely in lockstep. That was, of course, until 2013 when the two completely parted ways. So while the expansion of the Fed's balance sheet by $1.1 trillion would have implied a price of gold at the end of 2013 in excess of $2,500 per ounce (a +55% return for the year), had this relationship continued to hold as it did for the U.S. stock market, instead it closed the year at less than half of this amount at just over $1,200 per ounce.
(Click to enlarge images)
So what gives? Those who adore and disdain the precious metals market have both put forth a variety of compelling and well-reasoned explanations for the decline. Leading among the precious metals detractors included the explanation that the sell off was simply a validation that health had restored to the global financial system and we are now on the brink of sustained strong global economic growth. As for the gold and silver supporters, explanations ranged from market manipulation by selected sovereigns and major financial institutions to the fallout effects from repatriation, rehypothecation and major players seeking to convert paper assets to physical holdings. The debates both across and within these two sides of the precious metals market about why the price decline occurred are likely to be ongoing as we move through 2014.
But regardless of the causes, the fact that the gold and silver market performed as poorly as it did over the past year raises an important point about these metals. Investing in gold and silver is not for the faint of heart, as the prices of these metals can swing wildly at times and are heavily driven by sentiment among other mechanical factors in the short term. For those that are long these metals, this can feel tremendously rewarding when prices are rising. However, when prices are falling, it can feel agonizingly painful. And often, these short-term price movements in either direction can occur without any reasonable fundamental explanation. For those that are interested in trading the precious metals over the short term, I highly recommend following Avi Gilburt's articles on Seeking Alpha, as his work with Elliott Wave Theory in the precious metals space is superb.
(SA): Now that tapering has begun, how bullish do you remain on gold and silver?
(EP): I am completely indifferent about the impact of tapering on gold and silver for several reasons.
First, if gold and silver prices declined dramatically during QE3, how is it that they will be even more adversely impacted if a program from which they seemingly derived absolutely no benefit comes to an end? I am much more concerned about stocks under this scenario than the metals.
Second, what pundits almost universally overlook is the fact that the precious metals have performed very well when the Fed has attempted to step away from QE stimulus in the past. For example, after the Fed ended QE1 back on March 31, 2010 through Bernanke's Jackson Hole speech in late August 2010 revealing what would eventually become QE2, gold and silver gained +12% and +10%, respectively, at a time when the S&P 500 dropped by over -10%.
And after QE2 came to an end on June 30, 2011, gold and silver rose by as much as +26% at a time when the U.S. stock market dropped by -14%. In fact, it was with the Fed's announcement of Operation Twist in late September that actually took the wind out of the sails of the precious metals trade at the time.
Lastly, the reasons for owning gold and silver are not necessarily driven by the actual printing of money by global central banks including the Fed. Perhaps this might have motivated the precious metal trader with a short-term focus, but not likely the precious metal investor with a long-term view. Instead, the ownership of gold and silver is often much more motivated by the unintended consequences that may someday result from these unprecedentedly aggressive policy actions at some point down the road than the actual printing of the money today.
To this point, gold is an alternative global reserve currency. So too is silver to a certain extent. These precious metals function like money as a medium of exchange, a unit of account and a store of value. And it is not at all lost on the precious metals investor that the current fiat currency system with money being backed by nothing other than the full faith and credit of issuing governments has been in place for only 42 years. Moreover, 25 of these 42 years since 1971 have been spent with the fiat currency system under some degree of stress. And with global central bankers today printing currency with seemingly reckless abandon, the potential certainly exists for the unintended consequences of these policy actions leading to an outcome that suddenly has these alternative reserve currency metals in far greater demand than they are today.
(SA): How has your thinking changed in the last year (if at all) on the role of precious metals within a balanced portfolio? Have you bought into weakness in client portfolios (and your own portfolio) to keep your exposure to precious metals at the same levels, or have your tamped your exposure down as momentum and sentiment have turned against precious metals?
