With 2022 behind us, it is our duty as investors to re-evaluate our decisions, learn, and add new tools to our toolkit. Most holiday party conversations have probably been centered on growth equities getting crushed and bonds having their worst year in memory. Put the two together and the typical 60% stocks/40% bonds portfolio has had a truly miserable year.
But there were areas where one could find protection. As many of my readers know, my investment landscape consists of not only stocks and bonds, but also gold. I urge everyone to read one of my first articles from this past year before going further (Small Data Sample Shows Big Potential (forbes.com). In this piece I took a quant approach to 50 years’ worth of fed tightening cycles, coupled with macroeconomic regimes, and what our proprietary models at Proficio Capital Partners predicted for asset class returns. I then layered this analysis with one of two paths for the fundamental direction of the economy (will Powell turn into Volker 2.0? or will he take his foot off the gas early?). I came to the conclusion that gold would prove to be a great hedge to equities or have strong absolute performance.
Well, the dust has settled on 2022, and while Powell’s direction is still evolving, my gold prediction has been proven accurate. During a Russia -Ukraine war (helping gold) and the Fed raising rates more than many anticipated (hurting gold), we now sit with spot gold (in USD) essentially flat for the year… a nothing burger. Show of hands, who would take a significant part of their portfolio being flat this year?
But now we look forward, using what we have learned to guide us.
First things first, gold (like all risky assets) suffers when the Fed is raising rates. From its peak in March to the lows of September, spot gold was down just over 20%. This came after the geo-political fright of the Russia Ukraine conflict wore off and the Fed ramped up its hiking effort. Equities got hit during this time and when you line up the charts, they look identical. Recently, however, there has been a shift. The Fed has slowed hikes from 75bps to 50bps (which can change) and from November to year end the S&P was down ~1% while spot gold was up over 10%.
Similar to the prior piece I referenced, the work I have done recently is rooted in historical analysis. Fed tightening has caused significant inversion across the yield curve. Since 1973, I analyzed 5 periods of sustained inversion between 3 month and 10-year rates. Gold held its ground during each inversion period (the worst down 1.8%). Again, I went a step further and coupled this with our proprietary asset forecasting models. Today, our models predict gold to be in its highest quintile of projected returns (and equities in its lowest), which is similar to the 2000 inversion cycle. Upon exiting that inversion, gold nearly doubled over the next five years while equities were essentially flat.
While this is re-assuring, an n of 1 is no basis to make decisions. We must understand the fundamentals. The dot com bubble period and today are similar in that we are witnessing a major correction from non-sensible valuations and business models. So far, in both cases value and gold replaced growth as the primary investment themes.
It is also important to note that, separate from Fed hiking, there is a debate regarding recession (which usually occurs 12-18 months following inversion). As recession rhetoric then reality take over, equities suffer as estimates are revised downward amid margin compression. Gold, on the other hand, does not suffer from this as no earnings are tied to it. But gold investors know that Fed easing is just around the corner.
Finally, and arguably the most significant, fundamental reason to be bullish gold is the record amount of Central Bank purchasing. The World Gold Council reported that there were 400tn of global central bank purchasing in Q3 alone. YTD purchases are over 670tn, surpassing all annual totals since 1967. Couple that demand pull with little to no new supply coming on and the stage is set for prices to climb.
The timing today isn’t perfect as the Fed is still tightening. That said, the fundamental set up across the yield curve inversion, relative valuation, and Central Bank buying has me encouraged for the long-term prospects of gold and gold mining stocks. Remember the 60/40 portfolio is not the only asset allocation decision you can make. On the next bout of gold price weakness and clear direction toward pause/pivot from the Fed, I will reiterate using those opportunities to reach maximum gold exposure.
All data for this column was sourced from Bloomberg LP.