Dow Soars to New Highs: Should You Insure Your Gains with Gold?

 
The champagne was popping last week as the Dow set a new all-time record, eclipsing the one set in October, 2007. The buy and hold crowd ultimately prevailed, but it was an eventful journey.

From October, 2007 to March of 2009, the Dow lost over half its value, dropping from 14,164 to just 6547, as the subprime crisis morphed into a near full blown break down of our financial system. Amid fears of bank nationalization, unemployment soared to over 10%, producing a downturn not seen since the Great Depression.

Pushing back against the 2008 financial crisis has been unprecedented Federal Reserve stimulus: Short term rates have been pushed down to near 0%, while our central bank is buying longer dated paper at the rate of $85 billion per month, an amount equal to 80% of new debt issued by our government. Our Federal Reserve has vowed to maintain such purchases until the unemployment rates declines to 6.5%, so long as the “inflation outlook” doesn’t exceed 2.5% annually.

In the meantime, fiscal stimulus has been abundant. Annual spending deficits have topped $1 billion for the last four years.

Our economy has responded, helping to justify the stock market rise. February unemployment data showed the lowest jobless rate in five years, with over 200,000 new jobs created. 2012 saw the strongest housing market – the Achilles heel of the downturn - since 2006 as prices in the 20 largest metro areas advanced 6.8%.

Corporations are in fine shape, with profits margins at all-time highs and cash on the books at record levels. Dividend hikes and stock buybacks are robust, as companies plan to pay out at least $300 billion in dividends this year, topping last year’s $282 billion; and companies announced in February plans to buy back $118 billion of their own shares, the largest monthly tally since 1985.

Most analysts see stocks very reasonably valued, even cheap relative to fixed income. Stock dividends are now greater than the yield on the 10 year US Treasury (2.14% yield on the S&P 500 versus 2.05% on the 10 year Treasury), which is rare. Dividends tend to grow over time, on average 6% a year, so it’s hard to not bet in favor of stocks for a 10 year time horizon.

While investors are getting more enthusiastic about the market, there remains sufficient skepticism on Main Street to suggest that stocks have more room to run. The American Association of Individual Investors reports that bullishness has dropped from 42% of all investors to just 31% in the last three weeks. However, the market can’t continue at the double digit percentage return pace seen since mid-November.

So, with traditional stocks starting to reward investors, why is now the time they should consider gold?

Bottom Line

We are constructive on the market going forward but nevertheless urge investors to hedge their portfolio by devoting a small percentage of their assets to gold, namely gold stocks.

Although gold is difficult to price, it has historically served as a store of value over the centuries. Inflationary pressures will ultimately result in a higher gold price.

The cheapest way to participate in gold is via gold stocks, as an anomalous recent disconnect between the prices of gold and gold stocks has left the latter extremely attractive.

Gold is an Attractive Hedge

Gold is controversial. Such luminaries as Warren Buffett have scoffed at the metal, arguing that it’s unproductive. Unlike farmland, which can grow crops, or companies, which can generate revenues, gold has no earnings nor dividends.

Indeed, that makes gold extremely difficult to value. Stocks can be measured by their earnings, using the famous price to earnings ratio. By looking at the income spun off to stockholders in the form of dividends and earnings, investors can compare a stock investment with say the rent from real estate or interest from a bond.

We do know the yellow metal’s relative value is much improved over the last 18 months. Dropping from its high of $1921 in August, 2011 to the current $1582 at least gives you the comfort that it’s a better relative value by the nearly 20% discount.

There is no sign that gold’s historic role as a store of value is in any diminished. Nor has fundamental interest declined by long term holders. Russia is said to be stocking up, while Germany recently insisted that some its holdings be repatriated.

Recent gold price weakness may have been based on short term factors. For example, investors are spooked by the death cross (a technical short term pattern triggered when gold’s 50 day moving average price crosses underneath its 200 day moving average). However, fundamental demand, not chart patterns, will ultimately determine gold prices.

