(Bloomberg Opinion) -- When I went to business school at the University of San Francisco, our class was instructed to build a portfolio that we believed consisted of 10 stocks that had the best ratio of reward to risk, or in other words, the highest Sharpe ratio. I chose gold mining company Placer Dome as one of my stocks. At the time, Placer Dome (which has since been acquired) had a slight negative correlation to the rest of the market, which means that by adding it, I was reducing the overall risk in the portfolio. My professor was impressed, but he wouldn’t be now.
If you’ve been paying attention to prices of gold and gold mining stocks the last few weeks, you probably noticed that they go up when the stock market goes up, and they go down when the stock market goes down, limiting the usefulness of gold as a hedge. This isn’t the first time this has happened. Gold fell hard during the early days of the pandemic in March 2020 on the theory that investors would sell their winning trades, which included gold, to pay for their losing trades. For whatever reason, the risk-reducing properties of gold have pretty much disappeared.
Last year, I wrote that investors should think about an asset’s contribution to portfolio risk, rather than the risk of an asset in isolation. And that had been the main reason to hold gold, regardless of whether you think it’s price will go up or down. But lately, gold is adding to portfolio volatility, and it just goes down all the time no matter what else is happening in markets. In the interests of full disclosure, I have been holding gold continuously since 2005, on the idea that against the backdrop of very loose monetary policy and a leftward drift in the political environment, that precious metal would outperform stocks on a long-term basis. It’s turned out to be about a push.
At the risk of stating the obvious, inflation rates are very high and the performance of gold has been terrible. There are a number of theories for this, and none of them good. Lots of smart and very rational people believe that the price of gold is manipulated. For a while, it seemed like the price of gold would drop about $10 to $15 an ounce every day at 8:30 a.m. New York time. What other explanation could there be for these unusual moves and gold’s underperformance?
I have a few. The most obvious is that shorting gold has worked so well for so long that people reflexively keep doing it. Profitable trades attract copycats. Price discovery for gold takes place in the futures market, which is exceptionally liquid, allowing for the sale of a few years’ worth of mine production in a single trade. My guess is that there are lots of big macro hedge funds that routinely short gold, along with more than a few artisanal asset managers. But I don’t know anyone that is selling gold, but that is a bit like the old Pauline Kael quote about how she didn’t know anyone who voted for Richard Nixon. It is about who you surround yourself with.
What people tend to misunderstand about gold is that it is a “faith” trade, not unlike Bitcoin. There is a whole cohort of investors who will never sell gold, no matter how low it loses in price, which partially explains why even though it hasn’t performed well during a period of high inflation, it hasn’t gone down much, either. And as despondent as the gold bugs are about the performance, the drawdown in gold has been smaller than for stocks.
A good reason to hold gold is because it is a hedge against really bad things happening. During the stock market crash of 1987, gold jumped about 10% to $500 an ounce over a couple of months, and about the same in the weeks after the Sept. 11, 2001, terrorist attacks. But attitudes toward gold have changed in the last 20 years. It no longer commands the status as a rock-solid haven. On Thursday, during the worst day in markets in more than two years, when everything was down, so was gold.
It’s getting to be that faith is the only reason to own gold, everyone knows faith isn’t a strategy.
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Jared Dillian at [email protected]