No two investments have louder, more dedicated cheering sections than equities and gold. Equity investors are optimists. They see growth ahead and view their asset class as a means to benefit from an expanding economy. Gold bugs are pessimists. They see danger on the horizon in the form of financial crises, war and, above all, inflation. Equities and gold also have something that the other major asset class, fixed income, lacks: high volatility. Fixed income gives a steady return (though not always a positive one, especially after factoring in inflation). The common themes are that gold benefits from inflation, war, and economic distress. Equities benefit from stability and growth.While fixed income has a pretty good track record of risk adjusted returns and inspires a great deal of interest, it hardly spurs passion. Equities and gold have two other things in common:
While investors traditionally view gold and equities separately, and price them in USD, they can also be seen as a ratio (Figure 2), a scale that measures optimism and fear.
The S&P® / gold ratio is given to extremely long and powerful trends. Since the 1920s, it has essentially undergone seven phases:
The common themes are that gold benefits from inflation, war, and economic distress. Equities benefit from stability and growth.
The above analysis may be interesting to the historically inclined and to trend followers but it doesn’t really answer the key question: Is gold actually a good investment? In real life, investors don’t usually choose between equities and gold but rather between equities and fixed income. Also, in real life equities pay dividends. One of the short comings of the S&P 500® / gold price ratio is that it fails to take into account dividends. Two percent per year dividends might not sound like much but when one compounds them out for 87 years, they add up to about a 460% return – no small oversight. Gold, meanwhile, doesn’t really earn much in the way of interest.
For obvious reasons we can’t answer the question “is gold a good investment” with certainty. What we evaluate with confidence is whether or not gold was useful to portfolios in the past. To do so, we compare the risk adjusted excess returns of gold to the risk adjusted excess returns on stocks and bonds. First, we define an excess return as being equivalent to the price return + any dividend or interest – return of the risk free rate (T-Bills). Second, we scale up the risk of gold and U.S. Treasuries to the same level as equities – this can easily be done via futures. Finally, we find the optimal risk allocation between the three asset classes for two different periods (1928 to 2015, and 1985 to 2015). For the longer period, we use annual data assembled by Stern Business School and the St. Louis Fed. For the shorter (but still lengthy) period we use daily data from futures that trade at CME, CBOT and COMEX, rolled five days prior to expiry. Futures have the convenient property of already being in excess return and taking into account dividends, interest accumulation and storage costs.
The results show the following:
|Correlation Table||1928 – 2015 Annual Data||1985 to 2015 Daily Futures Data|
|U.S. Treasuries & S&P 500®||0.00||-0.03|
|U.S. Treasuries & Gold||-0.02||-0.06|
|S&P 500® & Gold||-0.09||-0.01|
|Source: Federal Reserve Bank of St Louis, NYU Stern School of Business, Bloomberg Professional (TY1, SP1 and GC1) for raw data with calculations performed by CME Economic Research.|
Correlations between the three asset classes are close to zero. Equities and bonds have historically earned much higher returns than gold on a risk adjusted basis.
|1928-2015 Annual All Asset Scaled to S&P 500® Risk||Average Annualized Excess Return over T-Bills||Risk = Standard Deviation (scaled from)||Information Ratio (Average Return / Standard Deviation)|
|U.S. Treasuries||4.13%||19.30% (from 6.97%)||0.214|
|Gold||1.30%||19.30% (from 17.29%)||0.067|
|Blend 1*||6.77%||19.30% (from 13.72%)||0.351|
|Blend 2**||7.02%||19.30% (from 11.81%)||0.364|
|*Blend 1 is 55% equity and 45% bond risk; **Blend 2 is 47.5% equity, 37.5% bond and 15% gold risk. Allocation is based upon risk and not upon $s because bonds and gold are adjusted to equity level risk using the risk-parity approach.|
|Source: Federal Reserve Bank of St Louis, NYU Stern School of Business for raw data with calculations performed by CME Economic Research.|
There is much to quibble with over the longer period analysis. Bond futures didn’t exist until the late 1970s and it would not have been easy or even possible to lever up their returns to equity-level risk beforehand. Gold futures didn’t exist until 1975 and gold was not really tradable by the public in the U.S. from 1933 until 1971. The strong point of the longer-term analysis is that it indicates how the three assets performed over many different economic periods.
