Wednesday, February 24, 2016

Gold Shines

Recently, one of my Emerging Trends Trader stocks outshined all others, figuratively and literally. It is an Aussie-listed South African gold producer. I tipped this stock some time ago, based on the forecast of a structural recovery in commodity prices. That obviously hasn’t happened; nevertheless, this gold producer’s stock price has skyrocketed.

In my initial stock report, I talked about gold’s ability to rally during a crisis. The crisis today was not what I was aiming for. Yet here we are, right in the middle of a stock market crisis.

I am going to talk about gold from three angles today: long term relationship with the commodities market, correlation with the stock market, and trading model.
Gold tracks the commodities basket overtime

This is what I have been repeating over the months and years — gold is not some ‘special’ asset. It tracks the commodities basket. When commodity prices go down, gold follows, as does silver and platinum. That means, unless you are forecasting a structural recovery in commodity prices, there is no basis for buying gold.

The economic reason for why gold tracks the commodity basket is simple. As a hedge against inflation, gold tends to go up when commodity inflation picks up.

Gold has one ‘special’ property, and that is its status as a ‘safe-haven’ asset. People view gold as a place to run when crises break out. This happened during the Global Financial Crisis, and it is happening again now.

The current market crisis has produced a rally in gold. We could speculate that, when market conditions calm down, gold prices are going to pull back somewhat in the absence of a broader commodities rally.

Over the past month, return on gold has been more than 10%. For the stock I tipped, it has produced more than a 50% return since last year.

Below is a distribution diagram for historical gold return at a monthly frequency. The ‘bell-shaped’ distribution tells you how many months (on the Y-axis) contained what returns (on the X-axis).

What we find is that gains of more than 10% are a rare occurrence in history. It happens to be the same for the negative side. That means it is rare to be in a situation like now. This naturally leads to a reassessment on how long this gold rally will last.
How does gold stack up against the stock market

Before I get to speculation on where gold is going to go next, I will analyse how gold has evolved against the stock market in recent years.

Below is the 12M correlation between the Emerging Trend Trader gold producer stock and the All Ordinaries. Correlation is a percentage number between ‘positive 1’ and ‘negative 1’. A positive 1 suggests a stock is perfectly in sync with the market. A negative 1 suggest a stock is a perfect inverse image of the market (market goes down but stock goes higher).

This particular gold producer has benefited from the rise of gold prices in recent months. Its correlation with the market went dramatically, and quickly, from positive to negative. What that suggests is that this stock has become a ‘perfect’ hedge against a falling market. And it is all thanks to the gold rally.

It doesn’t matter if you are an investor or a professional money manager, you should be looking for lowly-correlated and negatively-correlated assets in market crisis like now.

In essence, gold has saved the day…
Implications for trading

For anyone who can go long and short on gold, the simplest strategy for gold is to employ what we analysts call a ‘time-series’ model. It basically says there is a trend in gold price, and that you can profit from trading that trend.

The particular strategy for gold is very simple; if the long term trend of the gold price is going down, you ought to short it. If it is going up, you ought to buy it. That sounds awfully like a momentum trading strategy, doesn’t it?

Of course, that would mean you would take losses in rare occurrences, such as rallies during stock market crises. However, if you are trading for the long term, this strategy would win out by having the majority of the trades right.

The long term trend of gold was negative for the month of January 2016. That means you should have a short position on gold in February 2016. That, of course, would have given you a loss, but you would win over the long term.
The economics of gold

Gold is primarily consumed and produced by countries such as China and India. It is mainly used for marriage-use jewellery. There is a much smaller component of ‘financial-use’ of gold. That tends to fluctuate over time.

As a long-and-hold asset, gold tracks the commodities basket over the long term. Commodities can contribute to the overall diversification of a portfolio in the long term. This means diversifying into gold is a prudent move. If you are a long term investor, that is what you should be looking at.

For anybody who trades gold, some agility is required. Gold producers can be a good proxy for bullion prices due to their bigger price swings. I would recommend gold stocks over gold ETFs due to their higher return-to-risk profile.

Regards,

Ken Wangdong,

Analyst, Emerging Trends Trader

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