Thursday's worry (or not) #2

I somehow messed up the formatting in the first post, and so I'm going to add a post about "when" to buy gold again.  Since I wrote this, I've noticed several research newsletters I read are recommending buying gold now before it skyrockets.

Be careful, be very very careful... Have a good systematic approach to buying an investment in gold; not because analysts and others say it is a good time.

So here is my 2 cents worth:

GOLD:  When is the time to buy?  

The time to buy gold coins as a hedge against chaos is right now:  immediately, do not pass go, and don't wait to get an out-of-jail ticket.    

The time to invest, however, is not now (unless you want a very risky trade going short gold).

What moves the price of gold?  Well, inflation does not really correlate well to the price of gold unlike what we've been told.  However, there is a significant correlation between the interest rates in the US and gold.  Let me be so bold as to be attacked (if anyone read this blog) by stating that it is useful to think of gold as a kind of currency whose supply is relatively fixed. (Bernanke would become extremely irritated at such a statement.) We can then look at Gold's price as simply the exchange rate between $$$ and gold. (Or if your currency is Canadian $$ or UK pounds, the exchange rate between those currencies and gold.  )

Ah those currencies... so much to learn from them. 

The big factors that control exchange rates between currencies are: 1) differences in yields, 2) The investors perception of the currency safety 3) the real exchange rate.  (If you disagree, and want to look at gold vs. dollar in action, look at the $$$ and gold yesterday.)  

Among currencies, the relative yields are the main driver of exchange rates.  Higher-yielding currencies tend to appreciate against lower-yielding ones.  

However, Gold has no yield.  The only time it has a yield advantage is when paper currencies have negative short-term real interest rates. Read that again.  If you were to use data-mining techniques analyzing gold and inflation and then analyzing gold and interest-rates, gold's price is well correlated with interest rates.  (Source Claude B Erb and Campbell R. Harvey "The Golden Dilemma" 2013)  

Currency stability has a great deal of influence on the exchange rates.  When the market questions the safety of a currency, they demand a hefty risk premium to own it; which translates to higher real interest rates.  However, gold has no risk premium.  

• KEY IDEA:  The more investors question the future purchasing power of paper currencies (including the US $$$) the greater the demand for gold, and the greater the demand for gold the higher its price.  (The mirror image of that statement is if the perception is that a paper currency will purchase more in the future, gold will fall.)
• KEY IDEA:  Gold has very little use in the production of things (excluding jewelry).    Therefore, it is an offset to currencies.  According to the Federal Reserve St Louis, the main players in the gold market are central banks and institutional investors.  Emerging markets (Russia, China and India for sure) have been diversifying their foreign exchange reserves by buying gold.  This propped the price of gold up without driving it to new highs for at least 2 years.  
• Key IDEA:  Purchasing Power Parity http://en.wikipedia.org/wiki/Purchasing_power_parity is an economic theory used to determine the relative value of currencies.  It asks the question how much money would be needed to purchase the same goods (or services) in two countries, and uses that information to calculate an implicit foreign exchange rate.  Gold's version of this in the US would be the ratio between Gold's price and the Consumer Price Index compared with the ratio's historical average.  Currently this ratio is at historically high levels approaching the ratio touched in 1970s.  Over a long time period, this ratio will converge toward its mean. 

Of course, gold has other vectors that influence price in the near term -- wars, terrorism of significant impact, and other events that drive fear into all mankind.  Consider those items to be unpredictable, and where they are predictable, gold will have the expectancy built into the price. 

Currently (even after the drop yesterday) gold's valuations vs. real goods are stretched to extreme levels. ·         Over the long run gold's price will likely converge to its historical average against the currencies.   In the short term, gold's price is supported by the lowest real interest rates in history and the Emerging market's central bank purchases.

Simple Systematic Approach TO WHEN:

1. When gold is going up against the four major currencies over the last month, it is time to buy gold (at least for the medium term and probably longer).  The major currencies are US, Euro, British Pound and Japanese Yen.  (You can set this up in Stockcharts.com using a PERF chart.)

• Going up verses all four currencies month-to-month is a very stringent filter.  The investor (vs the trader) would not be in Gold very often.
• The investor who tracks this way, would be in front of world-wide inflation, and that is a guarantee. 

1. Look for the opposite of the "Death Cross" called the Golden Cross.  When Price moves above the 200 day MVA and the 50 Day MVA and the 50 DAY MVA greater than the 200 day MVA, buy gold.  Pretty simple, is it not?  

If you are in investor reading this, then you know that MVA systems lead to whipsaws.  Read my one paragraph on money management.  The biggest issue everyone of us has is emotions.  Are we patient enough to wait it out?  The second biggest issue is not have a plan to execute (entry, risk, position sizing and so-on).

When both signals are positive, Gold (either through ETF's that invest in bullion, EFT's that invest in miners, or directly purchasing bullion certificates) will provide excellent returns.  (See Market Vectors Gold Miners: GDX)

If invested, then do not watch the Gold market everyday.  If you do, your emotions will gain control, and you will do irrational things as the Gold market is very volatile.

I get angry with newsletter that do not warn about money management.  Every investment requires a money management technique. 

• "Know when to hold 'em, know when to fold 'em, know when to walk away, and know when to run."  Kenney Rogers The Gambler

One needs an entry setup.  Then one needs to determine their risk in the trade (how much will you lose before you get out?).  Then an algorithm for determining one's position size.  And very importantly, where will you exit with a profit?  Of course, there are case studies by large university doctoral students on each of these areas.  I happen to think that most academic studies are worded in such a way as to keep the laymen from understanding, and the concepts I've mentioned are not that complicated when focusing on one asset. 

Remember, owning some strategic allocation of your investment portfolio in gold makes sense if you are concerned about your country's currency value (or chaos in the streets for that matter).  This strategic allocation is not for investment  (although it is nice if it increases in value).