Brexit, Gold, Systemic Market Risk And You

| About: SPDR Gold (GLD)


The threat of a Brexit and its trigger of an EC breakup has helped boost gold back to 2014 levels.

I began an experiment in 2014 with gold trading around the $1200 levels, a point believed by many to be the long term "all in cost to produce".

My experiment is to hold gold for the safety until a macro disaster (financial meltdown, regional Mideast or China war, etc) where money traditionally flees to gold, then self-liqudate.

Success to date has been good, providing about an 8% income yield while holding GLD. Today, I review results and present new covered option writings on GLD for income.

Subscribers to Income From Covered Option Writing got an advanced look at this material.

The Midas Touch. It turns everything to gold, but like cake, you can't have your gold and eat it too. Until now that is. With my covered option technique, you can use Gold bullion fund shares to own gold as the traditional insurance against major macro catastrophes while still earning regular cash income at very attractive yield rates.

My introduction of the Gold Hold Strategy as insurance that pays you, began with my May 2014 article, "Buy Gold Now? What Every Income Investor Needs To Know." I followed that up with another article on the subject in October 2014, "Gold: Making The Most While Avoiding The Risks - A Strategy For Income Investors." If you have not yet read both of those, you should be sure to do so. They will provide the background and foundation for this current article updating my Survival Fund Strategy.

Plan Your Survival Fund:

The aim of a Survival Fund is to provide cash for essential living expenses during a time of disruption of your normal and customary income stream.

Financial planning should include risk management and catastrophic contingency strategies for when things go radically wrong, as they surely will from time to time. Gold can play a tactical role in some of those efforts. Part of your safety net should include 6 months to 2 years of liquid assets that can be used to cover basic living expenses in case of income disruption. This could be from job lay off, man-made or natural disaster, or such things as bank collapse or other macro economic disruption - things a retiree or other self-paying investor can face.

You do not want to have to liquidate assets in a hostile market when they are deeply down. Even the worst market crashes recover within 30 months. The ability to weather these periods is important to successful investing.

For income investors who depend on generating cash flow from their investments, traditional savings accounts just don't yield enough to both generate income and provide you survival fund reserve. Keeping these emergency funds in passbook or money market accounts generates almost no yield. Saundra Latham points out that "According to Bankrate, the average MMA interest rate has sunk from 0.52% at the beginning of 2012 to 0.26% in 2016. Not super impressive, but savings accounts and one-year CDs are faring even worse with average rates of 0.08% and 0.26%, respectively."

Why Gold

A successful survival fund strategy for income investors needs to A) provide a highly liquid reserve to pay essential expenses during a systemic crisis. At the same time, we desire to generate income yield on our assets to fund our ongoing lifestyle. Gold, held as the SPDR Gold Trust ETF (NYSEARCA:GLD) can provide that highly liquid reserve and at the same time generate superior income yields while the reserves do not need to be tapped.

Gold has long been held as a safe haven from widespread systematic disaster: war, national civil instability, economic collapse, hyperinflation, and national confiscations. The reason gold is effective to some extent in addressing these situations is that it has a very low correlation to all other asset classes, not following the moves of those, but maintaining a track of its own generally. This combines with its global market to make it fungible across borders.

Gold's has many useful features. These include: independence from any single government price/value manipulation, its global fungible tradability, high liquidity as the second most traded commodity in the world (second only to oil), and ultimately sharply limited supply with unlimited potential future demand.

On the negative side, gold bullion does not generate any regular periodic income. It is inconvenient to hold in significant amounts. Bullion can have significant spreads and transaction fees. Reliability of quality can be a question. It costs to store it and to insure (or otherwise protect it) from theft or disaster loss. Governments may restrict or ban its movement across borders.

Because of the traditional role gold plays as a safe haven in such times of trouble, it tends to rise in price as people flee into it at times go bad. This is one of the rare times that gold does correlate to most other assets, but in an inverse way. That is perfect for investors wanting to park assets in gold for all the benefits I cited above.

In order to address many of these negatives, the gold bullion ETFs were created. GLD is an ETF that holds gold bullion bars. It provides an easily accessible form of owning gold bullion that can be traded globally and minimizes costs of transactions, physical security, and quality control issues. Begun in 2004, GLD currently holds $33.84 billion in net assets of gold bullion.