The smart money (hedge funds) are said to have liquidated heavily in Q4. But, the smart money can also move back in very quickly, and is very short term oriented.

There’s no end in sight to central bank money printing, with Japan’s latest exhortation to its central bank to print more the latest example. While the G20 paid lip service to being against currency wars, it refused to call out Japan specifically.

In sum, gold is an excellent insurance against the inevitable depreciation of paper currencies. While it’s impossible to tell if the current gold price weakness will continue, purchases now are nearly 20% cheaper than a recent quote.

Gold Stocks: It’s Cheaper to Prospect on Wall Street

Gold stocks have plummeted during the recent gold price malaise. For example, over the 12 months ending yesterday, the S&P 500 is up 13%, gold the metal is down 7%, while RING, an exchange traded fund of global gold miners, is down 33%.

Over the last five years, the gold versus gold mining stocks disconnect is amazing, with gold itself up 60% but the XAU (an index of 16 widely traded gold stocks) down nearly 35%. As a result, it’s cheaper to prospect on Wall Street than in the traditional mines!

Indeed, the disparity between the value of gold stocks and the metal itself has by many accounts never been wider, near the level last seen in 1999 when gold was wrapping up a long term bear market. Two of the biggest producers, Newmont Mining (NEM) and Barrick Gold (ABX) are now trading at less than 60% of their reserves’ valuations, even including extraction and time value of money costs.

Gold mining stocks offer other advantages. Many pay dividends, unlike direct metal ownership. Second, gold metal investments, even investments in exchange traded funds holding gold, do not qualify for the favorable tax rates applicable to long term capital gains from stocks and most stock dividends.

Admittedly, gold mining stocks are riskier than the metal itself. The stocks represent leveraged plays on the metal; because of the costs involved in extraction, a small change in the gold price can have a big impact on profitability.

Gold stocks can also be affected by factors having nothing to do with gold. Strikes, floods and other natural disasters, company management, plus political issues can result in a gold company’s stock falling despite a rise in the gold price.

To mitigate the risk of company specific issues buy a basket of gold stocks, like a gold stock mutual fund. You could also buy into companies that have very diversified operations or that operate in countries considered less risky.

Bottom line, we think you could make money in gold stocks without a significant uptick in the metal’s price, and of course a big boost in the price of gold could result in a home run for gold stock holders.

Gold Investment Picks

To invest in the metal, try SPDR Gold Trust (GLD). This exchange traded fund represents gold bullion in a vault. Your advantages include convenience, liquidity, plus freedom from sales taxes, insurance costs, and storage issues.

Drawbacks include profits being taxed at the higher 28% collectible capital gains rate (not graduated for lower income tax brackets) versus the 15% rate (20% for high net worth investors) applicable to stock capital gains. Some prefer having bullion, not shares representing an interest in bullion, in their possession as the ultimate hedge on civil disorder and financial collapse.

To take advantage of the extreme weakness of gold stocks relative to the metal, your best investment may be a gold mining stock mutual fund. Our top pick would be ASA (ASA). This closed end fund contains a well-diversified portfolio of blue chip gold miners. While an expense ratio of 60 basis points applies, the shares currently trade at a 4% discount to the net asset value of the fund’s holdings. That means the discount offsets almost 7 years of that fee. Investors can profit from not only gold stocks rising in value but renewed investor interest resulting in the fund’s discount becoming a premium.

Newmont Mining offer investors a generous dividend in addition to appreciation
upside. The dividend, now at 3.6%, is expressly linked to the gold price, so gold
price bulls should expect to see hikes in the payout corresponding to higher
gold prices. Newmont is trading at an attractive 8 times forward earnings; its
share price is one third less than prevailed last September. Their gold mines
are diversified over three continents.

Barrick Gold is another high quality miner. Based in Canada,its mining assets are worldwide. As the gold miner with the highest market capitalization, it offers superior stability. The stock is 40% off its recent high, and trades at just 200% of revenues, 6.1 times expected profits, and sports a 2.8% dividend yield.