Start Buying GLD

Summary

• GLD has suffered a draw-down exceeding -16% from its all-time closing high in August 2020.
• While the current draw-down is mild compared to the worst historical drawdowns, GLD is now attractive relative to overbought stocks.
• Despite several downside risks, I believe it is time to begin allocating more to GLD while reducing exposure to equities.

Photo by Filograph/E+ via Getty Images

After falling over 16% from its 2020 highs, the SPDR Gold Trust ETF (NYSEARCA:GLD) is starting to appear relatively attractive compared to stocks in my opinion. While the gold price may decline further as the global economy continues to recover, I believe investors should begin reducing their exposure to overbought equities in favour of gold.

A mild draw-down compared to historical precedent

While the draw-down in GLD may feel like a sharp decline for an asset widely considered to be a safe haven, it is worth remembering that the spot price of gold fell almost 45% from its previous record high of around $1,920 per ounce in 2011 to a low $1,045 in late 2015:

Source: Created by author using data from Stockcharts.com

Although we cannot rule out a similar draw-down during this period of economic recovery, the current macro-economic context should not be as challenging for gold as the 2011-2015 period.

The 2011-2015 period involved a gradual withdrawal of monetary accommodation from the US Federal Reserve following an unprecedented era of support in the wake of the 2007-2009 Global Financial Crisis, or 'GFC.' By contrast, the recent rhetoric from Fed Chair Jerome Powell suggests that the Fed will likely be more active during this recovery. This may come about either by the Fed sustaining its current asset purchase program or implementing yield curve control should long-term rates exceed a threshold that they feel threatens the economic recovery.

The risk of further downside in GLD

The worst thing for the gold price is a broad recovery and a gradual bear steepener in the USD yield curve. In a bear steepener, the yield curve steepens because long-term rates rise and short-term rates remain low or rise at a slower rate. The current spread between the 30-year and 2-year US Treasury bond yields is 2.29%, which is far below the post-GFC high of 4.05% from early 2010. A further bear steepening is therefore entirely possible as investors force a repricing in longer-term Treasury yields due to evolving growth and inflation expectations while the Fed keeps rates low at the short end.

The worst thing for the gold price would be a broad recovery and a gradual bear steepener in the USD yield curve. A further bear steepening is entirely possible due to evolving growth and inflation expectations.

Rising Treasury yields are typically bad for gold because positive real interest rates provide a reasonable alternative to holding gold, which does not provide any income. In other words, positive real interest rates are the opportunity cost for holding gold.

It is important to note that the Federal Reserve did not start raising short-term rates until December 2015, which means the first rate hike coincided almost exactly with the bottom of the 2011-2015 bear market in gold. A repeat of this 'sell the QE, buy the rate hike' approach would mean that the gold price could decline further for years to come if the Fed were to once again gradually and cautiously tighten monetary policy.

Another important risk is a continued shift in preference among investors from analogue forms of gold (physical and paper) to digital forms like bitcoin. Many investors are embracing certain perceived advantages of bitcoin over gold, including institutional investors like Skybridge Capital:

Source: Skybridge Capital, December 2020

Investors must remain humble and proactive in the wake of such transitions in sentiment and position our portfolios accordingly.

Fickle correlations

Gold's correlations to various markets and data points are notoriously fickle. Many investors seek to divine gold's future price movements through their views on real USD interest rates, the US Dollar, USD inflation expectations, the size of the US fiscal deficit or some combination of these factors. While many of these relationships have held over the long term, particularly the inverse correlation between real USD interest rates and gold, they often break down from their usual patterns for weeks or months at a time.

Many investors seek to divine gold's future price movements through their views on real USD interest rates, the US Dollar, USD inflation expectations, the size of the US fiscal deficit or some combination of these factors.

At the moment, it seems as though gold is resuming its inverse correlation with real USD interest rates in that the gold price is declining at the same time that real rates are rising. This means the gold price would continue to decline if real USD rates rise in the near and medium terms.

