Friday, 14 April 2017

Portfolio Strategy: Why holding gold and associated equities may be a prudent action at this point.

Considering the present state of valuations in the US equity market with the S&P pushing 28x the shiller PE now is a time for caution in managing the portfolio. Only stocks with exceptional risk reward characteristics should be considered. I will continue to research these opportunities but I wanted to digress a little onto the topic of macro and gold.

"Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head." 
- Warren Buffet

Now in all honesty I agree with Mr Buffet. Except for the fact that others do consider gold a store of value and gold is a real asset by this measure. Not a productive one like farmland. Not a useful one like real estate. But it does have the characteristic of being liquid, tradeable on an exchange via physical ETFs and therefore it does qualify to go into my SIPP which needs to either be invested in securities or held in cash.

Therefore from a portfolio perspective I have to ask the broad question - is a stock market valued at 28x PE likely to give a significant return in the next year.  Valuations at this level are synchronous with poor or usually negative returns. Therefore I should hold more cash. Which I do.

[For the sake of simplicity I will stick to US valuations and the economy as due to the 'dollar standard' this really drives global markets]

Now the issue is in my opinion that the stock market is a bubble - and it will burst - followed by a huge negative wealth effect on the US consumer and things start to look highly deflationary. The US is already slowing and credit growth today is falling and this drives US economic growth. The Fed is tightening but they are way behind the curve. They are tightening into a slowdown. 

Trading Economics: US Loans to private sector

So currently the markets seem to have a collective delusion that the US is going to happily re shore jobs, raise interest rates and become the global powerhouse it once was. This is reflected in the very lofty value of the S&P because earnings growth has been very meager in the last 5 years. The S&P is rising due to expansion of the PE multiple. If earnings don't catch up, or fall, as happens in  recession, then the market is prone to a significant correction.

Now I may be wrong. But it would be prudent to position the portfolio defensively to prevent further capital loss when such an asymmetrical risk reward exists. And to take hedges.

Several weeks ago I bought a series of put options on the S&P because they seemed cheap. I have Puts at 1,975 expiring in June and in September. I took that level as it seems attractively priced. I consider these speculative insurance against a fall in the S&P. At current levels the S&P is at 2,328. This is less than 20% above the level of my options. Given the valuation levels today a very simple market shock could easily take the index down to a merely overvalued 23.7x Shiller PE at 1,975. Still well above the long run average of ~16x. 

Now back onto the subject of gold. 

The question one must ask oneself is; given gold was for a long time the standard of global trade and currencies should I hold gold instead of currency cash in my portfolio while being defensive and seeking out equity value opportunities? 

What would be the reason for doing this?

Well if we assume all governments want to remain popular I think we can assume that as the US enters a new recession and global markets sell off pricing in weaker earnings - I think we should also assume a renewed round of quantitative easing will take place as well as a fiscal stimulus to blow the bubble back up again. This is because the only alternative is a massive depression.

I have no interest in what Trump has said about the Dollar and strengthening the US and cutting their trade deficits - 

Trump has only one principle and that is 'how much do people adore me.' When he says to crowds 'I love you' he means 'I love this' adoration. 

Therefore Trump will do and say anything to remain popular and it is highly likely a massive stimulus will be announced. If the recession goes global (also likely) then here in the UK we can expect similar massive quantitative easing. And all this increase in currency is likely to lead to a decline in the real value of my cash in the portfolio. 

Trading Economics: The Fed balance sheet

Now my assumption here is that by the time the real QE kicks in equity valuations will already be on the floor pricing in recessionary earnings and I will want to be fully invested in equities again. But before this happens I expect gold to outperform the value of my GBP and USD cash in the portfolio in anticipation of further monetary easing. 

So at this point is seems prudent to move a proportion of cash in the portfolio into gold exposure. I will start with 5% into a physically backed ETF. I don't plan to get my gold out with a physical ETF - although I note SGBS offers this! - butI have no interest in futures backed ETFs because the rolling etc makes them less efficient and muddies the exposure.

Why an ETF and not a gold mining stock?

Simply because I will need more time to analyse the sector in order to select miners with the appropriate bottom up characteristics I want from my equities. And I am but one analyst. Furthermore if I am holding gold as a cash proxy the point is to then be able to be fully invested at a time offering better bottom up valuations for equities in general.

Something tells me I should really assign more than 5% of the portfolio cash to gold - but I will look for trading opportunities to move perhaps 10-15% of the my portfolio into gold and gold equities in the medium term.

Why not bonds instead of gold?

Treasury bills would be the other obvious alternative. But given it is likely the government will issue substantially even more of these in future they continue to lack the scarcity of physical gold. Also they are currently already at elevated prices (especially in the UK) with record low yields.

Trading Economics: UK 10 year yield

From the perspective of personal financial management the best things to own today seems like real assets; Houses, cars, land (maybe not boats - they are cyclical!) and a ready supply of cash to put into the stock market when times seem at their darkest.

For now all we have in global trade is the dollar standard. Until we have something else I struggle to foresee a better way.

plus ça change, plus c'est la même chose

Disclaimer: I have no interest in Gold of Gold backed ETFs at present although I may do in the future. These are opinions only, not investment advice. If in doubt read my disclaimer.

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