February 25, 2013 at 9:37 pm #17640
A few thoughts regarding Bill’s recent piece on “The Maddening Meaning of Cash” and the ongoing debate around the question of asset allocation, most recently covered in Rob’s February report:
I find it helpful to think of gold as money – after all, it has been for 5000 years or so, so why change that view now? If you see gold as money, then your gold holdings become part of your total cash position and the question of how much gold you should hold and whether you should be buying or selling it is reframed into a question of how much of your total cash position should you hold as gold, vs how much in each of the paper currencies. Seeing it in this light opens up some possibilities that might otherwise be obscured.
In this context, I’ve recently revisited an analysis I first did some time ago that triggers a “ buy” or “sell” signal for gold, based on the spot price vs a simple moving average. The spot price comes from the statistics page on the World Gold Council’s website (http://www.gold.org/investment/statistics/) and to reduce the effect of “noise” in the data (as well as the workload!) I’ve been using the month end spot price data that goes back to 31st December 1969. This gives us 518 months (43 year’s data to the 31st January 2013) to play with and includes two bull markets – the 1970s and the 2000s and the two decade long bear market through the 1980s and 1990s
The best results come from using a 12 month simple moving average (sma), where a buy signal is triggered when the month end spot price is above the 12 month sma (this is a “hold” signal if you are already in gold at the time) and a sell signal when the month end spot price is below the 12 month sma (this is a “hold paper currency” signal if you are already out of gold at the time). The analysis would need to be refreshed once a month when the month end spot price is updated by the World Gold Council. Not too arduous a task once you have set it up.
The analysis assumes that when you are out of gold, you are in US$ and you invest this paper currency at the Fed Funds rate. It is these funds, including interest earned when in cash, that are reinvested in gold when the next “buy” signal appears.
The results are really quite surprising: if you start with 100 oz of gold at 31/12/69, you finish up with 513 oz as of 31st Jan 2013 – a total return of +413% in gold, corresponding to a compound annual rate of return of 3.87% over 43 years, from an asset that is supposed to be “dead money”. This is achieved without investing any more capital than the original 100 oz of gold and interest earned at the Fed Funds rate when in cash.
You might think this is worth getting out of bed in the morning to look at.
This result is also quite counterintuitive – how on earth can you effectively accumulate “interest” on a holding of gold – so worth some explanation: The sma-based “buy/sell” signal tips you out of gold during prolonged bear markets and into cash, where interest rates are high at the time (which is why gold is in a bear market at such times). It then tips you back into gold when the gold price is significantly lower but on a rising trend, so you accumulate more gold in this way. The paradox is that the sma system works really well during gold bear markets, but not at all as well during bull markets, since short term reversals in the gold price during a bull market can tip you out of gold and you may be then be tipped back in when the rising underlying trend has pushed the price up, and in the course of doing so, has pushed it above the 12-month sma, triggering a buy signal but at a higher price that your previous exit price.
This effect can be summarised as follows: During the bull market of the 1970s, if you started with 100 oz gold on 31/12 1969, 10 years later you would have 136 oz – not a bad result, you might think. However, during the bear market of the 1980s, this would have risen to 452 oz, then to 693 oz by the end of the 1990s. Well done! But since then, during gold’s current bull market, your holdings would have dropped to the 513 oz referred to above – ie a loss of 26% from the level as at 31/12/1999
On the face of it, a trend-following approach like this looks like a trading system rather than a way of managing your gold holdings, therefore may not seem suitable for family offices wanting to take a long-term view of their portfolio. Returning though, to the original point in this note, if you see gold as cash and you actively manage your cash balances between currencies, then perhaps you are doing this sort of thing already. To put this into context, the 12-month sma system generated a total of 50 trades over the 43 year period, or just over one per year. How often do you switch currencies?
A few final notes:
First, to keep this model as simple as possible, I’ve built in some assumptions: I’ve had to assume that transactions are “frictionless” – ie there’s no commission on purchases or sales, no capital gains tax, no holding costs for gold and no tax on interest earned when in paper currency. All of these would reduce the calculated return. To scope the latter point, if I reduce the interest rate earned on cash in the model (the Fed Funds Rate) to zero (ie, equivalent to 100% tax on interest), the gold held at the end of the period falls to 178 oz from the 513 oz described above – ie an effective annual accumulation rate of 1.35% on gold over the 43 year period. Still, better than just sitting on the metal, but well short of the “frictionless” 513 oz
Second, there is the point that if this system works really well during bear markets but not so well during bull markets, you might ask: don’t you first have to know whether we’re in a bear or a bull market, to know whether to use it or not? The answer to that is that unless you are highly confident about the direction of the market, you either have to use this system all the time or not at all. You might, for example, consider using this system for some of your gold all of the time
Finally, the really boring one: I’m not an independent financial adviser, so the usual caveats about this not being financial advice apply, plus the past 43 years is no guide to the future, etc, (blah, blah, blah…). No-one is paying me to do this piece of work – I just enjoy playing with the data in my spare time and most important of all, I can make mistakes, so don’t take what I say as the gospel truth! However, at the risk of repetition, it might be worth worth getting out of bed in the morning to look at this…
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