Gold: The Ultimate Secular Stock Market Hedge

 |  Includes: GLD, SPY
by: Eric Parnell, CFA

It is tough for gold to get respect. Many often conclude that only those investors filled with mistrust and paranoia about the current financial system hold gold.

But here is the thing. If you took the name tag off of the asset class and examined it over history, many would likely conclude that gold is a category that demands close attention and deserves more esteem.

First, any historical examination of gold as an investment must begin in 1971 when the direct convertibility of gold into U.S. dollars was officially eliminated and the gold price was free to fluctuate. Since that time, gold has generated an annualized return of just under +10% versus stocks as measured by the S&P 500 at just over +10%. Thus the rate of return is comparable. Moreover, the risk characteristics are also in the same ballpark, as gold has annualized return standard deviation of 23% versus stocks at 18%. So on a Sharpe Ratio basis, stocks score better, but not overwhelmingly so. But what is most notable about the returns of gold versus stocks is the correlation of returns between these two asset classes at -0.22. Thus, gold and stocks are two asset classes that have generated comparable long-term annualized risk-adjusted return streams that are slightly negatively correlated to one another. This is a beautiful thing from a portfolio perspective.

What is even more notable is the performance of these two categories when examined in the context of the secular market cycles we have experienced over the last four decades. In 1971, we were in the early stages of a secular bear market for stocks. And from this point until the end of the secular bear market in 1982, gold posted an annualized return of +27% versus stocks at just under +2%. As might be expected during the secular bull market from 1982 to 2000, stocks outperformed with an annualized return of +18% versus gold at roughly -2%. But in the current secular bear market that began in 2000, gold assumed the leadership mantle once again with a +15% annualized return versus stocks at less than +1%. This is an even more beautiful thing, for having owned both categories over the last four decades would have provided comparably strong returns with considerably less volatility than selecting just one over the other.

But where is the love for gold? After all the recognition for stocks is indisputable. We have three media outlets and two major newspapers in the U.S. that dedicate the lion's share of their coverage to the stock market. But when it comes to gold, the coverage is decidedly less and the dialog toward those who own it is often laced with scorn and skepticism. Moreover, those that own gold are often cited as being almost fanatical about the asset class, but perhaps their passion is inspired by the fact that their investment often does not receive the respect it deserves in broader asset class discussions.

In the current environment, the appeal for owning gold remains as strong as ever. We remain firmly entrenched in the thirteenth year of a secular bear market for stocks that began in 2000. Given that secular market cycles have typically lasted sixteen years on average, we likely have a few years to go before we've reached the beginning of a new secular bull market for stocks. And an examination of current conditions supports this idea. The U.S. economy continues to sputter, economies across Asia are slowing and Europe remains on the brink of full-blown crisis. This backdrop has countries around the world engaged in aggressively easy monetary policy and competitive currency devaluations in an effort to resuscitate the global economy. Such conditions are highly supportive of gold and will likely remain in place for the foreseeable future.

Thus, I own gold. I do so not out of fear. Instead, I own it as an essential component to enhance returns and manage risk in the broader long-term asset allocation framework.

Disclosure: I am long GLD.

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.