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September 29, 2009
While gold looks valuable from the perspective of strategic asset allocation, because of its low correlation to equities, there is cause for concern that gold’s big run-up in prices recently may have left it overvalued. From a tactical perspective, it is preferable to buy into the components of an asset allocation when they are out-of-favor, not amid a multi-decadal run-up in price. Gold last experienced a run-up similar to its recent rise in the late 1970’s, and the price of gold lost more than 50% in the two years that followed.
An interesting and infrequently discussed alternative for investors who want exposure to gold but may be concerned about a decline is to establish a floor by buying call options on GLD. There are options available on GLD with expirations out to January 2011. (see here) The $100 call option on GLD for January 2011 allows the owner to purchase GLD at $100 at any point between today and Jan 21, 2011. This option can be purchased for $12.90.
The current prices of GLD call options are fair. When I computed the price of this call option in the Monte Carlo simulation, this price is almost exactly what the model yielded, once we calibrated the projected future volatility for the S&P500 as described earlier. The implied volatility of the Jan 2011 options on GLD (which are very close to the value generated by the Monte Carlo simulations) is about 28%. (see here) This is higher than the near-dated options (October 2009), which have implied volatility of about 22% as of this writing. The options market is projecting higher future volatility for GLD in 2010-2011, consistent with the Monte Carlo simulations. Both the options market and the Monte Carlo simulation are projecting a period of volatility for gold substantially higher than its long-term averages. Over the last 30-50 years, gold has exhibited annualized volatility of around 19% (see earlier table). A period of 28% annualized volatility will be quite a shock. At this level of risk, there is a chance (albeit a small one) of more than a 50% decline in a year.
A recommended strategy for gold
So where does all of this leave us? Gold has out-performed substantially in recent years, but this, by itself, is not reason enough to buy it, just as $140+ oil was not a good reason to buy oil. Gold’s low correlation to equities argues for some allocation in a long-term portfolio, and the fact that gold has provided some much-needed defense in diversified portfolios in the recent bear market is a great example of the value of low correlation. Many asset classes are beaten down, and gold is probably overpriced, so while gold may decline, there is a reasonable probability that other asset classes will outperform in that scenario. This is the strategic argument for having some allocation to gold.
From a tactical perspective, however, gold is very expensive and is due for reversion to the mean if history and Monte Carlo simulations are correct. It is very hard to make the case that the run-up in gold represents a rational response to the risk of inflation when other inflation-trackers gave been declining or have at least lagged far behind gold.
Some investors will want to hold gold for idiosyncratic reasons: They may like the idea of being able to keep it in their own safes in case banks fail, or they may like the historical narrative for gold as a store of value. I am not going to dispute these points.
Those who view gold as an inflation hedge, however, should think twice. For those who really want to hold gold, buying long-dated options to achieve a leveraged position and buying bonds (either nominal or inflation-protected, depending on how strongly one wants to bet on inflation) can provide a floor on losses in the event of a decline in gold prices. (Rather than buying one share of GLD with $100, that is, you buy a Jan 2011 / $100 call option for $12.90 and invest the remaining $87.10 in bonds.) This approach seems especially timely given that the options market in gold is signaling a substantial increase in volatility (risk) in coming years and that options have historically provided good estimates of future volatility for a range of asset classes. (see here)
With this approach, you get the upside of gold with an absolute floor on a $100 investment of $87 between now and January 2011. The leverage ratio (the fraction of money invested in calls vs. bonds) can be adjusted, of course, depending on how large a bet one wishes to take on gold. For investors who prefer simply to take a long position in gold, the long-term role of gold as a diversifier still holds up, but the big run-up in price in recent years and the high implied volatility on GLD suggest that the next few years will be very risky for this asset class.
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