The negative side of holding gold bullion through the GLD ETF is that a freeze up of market access due to disaster, war, government order, or cyber attack could block available asset liquidity without warning. These same restrictions may be applied to personal holdings of the metal itself, as in the United States from April 5, 1933 until December 31, 1974.

Clearly, holding gold via GLD can offer one of the best ways to have a globally accessible liquid asset in times of major systemic crisis. The nature of it as a traditional safe haven makes it likely that its price will gravitate to the high side of trading ranges during any such crisis, giving us the ability to liquidate in troubled times without suffering the general steep fall of alternate investment classes such as stocks, bonds, and real estate.

The remaining question is how to keep generating income from our GLD assets to help fund our lifestyle during good times. Writing covered calls at or above our GLD cost is the answer to that. The theory is that we want our liquid asset when crisis hits. Our goal is simply capital preservation of our reserve survival fund at the time of withdrawal during a systemic crisis. We do not seek a profit on gold, merely avoiding a loss (as our other asset classes are expected to be experiencing at such a time) will be sufficient. Inflation protection can be included by allowing for that in setting the strike price of your GLD covered calls.

By following these principles, I have been generating about an 8% annual income yield on my GLD survival fund since I began in 2014. The Grexit and current Brexit threats of systemic crisis each pushed gold higher, in accordance with theoretical expectations of "flight to safety." My inflation adjusted exit points (covered call strike prices that would trigger call-away) have never been met, but they are approached as crises threaten.

If GLD should ever be called away, it will have self liquidated into the cash I want for a crisis and without any loss of capital, all the while having generated extra annual income from the covered call premiums. Should it liquidate without a crisis, I can simply opt to reinvest back into GLD again and sell new covered calls to continue my survival fund.

One caveat is the downside risk to gold prices. For this, I avoid entering (buying) GLD when gold is trading above its all-in-cost-to-produce. While gold may spend long periods below these costs, ultimately, they provide a long-term natural price floor since sustained lower prices result in curtailment of most mining production and thus an eventual imbalance in supply to demand.

The price chart suggests strong support at $112.50 and a bottom around $102.00. Rising channel support has risen to about $118.00.

According to a 2015 survey by Gold Fields Mineral Services Ltd., gold miners' average all-in costs, including interest and extraordinary costs, were close to $1,208 per ounce in 2014. This excluded the impact of impairments. The average gold price was $1,260 per ounce. Thus, I find reasonable comfort on long-term downside volatility exposure if I enter gold at $1260 or better ($126 for GLD).

Currently, GLD is trading at $120.84. With 2016 inflation running at 1.0%, an adjusted 1-year neutral strike price would be $121.00. For current entry or holding, the short term contract (the preferred survival fund strategy) should consider the calls for 58 days on the 8/19/16 $121.00@ $3.50. This is an absolute return of 2.98% (18.77% annualized yield rate). It allows you to buy gold at market today and if Brexit occurs and it (or anything else) does trigger a systemic crash, causing gold to rise, then your shares will get called away probably. You will have your $3.50 premium plus the $121.00 call-away sales price (for an additional $0.16 intrinsic gain). Should the markets settle down, you simply continue to write new short term (generally 60 day or less) covered calls on your GLD holdings with a strike price close to your basis cost ( inflation adjusted if you prefer) and continue to await the next potential systemic crisis while generating income.

Such a GLD-based survival fund strategy generates:

  1. Almost 19% annual yield rate on your reserve liquid assets of GLD while tying up the asset only 58 days.
  2. Is likely to self-liquidate in any crisis as gold surges and your units are called away (or you buy to cover at the lower premium cost).
  3. Allows you to enter the market now at an out of pocket cost 2.98% below current market retail, at a net debit cost of $117.34, providing a reduction in market risk.

Consider if a GLD-based survival fund is appropriate for you.

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I am not a licensed securities dealer or advisor. The views here are solely my own and should not be considered or used for investment advice. As always, individuals should determine the suitability for their own situation and perform their own due diligence before making any investment.

Disclosure: I am/we are long GLD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.