Stretched sentiment

I recently wrote about how the iShares 20+ Year Treasury Bond ETF (TLT) reached an oversold extreme in the weekly Relative Strength Index, or RSI, creating a good short-term buying opportunity. There is no such oversold extreme in the weekly RSI for GLD, which means we do not have a similarly strong technical buy signal. However, GLD is close to the oversold threshold given that weekly RSI has fallen to 39.91:

Source: Created by author using data from Stockcharts.com

We can observe an even more acute example of extreme sentiment by looking at the extent to which the 30y-2y Treasury bond yield spread has become overbought:

Source: Created by author using data from Stockcharts.com

I believe such extremes in treasury yield spreads represent a good opportunity to buy GLD for a short-term trade.

Start reducing exposure to equities in favour of gold

I recently wrote that stocks, particularly small and mid-cap US stocks, appear to be approaching a short-term top and are vulnerable to a sharp correction. We can sometimes anticipate such corrections by observing the relative strength of risk assets, like stocks, versus safe haven or 'risk-off' assets like Treasury bonds and gold. Indeed, the relative strength chart of GLD versus the Vanguard Total World Stock Index ETF (VT) shows us that gold is oversold relative to stocks based on weekly RSI:

Source: Created by author using data from Stockcharts.com

Periods when gold becomes 'oversold' relative to stocks on weekly RSI often coincide with turning points when gold starts to outperform stocks. The risk vs. reward of taking some profit from your equity exposure and investing the proceeds in gold is therefore strong in my view.

Gold miners or gold?

Investors considering an allocation to gold miners should keep in mind that the VanEck Vectors Gold Miners ETF (GDX) suffered a draw-down of -80% over the same 2011-2015 time period that GLD fell -46% from its previous all-time high:

Source: Created by author using data from Stockcharts.com

Moreover, GDX has yet to recover its all-time high even though gold prices made a new all-time high in 2020. This means an allocation to gold miners, even through a diversified approach, requires a nuanced and independent assessment.

From a fundamental perspective, it appears as though gold miners are relatively undervalued compared to analyst expectations. Based on the most recent data I was able to obtain, the weighted average upside to the average analyst price targets for the top 10 holdings of GDX is over 26%:

Source: Created by author using data from Yahoo! Finance, VanEck.com and TipRanks.com, April 5, 2021

I consider this to be a positive point for an investment in GDX. However, the fact that stocks are generally overbought means I would prefer to see at least 30% of upside before considering a position in GDX more seriously.

We can also see that the top 6 holdings, which represent just over 50% of the total, have relatively solid balance sheets given the net-debt-to-trailing-EBITDA figures. This is important in terms of assessing further downside risk since over-leveraged companies are more likely to struggle, especially during periods of rising interest rates when refinancing becomes more challenging. Also, these stocks do not appear on average to be egregiously expensive based on forward P/E multiples and trailing EV/EBITDA:

Source: Created by author using data from Yahoo! Finance and VanEck.com, April 5, 2021

Given the historical volatility and draw-down profile of GDX, I would only consider GDX for short and medium-term trades rather than a permanent holding in a diversified portfolio. With that in mind, we can observe an interesting trade set-up emerging for GDX where there appears to be support at $30 and resistance at $45. For investors who are keen to increase their exposure to gold through the miners, I would start with a 40% position between $32 and $34 and seek to complete the position if price declines below $31.

You can place a stop-loss below $30, with the exact level of your stop-loss depending on your conviction. However, I would not chase this trade higher given that the price has already recovered over 10% from recent lows.

Given the historical volatility and draw-down profile of GDX, I would only consider it for short and medium-term trades rather than a permanent holding in a diversified portfolio.

Asset allocation considerations

I suggest below a couple of simplified asset allocation profiles for investors with long (over 10 years) and medium-term (7 to 10 years) time horizons along with short-term tactical considerations:

Source: Created by author

In each case, I suggest holding at least 5% in gold as a strategic or permanent allocation since it can provide a small amount of protection in terms of volatility and draw-down risk in a portfolio dominated by stocks. Moreover, gold should retain its value better than cash as long as the rate of monetary inflation remains positive and exceeds the rate of any depreciation in the gold price.

Conclusion

Amid the sharp drop in GLD, I am short-term bullish and medium-term neutral at the current price level of $162. As such, I believe it is a good time to start reducing equities in favour of gradually increasing allocations to gold. If GLD continues to underperform equities in the coming months, my medium-term view will likely switch from neutral to bullish.

Analyst’s 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.