Alchemy: Gold As An Income Play

|
Includes: DGL, DGLD, DGP, DGZ, DZZ, GEUR, GLD, GLDI, GLDW, GLL, GTU, GYEN, IAU, OUNZ, PHYS, QGLDX, SGOL, UBG, UGL, UGLD
by: Pawoto Investments

Summary

Warren Buffett hates gold because it's not a "reproductive asset".

Gold can produce income and serve as portfolio insurance that pays you a premium.

There are several reasons that gold should be a part of your portfolio in today's market environment.

For the last 10+ years, I've been deeply suspicious of gold as an investment. When I read Warren Buffett's 2011 letter to shareholders (which is appointment reading every year as far I'm concerned) - my mind was officially made up: No Gold! Now, five years later, as I survey the capital markets for opportunities, I am reconsidering my position. There are a number of compelling reasons that investors should consider having gold in their portfolio. Furthermore, through the power of options writing, investors can use gold as portfolio insurance that pays you a premium!

Why Buffett Hates Gold

In the investor letter mentioned previously, Warren Buffett outlines his case against gold. I'm not a better writer than Buffett, but I might be a superior cut & paster:

"The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer's hope that someone else - who also knows that the assets will be forever unproductive - will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century. This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce - it will remain lifeless forever - but rather by the belief that others will desire it even more avidly in the future. The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end."

He goes on to say (told you I was a talented cut & paster):

"Today the world's gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce - gold's price as I write this - its value would be $9.6 trillion. Call this cube pile A. Let's now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobil's (the world's most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?"

The Oracle has got a point!

What We Know About Gold

Of course, we now know that gold is not a reproductive asset, doesn't pay a dividend, and can't be valued using fundamentals. Then again, conventional wisdom also tells us that:

  • Gold is considered by many to be a good long-term inflation hedge.
  • Gold has historically been a safe haven asset - i.e. in times of market stress, gold typically does well.
  • Gold is typically negatively correlated with the US Dollar.

Let's take a brief look at each of these attributes of gold.

Gold As An Inflation Hedge

Erb & Harvey (2013) explored this in a 2013 Financial Analysts Journal article - The Golden Dilemma. They conclude, "We found little evidence that gold has been an effective hedge against unexpected inflation, whether measured in the short term or the long term."

While a bit dated, the article referenced above is worthwhile reading for any gold investor, as the authors evaluate various purported attributes of gold.

Gold As A Safe Haven Asset

State Street, sponsor of the largest gold ETF (NYSEARCA:GLD), published a piece in early 2016 titled "Good as Gold: Re-appraising Strategic Allocations to Gold." The chart below, from that piece, demonstrates gold's reliability in times of market stress.

Gold Performance in Down Markets

Gold Is Negatively Correlated With The US Dollar

This relationship is evident in the chart below comparing an ETF that invests in the USD (NYSEARCA:UUP) versus the gold SPDR ETF.

USD vs. GLD

The argument for gold as an inflation hedge is questionable, but gold has clearly demonstrated its value as a hedge against significant market stress and its inverse relationship with the US dollar.

What's The Punchline?

I would argue (and I have) that the stock market is due for a 10%+ correction. 10% corrections are healthy and have occurred fairly frequently over time. Furthermore, after a couple of weeks with President Trump, I think it's clear that legislative and geopolitical "tail risk" has increased.

The financial times put a piece out on Jan 31 (subscription required) that outlined the bear case for the US dollar. The premise of the article was that everybody is bullish on the dollar, so much so that all of the optimism over Trump's policy initiatives may already be priced into the market. They conclude with a comment on valuation, "Today, the trade-weighted dollar is approximately 15% overvalued on a purchasing power parity basis against other G10 currencies. While expensive assets can get more expensive in the short run, valuations act as an anchor over the long run." Barron's ran a similar piece this weekend.

I agree with both of the positions above - we're due for a correction in stocks and the US dollar is more likely to weaken from here.

What's The Trade?

I think owning gold makes sense, but I learned early in my investment career to avoid "negative carry trades" (i.e. trades where the cost to own a security exceeds the yield earned) are a bad idea. In order to avoid holding an unproductive asset that just sits there, an investor can sell covered calls on their GLD position - effectively turning GLD into a dividend-paying asset.

One obvious drawback of selling a covered call on your gold position is that you cap the potential effectiveness on your hedge. For that reason, I want to leave plenty of upside (roughly 10%) between the current price of GLD and the strike price of the option.

GLD closed on Tuesday at $117.46. The $130 option expiring December 29, 2017 had a closing bid of $3.40. By selling the option above, you take in the premium of $3.40 (less commissions which should be minimal) for a cash-on-cash yield of 2.89% (or 3.25% annualized). If the stock market corrects or the US dollar weakens significantly, your GLD position should do well. You've limited your upside to 13.5%. If GLD does poorly, you've reduced your cost basis by $3.40/share, but the rest of your portfolio has probably done okay.

In summary, by utilizing a covered call strategy, you can turn gold into a portfolio insurance policy that pays YOU a premium (unlike traditional insurance). You capture the best investment attribute of the shiny metal (its reliability as a hedge in distressed markets), while mitigating its worst investment attribute (its lack of a dividend).

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GLD over the next 72 hours.

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.