Radical Gold Underinvestment

by Adam Hamilton, Zeal Gold remains deeply out of favor thanks to global central banks’ extreme money printing. This fueled a global stock-market levitation that has temporarily short-circuited normal market cycles, leaving investors infatuated with stocks to the exclusion of prudent portfolio diversification. This has left them radically underinvested in gold, which sets the stage for massive mean-reversion buying when they inevitably return. Portfolio diversification is an absolutely essential tool for investment risk management. This simple and powerful wisdom is ancient, as a three-millennia-old quote from the Israeli king Solomon reveals. He advised, “Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.” Indeed history has proven countless times that putting all one’s eggs in one basket is foolish. And that doesn’t just mean diversifying portfolios across individual stocks, but entire asset classes. The vast majority of stocks are highly correlated with each other, and the general stock markets. So when the next major selloff inescapably arrives, individual stocks are all going to spiral lower together. While owning different stocks mitigates individual-company risks, it has very little diversification value in major selloffs. So throughout the dozens of centuries since the super-wise Solomon opined on portfolio diversification, the truly smart investors have diversified across asset classes. While they owned stocks or whatever the equivalent ownership stake in businesses was in their time, they also owned the local bond equivalent, real estate, and precious metals. Because of its unique behavior, gold is the most important diversifier of all. Stocks are highly correlated with each other, and the stock markets as a whole are highly correlated with the broader economy. And so are bonds and real estate. So when the market cycles inexorably turn and a new bear market begins, these portfolio mainstays all drop together. The precious metals are the only major asset class with a strong inverse correlation to stock markets, they thrive when stocks are weak. Prudent investors have always understood gold’s indispensable roll in portfolio diversification. The best financial advisors throughout history have recommended all investors have 5% to 20% of their portfolios in gold. It is the ultimate portfolio insurance, tending to rally dramatically when everything else sells off. But thanks to the extreme central-bank distortion in the stock markets today, gold has been left for dead. Stock markets normally meander in endless bull-bear cycles, driven by valuations. But in early 2013, the Fed’s unprecedented open-ended third quantitative-easing campaign started short circuiting them. The Fed was aggressively conjuring money out of thin air to buy bonds. And Fed officials kept on hinting that they would ramp up these debt monetizations if the stock markets fell materially, greatly altering psychology. Normally investors are wary of periodic healthy selloffs that rebalance sentiment, and act accordingly. But with the Fed effectively backstopping stock markets, this prudence vanished. Every selloff since early 2013 was quickly nipped in the bud. Buy-the-dippers rapidly flooded back in, usually on direct Fed-official jawboning. Eventually, investors started believing that serious stock selloffs can’t happen anymore. So they forgot about prudent portfolio diversification, and moved all their capital into that stocks basket. They bought into the Fed-fostered fantasy that the stock markets were essentially riskless as long as Fed policy remained super-accommodative. So they abandoned gold, leading to today’s situation of radical underinvestment in this essential negatively-correlated portfolio asset class. This extreme anomaly won’t last. American investors have probably never been close to even having 5% of their portfolios in gold, the lower end of the historical best practice. But we can still approximate how much their gold exposure has plunged in these recent Fed-distorted years. This is evident through comparing two key metrics, the capital invested in the GLD gold ETF and the collective market capitalization of the elite S&P 500 companies. GLD is the world’s dominant gold ETF, and acts as a conduit for the vast pools of stock-market capital to flow into and out of physical gold bullion. It is the cheapest, easiest, and fastest way for stock investors to get gold exposure in their portfolios. And of course the S&P 500 (SPX) is the flagship benchmark US stock index, containing the biggest and best US companies. The contrast between the two is illuminating. This week, the gold bullion held by GLD on behalf of its shareholders was worth $27.1b. Meanwhile the total market cap of all SPX companies was $19,729.8b. Run these numbers, and it suggests American stock investors’ total portfolio exposure to gold is just 0.14%. That’s far too trivial to offer any portfolio diversification at all. And such radical gold underinvestment is very atypical, even in the gold-agnostic US. Back in December 2012 just before the Fed’s incredibly-manipulative QE3 campaign kicked into full gear, GLD’s holdings were worth $74.1b. That worked out to 0.56% of the SPX components’ market cap. While still low, that was a whopping 4.1x higher than today’s anomalous levels. And back in August 2011 the last time gold was really in favor, this GLD-holdings/SPX-market-cap ratio climbed to 0.79%. So even in recent history, relative gold investment as a percentage of stock investors’ portfolios was 5.8x higher than today’s levels! This reveals how extreme today’s gold underinvestment by American stock investors is. Their portfolio gold exposure today via GLD is only around 1/6th of peak levels relative to stocks, and about 1/3rd of absolute levels in terms of capital invested in GLD. This is super-bullish for gold! Continue Reading>>>

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