(EP): If you are a precious metals trader, you are likely browbeaten and exhausted from your experience over the past year, particularly if you had a long bias. However, if you are a long-term precious metals investor, in many respects you have to be thrilled with the opportunity that presented itself throughout 2013.
Before going any further on this counterintuitive point, it is worthwhile to take a moment to discuss what makes the long-term precious metals investor both special and unique.
First, gold and silver investors often have a deeply ingrained long-term discipline that helps them overlook short-term volatility that might occur along the way. Many have been accumulating these metals on a regular basis for years if not decades as part of a long-term strategy. Thus, they are typically unfazed by the recent price decline, as they are still sitting on substantial gains since the turn of the millennium (and the start of the current secular bear market in stocks) or even over the last several years for that matter, as gold was trading below $1,000 and silver below $15 as recently as 2009.
Second, precious metals investors by their nature are realists in contrast to the stock investor that is typically an optimist. When things turn badly for the optimist, they are often panicked and devastated by it. But when challenges arise for the realist, they are often not surprised at all since they have already anticipated the worse case scenario playing out, which is why they own gold and silver in the first place. This predisposed conditioning to expect the worst enables the precious metals investor to keep a cool head during periods of short-term price turbulence.
Lastly, precious metals investors sometimes even find themselves cheering the price drop. For many, they are viewing the recent price decline as an extraordinary buying opportunity, not a reason for despair, particularly given the fact that they are witnessing all of the reasons they have owned gold and silver over the years in the first place playing themselves out on the global stage today.
So from the perspective of the long-term precious metals investor, many are viewing the price decline in 2013 as an exceptional buying opportunity. To them, it is the equivalent of someone behind the wheel of an automobile that is driving increasingly recklessly suddenly seeing their auto insurance premiums cut in half. It may not make sense since the probability of the driver getting into a car accident continues to increase, and this makes buying the insurance all the more attractive since the benefit is all the more pronounced given the drop in price and the potential that some sort of accident is likely to occur at some point in the future. You may not know when, but it's likely to happen at some point. And in the case of precious metals, the payoff has the potential to be absolutely enormous.
(SA): As badly as gold has performed in 2013, gold miners have taken a serious beating. What is your sentiment on the miners as we look toward 2014 and beyond? Are they too risky, or is there still a place for them within portfolios?
(EP): If owning the precious metals is not for the faint of heart, owning the miners as an investment is even more so only for the intrepid and those that have real conviction in the precious metals thesis. This is due to the fact that the price swings among the miners is even more pronounced than the metals. For example, the daily price movement of the Market Vectors Gold Miners (GDX), which is a leading gold miner ETF, has averaged over 2% since the inception of the product back in 2006. Thus, a heavy dose of volatility should be expected with any such allocations.
With that being said, many of the precious metals miners are trading at extraordinarily discounted valuations at present. The reasons for these discounts are more than understandable, particularly given the staggering price decline in the metals over the past year and the operating risks associated with mining. But such discounts provide the potential for outsize rewards in the future, particularly if precious metals prices eventually regress sharply back up to the mean at some point going forward.
In terms of allocations, I would suggest a broader basket such as the GDX over individual names for diversification and risk control purposes. I would also recommend biasing toward the larger miners instead of the junior miners, as the latter tend to be even more volatile and are at far greater operational risk if recent precious metals price trends persist.
As a final point, for those investors that are interested in rolling up their sleeves and going in depth with the miners, I recommend following the articles on Seeking Alpha by Hebba Investments, who provides very good detailed analysis on a variety of names in the space.
(SA): What percent of an investor's portfolio do you feel should be in gold and other precious metals heading into 2014? What about precious metal miners?
