Obviously, both have performed very well lately. This is a trade I've had on for awhile now (since June which is a long time for my trading style). I've had it in a bit more complicated and leveraged form but for the sake of simplicity, we'll analyze it in this form.
So, why has this been and will this be a successful pair trade? Let's look at each position individually.
Gold is a real asset meaning you can hold it in your hand. It cannot be created or grown, so its supply is relatively fixed. Historically, gold has been used as currency for just this reason. So while gold has a relatively fixed supply, dollars do not. Central banks and specifically the Fed have money printing power; they can increase the supply of dollars anytime they want and lately have been doing it via quantitative easing or QE. When dollars increase, there are more of them for every ounce of gold, so gold's dollar value increases and the dollar's value is decreased. Our current Fed chairman, Ben Bernanke, has an affinity for printing money as he believes that artificially reducing interest rates by buying treasuries will help the economy (whether it does is up for discussion but I think it clearly hasn't). So, gold's value has been increasing in dollar terms pretty much since former President Nixon took us off any form of gold standard for good. In fact, it has risen from $250 per oz to now $1850 per oz since 2001 (a 640% return). So, inflation is one reason gold has risen so much.
The other reason gold has performed well, especially as of late, is the mounting fears of a US currency crisis. The US dollar is by far the most used currency in the world and has what is called "reserve" status. The debt ceiling drama has alerted the public to the massive fiscal problems the US has and has many worried that we will default on our debt i.e. not be able to pay our creditors. If the US defaults, the dollar will lose its reserve status and will suffer a cataclysmic drop in demand, lowering its value. However, since we are able to simply print money that can pay off debt, it is unlikely it will occur and we will indeed print dollars. This has caused a scare among some investors who seek safety with their assets. The US has been viewed for about a century as the safest place to put your money, so it is pretty standard to have a portfolio with a significant amount of money invested in dollar denominated treasuries. This is slowly changing with the increased fear of US fiscal issues and has caused some investors seeking safety to invest in gold rather than treasuries as gold is a real asset that cannot be created with some paper and ink. Currently, an average portfolio contains between 1% and 5% of assets allocated to gold. Clearly, there is a lot of potential demand out there to further increase the price of gold.
In sum, gold will continue its increase in value because the Fed has to continue to print money to pay off debt and they believe it's good for the economy.
Onto equities: US equities have suffered quite a bit lately beginning with the debt ceiling debacle and then were exacerbated by the S&P credit downgrade. Also, economic indicators have taken a downward turn since the spring and have caused many economists to lower their GDP forecasts and corporate profit estimates. It seems anytime you hear about the economy on TV now, you hear people discussing whether or not we will have a double dip and go back into a recession. Arguably, we haven't dug ourselves out of it and the only reason people think we have is because they believe in the government's unreliable and inaccurate numbers. However, from September 2010 to May 2011 we had a 30% increase in the S&P 500. This rally was sparked by the Fed announcing QE2 at Jackson Hole last August. Some people thought QE2 created real growth in the economy and perhaps it did, but it is now looking like it was temporary, or as the Fed likes to say, transitory growth and we are now back where we were prior to QE2. Another reason QE2 may have created a stock market rally is simply inflation. Dollars were printed to the benefit of banks and banks invested those dollars into stocks and commodities. To see the dollar's devaluation from QE2, view the below chart of the ETF 'UUP' which represents the dollar.
|Clear dollar devaluation|
To see how commodities were the biggest beneficiary, view the below chart of oil after QE2 was announced and after it was affirmed to be ending:
|A clear boost to oil prices|
So, for the scenario where we get QE3, gold will most certainly increase and I believe equities will ignore the monetary boost and continue their downward trend but to be conservative, we'll say they are flat.
GLD up, SH flat. Portfolio up.
The no QE3 scenario is harder to predict in my opinion. Gold will probably sell off for a few days as people seem to expect some kind of easing. I believe gold will resume its uptrend, though, as no QE hurts banks and will lead to fears of another Lehman Brothers incident thus inducing a run to safety in gold. Equities on the other hand are a tough call as some investors may be happy that we won't have QE and inflation while others believe QE is necessary for this economy that needs its life support and saw what QE2 did to equities. Again, we'll say conservatively that equities will be flat from this outcome but I believe they would sell off.
GLD up, SH flat. Portfolio up.
The reason I really like this portfolio is because it seems that there are very little downside risks. It is hard to think of a situation where gold would fall while equities would rise. I think the only thing that could hinder gold's momentum is market manipulation via margin hikes like we saw in silver earlier in the year, but that is only a short term problem as silver is back at $40/oz already. With so many economic indicators pointing towards another recession, it is hard to believe that the market has priced it in with only a 17% drop in equities especially since fears of default have also factored into the sell off. For these reasons, long gold and short equities will continue to generate absolute returns for the foreseeable future.
Since this is my first blog post, I want to let people know that I'd love to hear their thoughts in the comment section. I like to think I have no ego, so feel free to hate, love, or anything in between regarding the blog and this post. Obviously, there are numerous other factors that make me feel confident in this portfolio but for simplicity's sake and for the sake of not writing a novel, I think this post adequately states my thoughts and views.
Also, I like music. So, I'll put an appropriate YouTube clip of a song that relates somehow to each post.