Gold: Some Interesting Graphs To Round Off 2014

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Includes: AGOL, GLD, IAU, OUNZ, SGOL
by: Matthew Salter, CFA

Summary

Gold lacks the characteristics of a traditional asset class, namely the ability to value it through discounted future cash flows.

Nevertheless, gold plays a significant role in investment portfolios.

Therefore, looking at trends and historical characteristics of gold can be informative and a useful alternative to valuing discounted future income streams.

Gold graphs - some useful statistics to kick off 2015

I am not a huge supporter of gold by any means - I think that as an asset class it lacks certain fundamental characteristics that should characterize an asset class if it is to be held in an investment portfolio. This includes primarily a way of valuing an asset through discounting future income streams - gold has no future income streams and very little fundamental uses. So it makes it very difficult to justify as a part of an investment portfolio other than for the reason that "everyone else does" (which is not an insignificant reason by itself).

But that has not stopped gold forming an intrinsic part of investment portfolios since almost the beginning of time (or thereabouts). And therefore as investment professionals its worth thinking about gold from time to time in terms of its likely returns and its contribution to the characteristics of an overall portfolio. Sometimes the best way of doing that with an asset like gold is to look at trends and historical characteristics.

About a year ago I pointed out how the dramatic 27% loss in gold in 2013 was really not an aberration at all. For those familiar with the concepts of volatility I explained how the 27% loss was well within the expected return characteristics of gold, based on historical observations.

As I like to often do, this article takes a step back and looks at the bigger picture including long-term trends, and sets out some key characteristics of gold which are worth considering when (or if) allocating some part of an investment portfolio to the world's favorite precious metal, as we head into 2015.

Graph number 1 - returns since the 2001 bull market

This graph shows quite clearly how the spectacular twelve year bull market of 2001-2012 came to a grinding halt in 2013 with losses of a magnitude not seen since over thirty years previously. And while there were fears that these losses would continue into 2014, the maximum loss seen during the year involved a loss of about 5% as gold traded below $1,150 in November. On the flip side gold also looked like it was reversing course as it surged towards $1,400 much earlier in the year, with gains of about 15%.

In the end neither the bulls nor the bears could claim victory as gold closed out the year almost bang on $1,200, with a negligible change from a year previously.

Graph number 2 - long term returns

The longer term picture of gold is very instructive for reminding the investor of how unusual the recent bull market in gold was when considered next to historical trends.

The years before 2001 can be characterized very approximately into two different and distinct time periods. These could be termed as a period of 'extremely volatile returns' (roughly corresponding to the 1980s) and a period of 'extremely poor returns' (roughly corresponding to the 1990s).

Being a gold investor at almost any period between 1980 and 2001 would have been a deeply unsatisfying experience. In fact, except for 1985-87 there was not a single time when gold saw positive returns in two consecutive years. Set alongside the returns of the recent decade, the contrast is quite dramatic and puts into question whether the bull run of the 2000s was an exception to the general trend of gold.

Graph 3 - volatility of gold

One reassuring aspect of gold in 2014 for investors was the fact that after several years of high volatility (compared to the historical average) the volatility of gold fell to lows not seen for about 10 years. The volatility of gold fell to just under 13%, following eight consecutive years where volatility has been above the long term average of 15%.

This may not sound like a big difference, but another way of looking at the volatility is to see how many individual days the closing gold price varied by more than 2% from the previous day's close. This is perhaps a more tangible way of getting a feel for the volatility of an asset class for the retail investor. (For those scared of words such as volatility and standard deviation, my 2014 article on gold - referenced above - contains a simple explanation of how to interpret volatility).

Indeed as the above diagram shows, the number of 'extreme' days in 2014 was positively sedate with the number of days where gold moved by more than 2% numbering just five days. This was the lowest number of days in a single year for almost twenty years and made gold look dreadfully boring compared to the experience over the last eight years or so.

Graph 4 - correlation with equities

One final thing interesting thing I look at is the correlation of gold with equities. While it is difficult to justify buying gold on a valuation basis (in my opinion) it has been argued that gold acts as a good diversifier in a portfolio, specifically providing 'insurance' in times of financial market stress. This was certainly true in the financial crisis of 2008 when the S&P 500 lost a whopping 37% while gold eked out a gain of 4%. Similarly in 2002 the S&P 500 lost an impressive 22% and the safe haven of gold provided a comforting 26% return.

So on the face of it, gold looks like it may have an important role to play in a diversified portfolio at times of financial market turbulence. But not so fast …

In 2008, at perhaps the height of the financial crisis (in terms of shocks to the markets), the S&P 500 lost over 23% over the course of a three month period from August to October. Over the same three month period, gold lost over 12%. So despite the fact that over the whole of the 2008 calendar year gold managed to act as an insurance policy against equity losses, it had to sustain a bumpy (or possibly ineffective) ride in the short term.

The following graph plots the monthly returns of the S&P 500 against the monthly returns of gold, over the last 35 years.

The trendline, shown in dotted black, is indeed negative as we would expect. But the relationship is hardly a strong one - indeed the correlation of the monthly returns over the whole data set is only just negative.

Concluding comments

We looked at long term returns and saw that a sustained period of positive annual returns has been a relatively new phenomenon of gold, but perhaps something that investors got very used to in the spectacular bull run of the 2000s.

I then showed how the volatility of gold in 2014 made for a quieter year compared to recent experience, even if the returns have certainly not been spectacular.

And finally the correlation of gold with equities (using the S&P 500 as a proxy) has not shown itself to be robust enough to provide evidence that gold will always act as useful insurance policy at times of financial market stress.

What does that mean for gold in 2015? Well, most major investment banks are forecasting 'more of the same' with the 2014 price action to continue into 2015. Most major gold forecasts are predicting gold to trade throughout 2015 in the $1,100 - $1,300 range as it has done for most of 2014.

But gold, more than any other financial asset, has a tendency to light up strong passions both in bulls and bears. The information above should hopefully provide a solid basis in which to anchor those passions as the year moves forward.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.