Sound Money

Subsequent my March 2020 post “Protect Capital: The Case for Gold” the yellow metal has rallied 20% to all-time highs of $1975/ounce. Record highs incorrectly suggest to some that gold is expensive and that the rally is long in the tooth, but evidence refutes this inclination. Volatility and drawdowns should be expected, but current gold prices remain cheap. In this article I argue that we are in the early stages of the 4^th post 1970 gold bull-market. Allocations remain attractive as investors re-discover Store of Value.

The new All Time High (ATH) in the price of gold confirms that we’ve entered the 4^th gold bull-markets since the 1971 Nixon Shock when US President Nixon decoupled the USD from gold (prices reach a new record high during each cycle). Gold has rallied 75% from late 2015 to July 2020 which is tiny in comparison to those three bull-markets (monthly data). In the 1971-1974 bull market gold rallied 330%, in the 1976-1980 bull-market gold rallied 440% and in the 1999-2011 bull-market gold rallied 511%. Gold would have to rally another 240% to match the previous cycles, which suggests we’re very early in the 4^th post-1970 bull market.

An All Time High (ATH) is usually cause for concern, suggesting overvalued and expensive prices, but this is not the case with gold. Historically, if one had bought gold at an ATH you’d have recorded 2-year annualised gains of 18.2% on average. There’s wide dispersion in results between the various observations, which I’ve included in the graph below. Buying during the first 1 or 2 years of ATH in a new bull-market proved to be a very profitable strategy. It was only late in the gold bull-market that buying at ATHs proved unprofitable – subsequent 2-year annualised returns were negative. Given July 2020 was the first ATH since 2011, there’s a high probability that we’re early in this bull-market. 20%+ annualised returns in US dollars over the next two years is a very attractive prospect.  

A defining feature of previous gold bull markets was significant gold outperformance vs. equity. Not only did gold rally during these periods but it rallied relative to equity markets. I’ve included the gold/S&P500 ratio in the graph below to highlight this relative outperformance of gold. In the 1971-1974 bull market gold rallied 590% vs. the S&P500, in the 1976-1980 bull-market gold rallied 470% vs. the S&P500 and in the 1999-2011 bull-market gold rallied 418% vs. the S&P. Gold would have to rally another 570% vs. the S&P500 over the coming years to match the previous cycles. I’m not saying that I’m massively bearish S&P500. I’m cognisant that central bank liquidity can keep equity markets elevated. I’m not foolhardy enough to want to short equity, despite the overvaluation But I’m convinced that the outlook for gold is significantly more constructive than equity. This is a critical asset allocation implication given the majority of portfolios are heavily invested into equity. Small shifts in portfolio allocation towards gold, could see the gold price rocket higher.

My relative valuation metric (below) has ticked slightly higher over recent months as the gold price has shifted from $1600/oz in March to $1975/oz in August. But the change in relative valuation is muted because US money supply growth has ratcheted aggressively higher and asset prices haven’t fallen much (i.e. denominator is elevated). Relative to the store of value alternatives, gold remains cheap. We assess levels towards 1 standard deviation above long-term averages as a powerful exit signal for the precious metals bull-market. We’re a long way away from that point.

I looked at the previous incidences of new ATH during each bull-market to understand the price action and potential correction risks. In the early 1970s there wasn’t much a pull-back in prices at all. During the late 1970s prices corrected 15% lower after reaching ATHs, rallying another 430% from there.  

In 2008 prices corrected 29% lower before rallying another 167%.

A 29% decline in the gold price today would take prices back below $1400/oz, which would be significant.

I consider a 30% drop in prices unlikely given that the 2008 correction took place during the liquidity crunch of the global financial crisis. Nevertheless, it’s important to consider the potential volatility. A 10-15% correction is a more reasonable expectation after the massive run in the past 6 months. Mental preparation for downside volatility is important when investing into volatile speculative asset classes like gold.

Final point for this update, silver has experienced an eye-watering rally over the past couple of months, 106% since its March 2020 lows, outperforming gold. Silvers strong gains could cause some to take their eye off the ball and lose interest in gold. But it’s important to point out that silver gains vs. gold is another confirmation of the precious metals bull-market. Silver is the poor-man’s gold, with a lower stock-to-flow ratio. It has similar monetary characteristics to gold but is easier to find, easier to mine and its used for industrial purposes. It’s a store of value, but a less pure version than gold. When investors rediscover gold’s store of value characteristics during precious metals bull markets, this tends to spill over into the rest of the precious metals market and can result in strong gains in silver.

The chart below shows that the XAU/XAG (gold/silver) ratio tends to fall during gold bull-markets, confirming the silver gains vs. gold don’t detract from gold’s standalone performance.

I expect increasing interest in silver, gold miners and the rest of the precious metals complex as this precious metals bull-market heats up. For those who want to get cute and reach for potentially higher gains, they might find interest in these “sexier” opportunities. But obviously these opportunities come with risks. The smaller the niche, the greater the complexity and the more experience required to fully appreciate these risks. My primary thesis remains rediscovery of store of value in primary store of value technologies, like gold and bitcoin. Gold and bitcoin are specifically store of value technologies. There’s plenty opportunity, and risk, in both these asset classes without getting overly cute with the derivative investments.

Global central banks are in the midst of the greatest monetary experiment of history. They’re flooding money into the banking sector and financial markets as though there is absolutely no consequence and have confirmed over and over again that they will re-enter financial markets if there is renewed volatility. I appreciate that equity markets can march higher, climbing a wall of worry in the face of ridiculous quantum monetary loosening. But portfolios require a hedge, an insurance mechanism, against this monetary madness. Gold is just that, an insurance mechanism. Cash and bonds no longer provide that insurance. Clearly it would have been better to allocate to this asset class earlier this year, but this bull-market is just getting started. History suggests buying at All Time Highs is a profitable strategy. One might feel late the party in August 2020, but I expect that the FOMO (fear of missing out) will grow stronger over the coming quarters.