(EP): The suggested allocation to gold and other precious metals varies widely depending on the individual's return expectations, risk tolerance and time horizon. A growth oriented investor with a longer-term time horizon and a high level of conviction in the precious metals theme may feel comfortable with an allocation to gold and other precious metals as high as the 15% to 20% range. As mentioned previously, however, any such allocations are only for those with a very high-risk tolerance due to the extreme price swings that can occur at any given point in time. In addition, I would recommend biasing allocations toward gold instead of silver for risk control purposes given the fact that the white metal is considerably more volatile than its yellow counterpart. Moreover, silver also has economically cyclical characteristics given its industrial uses. Thus, a 3-to-1 or 4-to-1 ratio between gold and silver in a precious metals allocation would be prudent from a risk control perspective. As for the miners, any such allocation should be kept very low as percentage of an overall portfolio given the heightened price volatility associated with these names unless the investor has a particularly high conviction in the precious metals space. A peak allocation in the 2% to 3% range would be reasonable.
For the general investor that is more indifferent to the precious metals, I would recommend limiting portfolio allocations to 5% at most, particularly among more conservative accounts. I would also suggest allocating to gold only to reduce the overall risk and price volatility associated with the position.
As for the timing of any such purchases, I would recommend taking a more cautious, wait and see approach as we enter 2014. Precious metal price movements in 2013 were volatile and at times unpredictable. Sometimes they were even blatantly questionable. And sentiment still remains strongly against these metals despite the favorable fundamental backdrop. As a result, I would suggest waiting until we see what starts to shape up as a sustained reversal in precious metals prices before building out or adding to an allocation. For while gold and silver prices are likely to recover sharply once a true reversal finally takes place, prices may fall further in the meantime before a bottom is finally in place.
(SA): Regarding precious metals funds: physical or futures-based? Which are your preferred vehicles to gain exposure to the precious metals?
(EP): In regards to funds, I recommend physical products over futures-based. Precious metals futures certainly have their place, 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 often higher than the expected spot price at maturity due to 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.
As for preferred vehicles to gain exposure to the precious metals, I will start by saying that owning the physical is the best option, particularly for long-term investors. But for those that are not interested in taking on the added time and responsibilities associated with taking delivery of the physical product, several closed end funds stand out as particularly good choices. These include the Sprott Physical Gold Trust (PHYS), Sprott Physical Silver Trust (PSLV), Central Fund of Canada (CEF) and Central GoldTrust (GTU). These offerings are favored over the leading exchange traded funds because their prospectus language is far more straightforward and hold their assets in segregated and insured physical bullion that is not lent out. Moreover, they also have net asset values that currently trade at a discount to the underlying fair value of the physical bullion, which is notable since these products historically have traded at reasonable premiums on average.
(SA): What advice would you give to a 'do-it-yourself' investor looking for opportunities in gold in the present environment?
(EP): My advice would be to proceed with caution while maintain a long-term view on the potential opportunity. The price of gold has fallen precipitously in the last two years and the trend remains definitively lower, suggesting the price may have further to fall before it finally bottoms. Thus, investors need not rush into any precious metals allocation just yet. But for those interested in moving forward with beginning to establish an allocation today, I would recommend dollar cost averaging into any position in order to smooth out any near-term price volatility. Otherwise, I would suggest waiting until we see a definitive upside breakout in gold prices finally adding a position. And once the position is in place, one will want to try to pay relatively less attention to the daily price movements in gold, as your reasons for investing in it are at a minimum as a long-term insurance policy and perhaps more so for the tremendous returns potential that may finally be unleashed at some point as gold regresses back up to the mean in a potentially meaningful way.
(SA): Any additional considerations you'd like to share with readers as they ponder their investing strategy in 2014 and beyond?
(EP): Capital markets offer tremendous opportunities for investors as we enter 2014. But they are not necessarily likely to come from the straightforward trade of being long the stock market. And they are likely to require patience and periods of navigating higher volatility than stock investors have been accustomed in 2013. For just as regression to the mean can be brutally painful for asset classes that have stretched well beyond their implied potential, so too can it be tremendously rewarding for those categories that have been unduly punished. And the precious metals space including gold and silver have the great potential to rank among the latter.
Disclosure: I do not currently hold positions in any of the securities mentioned in the article and do not intend on purchasing any of these positions in the next 72 hours. This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
To read other pieces from Seeking Alpha's Positioning for 2014 series, click here.