In his latest online report, fund manager Axel Merk looks at the ongoing battle between gold and stocks. As many Denver Broncos fans are likely doing as their team heads to Sunday’s Super Bowl against the favored Carolina Panthers, the president of Merk Investments wonders if gold can prove its mettle.
“‘Stocks beat gold in the long run!’ is a ‘rallying cry’ to buy stocks we have heard lately that gets me riled up,” he said. “It’s upsetting to me for two reasons: first, an out of context comparison, in my opinion, misguides investors. [Second,] it might be the wrong assertion in the short to medium term.”
According to Wharton Business School Professor Jeremy Siegel, U.S. stocks had a real (after-inflation) rate of return of 6.7% from 1802 to 2013 vs. 0.6% for gold during the same period.
Year to date through mid-Wednesday, the SPDR Gold ETF (GLD) is up nearly 7.5% vs. a drop of 8.2% for the SPDR S&P 500 ETF (SPY). DoubleLine Funds CEO Jeffrey Gundlach says he thinks gold could hit $1,400 an ounce this year; it traded near $1,140 on Wednesday.
Merk admits that gold is not meant to outperform stocks in the long run. However, like bonds and cash, investors choose to add gold to a portfolio “not because we think they’ll outperform stocks in the long run, but because they may be valuable diversifiers.”
The portfolio specialist says investors need to recall how bonds performed from the end of the Great Depression through August 1979. “That negative performance has a good reason: We experienced an environment of financial repression as real interest rates were negative,” he explained.
Here We Go Again
This is the type of environment that Merk believes is favorable to gold, since receiving no interest is better than negative real rates.
Before 1971, though, gold couldn’t react due to the link between it and the U.S. dollar (“The ‘gold window’ closed because the U.S. could no longer sustain the link; not surprisingly, the period after 1971 was rather volatile and distortions (the boom/bust of 1980) were a side effect,” Merk stated.
As for today, we may be in a period like the Great Depression, he says, since “we are near the end of a debt super cycle.”
This means that after decades of credit expansion, it’s time for a reduction in the relative level of debt in the economy. This usually happens via growth, default or inflation.
“If our analysis is correct, then odds are high that the era of financial repression may well persist for some time, as the huge debt overhang is worked through,” Merk said. “In that context, gold, these days no longer pegged to the dollar, may perform favorably compared to bonds and the dollar. As such, gold may be a good diversifier to a stock portfolio, in the right circumstances.”
It’s within the context of diversification that Merk sees Siegel’s bullish stock stance as possibly “doing a disservice to investors,” he says. “Very few advisers recommend a 100% stock allocation; the reason we diversify our portfolios is because most of us are looking to maximize risk-adjusted returns.”
In fact, the portfolio manager adds, diversification is “the one free lunch that Wall Street offers.”
Though this does not necessarily mean that gold or any other specific asset is the “ideal diversifier … it strongly suggests that touting gold or any asset class as the single best investment may be problematic, unless accompanied by a litany of disclaimers/qualifiers.”
David vs. Goliath
Given stocks’ apparent outperformance, could gold possibly outperform stocks over the next two, 10 or 20 years?
“The challenge with historical comparisons is that one can always cherry pick to choose what suits one’s argument,” Merk said. “One can choose the price of gold at the peak of 1980 to see how long it has languished; or one can pick the top of the Nasdaq bubble, just as gold bottomed out a few years later to see how gold might do versus stocks for many years. Ultimately, what matters to investors is what the price of gold is going to do going forward.” The price of gold since 1971 (when it was decoupled from the dollar) during past bear markets produced an annual return of 7.7%, he says, “with a correlation to equities of zero.”
The one exception to this occurred in the early-1980s when rates rose. “As I have indicated in the past, anyone who expects a similar monetary policy, should not expect gold to perform well,” Merk pointed out.
“If we take the Fed at its word … rates may continue to be lower than normal (as the last paragraph of the FOMC statement has stated this since the spring of 2014). To me, that’s a commitment to be ‘behind the curve’, i.e. that rates will be rising slower than inflation,” he explained.
Of course, there is no assurance gold will do well in such an environment, Merk adds. But low rates are “a key long-term driver for the price of gold,” he said.
“If I look out 10 years and consider the projections of U.S. deficits, I have a hard time seeing how we can afford positive real interest rates. This may bode well for the price of gold,” the portfolio expert explained.
Merk is bearish on stocks in the current environment based on the premise that the Fed has “compressed risk premia, i.e. bid up asset prices and taken fear out of the market.”
Merk believes investors are now overexposed to equities, “having ‘bought the dips’ rather than prudently diversifying,” he says. “It seems the mentality is gradually shifting toward capital preservation, i.e. ‘selling the rallies,’ but this is a process that, in my assessment, will – at a minimum – take months.”
Furthermore, he equates the current environment to that of 2000, when investors seemed to be “in denial.”
The Fed could join the easing camp again, but Merk thinks it “will be late as [it is] too focused on the labor market that’s generally considered a lagging indicator. Think of the Fed having removed the lid from a pressure cooker; so even if or when the Fed turns to easing once again, it might have a difficult time preventing this bear market from unfolding.”
Given these conditions, gold could “perform quite well,” he states, and has put his money where his mouth is.
Merk started shorting equities in August, increased his short position in December and owns “a substantial position in gold, much higher than the small diversification amount advocated by some.”
While noting that gold “can be rather volatile measured in U.S. dollars,” just like stocks, “I’m not suggesting that everyone should go short equities; such a strategy is fraught with many risks,” he explained. “But I believe there may well be times when gold can outperform.”