The shorter-term analysis using daily futures data from January 1, 1985 until present (almost 31 years) comes up with some fairly similar conclusions, at least insofar as gold allocations are concerned. What is strikingly different is the relative allocation of stocks and bonds. While stocks did better than bonds in risk adjusted terms from 1928 until present, the opposite is true from the 1985 to-present period. Bonds were the chief beneficiaries of the great disinflation and the financial crisis.
|1985 - 2015 Daily Futures with All Asset Scaled to S&P 500® Risk||Average Annualized Futures Return||Risk = Standard Deviation (scaled from)||Information Ratio (Average Return / Standard Deviation)|
|U.S. Treasuries||13.65%||19.61% (from 6.51%)||0.696|
|Gold||2.25%||19.61% (from 16.4%)||0.115|
|Blend 1*||15.27%||19.61% (from 14.66%)||0.779|
|Blend 2**||15.51%||19.61% (from 10.49%)||0.791|
|*Blend 1 is 31% equity and 69% bond risk; **Blend 2 is 26.5% equity, 62.5% bond and 11% gold risk. Allocation is based upon risk and not upon $s because bonds and gold are adjusted to equity level risk using the risk-parity approach.|
|Source: Bloomberg Professional (TY1, SP1 and GC1) for raw data with calculations performed by CME Economic Research.|
Going forward, we think that two things from the past will likely remain the same:
Those familiar with our research will know that we aren’t especially optimistic about gold in the short term because we think that it’s driven by mining supply to a much greater extent than most people realize, and that mining supply, in our view, is likely to continue growing. Our perspective on mining supply appears to be in the minority. Many analysts think that gold mining supply is likely to come down significantly in the next few years. If mining companies begin shutting down production, it would be bullish for gold.
With respect to gold demand, we don’t see inflation becoming a major problem with average hourly earnings growing at a modest 2.5% year on year. The Fed seems to disagree, however. If they didn’t think that inflation was a threat at all, they probably wouldn’t be considering raising rates. To the extent that they tighten, however, this should be negative for gold as it will quell inflation fears while, at the same time, highlight the contrast between (near) zero interest rate gold deposits and rising interest rates on T-Bills and other short-term interest rate instruments in the U.S.
While we aren’t particularly hot on gold, it’s hard to be enthused about bonds or equities either. Whatever bonds do over the coming decade, with ten-year yields currently around 2% in the United States, the UK, Spain, and Italy, and below 1% in France, Germany and Japan, it will be a challenge for them to produce strong risk-adjusted returns that resemble what they have achieved during the past three and half decades. In fact, we wouldn’t be surprised if fixed income returns are close to zero or even negative, after inflation, over the next decade or so. U.S. fixed income yields were at levels similar to those that prevail today during the late 1940s and early-to-mid 1950s. Over the course of the late 1950s, 1960s and 1970s, investments in ten year U.S. bonds earned negative returns after subtracting inflation.
Equities present a more complex picture. U.S. stocks have moderate to somewhat-higher-than-average valuation measures on an outright basis with P/E ratios of around 17.5x earnings. On the downside, corporate profits aren’t growing very quickly and with the Fed apparently getting ready to hike rates, the cost of capital might begin to increase slightly. Equities in Europe and Asia are a bit cheaper than in the U.S. and might outperform the S&P 500® in coming years, especially if the U.S. dollar remains strong.
Even if neither gold nor financial assets, like bonds or equities, look especially attractive, investors presumably have to put their money somewhere. Chances are that one or maybe two of these asset classes will perform quite well over the next decade or so. The problem is that we don’t know which one it will be in advance. This is the argument for holding a diversified portfolio. In the past, which is no guarantee of future results, holding gold as part of a diversified portfolio would have marginally improved the portfolio long-term risk adjusted returns. Gold would have helped portfolio returns during periods of high inflation, negative real interest rates, war and declining mining supply and would have detracted from portfolio performance in most other periods.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.
View this article in PDF format.