For gold investors, it has been an excellent year, with the outright price of the precious commodity rallying by over 26% on a year-over-year basis.
In this piece, I rely on a number of studies, backtests, and models which I have created for analyzing gold – all of which are giving strong buy signals at this time. In my opinion, gold is headed higher over the next year and investors should look for continued upside gains in the commodity.
In case you’ve missed the news, the last month has been fairly turbulent for the overall stock markets. What started out as a fairly sharp correction in the S&P 500 has resulted in a pullback in price of nearly 10%.
When markets contract, investors tend do a few different things. The first things investors tend to do (when measured en masse that is) is buy some sort of protection on their portfolio holdings. Since most investors tend to be at least partially tracking the broad indices like the S&P 500, this tends to manifest in the form of puts being bid up as investors look to protect the downside of their portfolios. This buying of puts elevates the VIX, which is a calculated index based on a basket of options on the S&P 500 – as options get more expensive, the VIX moves higher.
As you can see, during the initial selloff phase about 4 weeks ago, the VIX hit around 35-40 as investors purchased options to protect their downside.
While this is interesting in its own right, what does it have to do with gold? Good question. It is very important to monitor the outright level of the VIX because it actually has a statistically strong trading recommendation for gold traders. You see, the second thing investors do when the market pulls back is that they tend to look for alternative investments and more safe assets. And this is when gold shines.
This chart shows a very clear relationship between the level of volatility in the market and the future return in gold. Given that the VIX has recently hit the territory of 35-40, data since 1991 would say that on average VIX traders can expect a rally in the price of gold of around 20% over the next year. In other words, given that the market is in a fairly sharp pullback, around three decades of history would suggest that now is a strong time to buy gold.
Investors in gold may protest at this point – because after all, isn’t gold up 25% on a year-over-year basis already? Shouldn’t investors be considering selling at these elevated levels and taking profits while they are available? Another good set of questions.
While investors may be considering profit taking at these levels, I believe this is the wrong decision. The reason why I say this is that the data has another interesting wrinkle in it: gold exhibits strong momentum. In financial lingo, momentum basically means that if an asset has been outperforming on some basis (relative, outright, etc.), then it is likely going to keep outperforming. To see what I mean, here is the average return of gold 1-year into the future grouped by its past 1-year return.
This chart shows a clear and unmistakable trend: the stronger gold performs, the stronger it is likely going to perform in the future. Given that gold is currently sitting at around 25% year-over-year gain, this study would suggest that the average gold movement over the next year will be a 19% gain. However, it is interesting to note that as a little as 4 weeks ago, the year-over-year gain in gold was in the territory of 30-35% which would suggest even higher future returns of upwards of 34%. In other words, recent market history would suggest that we could see gold rally anywhere from 19-34% over the next year.
The key concept here for investors and traders in gold is that gold exhibits momentum: when it has been strong, it tends to continue displaying strength. I believe the fundamental mechanism here is that gold investors tend to be yield-chasing and respond to performance in the commodity. In other words, when gold has been performing well, investors tend to continue to shift capital into the commodity which establishes a virtuous cycle of sorts in which higher returns attract additional capital which fuel higher returns. All trends do come to an end, however the data does suggest that playing gold to the long side while the market is strong tends to win on aggregate.
To this point, we’ve covered two key studies which demonstrate two key relationships at work in gold: investors use it as an alternative to turbulent markets and past performance does indeed seem to influence future performance. This said however, another key relationship informing the price of gold is the dollar: as the dollar falls, gold tends to rise.
Most investors are likely aware of this key relationship between the strength of the dollar and that of commodities in general. The basic relationship is that as the dollar falls, it tends to require more dollars to purchase the same basket of goods which means that the dollar price of the basket of goods increases.
However, this relationship isn’t terribly useful to gold traders as-is. That is, unless you have a functional crystal ball and can tell me where the dollar is going to trade, then I can’t use this kind of hindsight correlation to make predictive calls in the price of gold. But there’s an interesting wrinkle in the data: past changes in the dollar tend to have ripple effects which price into the future changes of gold.
This relationship shows an interesting trend between changes in the dollar over the past 12-months and what happens to gold over the next 12-months. In other words, we can use this chart to say, “the dollar has performed by X, therefore on average gold will likely perform by Y.”
This year has been very turbulent for the dollar. We started off the year with a classic flight-to-quality trade with global investors buying dollars to park capital in U.S. markets (and in particular U.S. government issues). However, since markets have started to largely recover from the historic volatility seen in the February and March timeframe, we have witnessed the dollar actually see outright year-over-year declines in the territory of over 2% within the past few weeks. Historically speaking, the dollar falling by this magnitude tends to be associated with rallies in gold by around 11%. While this 11% figure is certainly lower than the previous studies we’ve looked at, the key thing here is the relationship: weakness in the dollar tends to see rallies in gold.
I believe the fundamental picture is supportive of gold rallies over the next year. There past few weeks have seen a good degree of volatility in gold, however, each of the above price studies show that gold historically rallies in the year following the set of economic conditions we have recently seen. Indeed, over the past month or so, we have witnessed some of these studies give buy signals suggesting that gold could rally as much as 34% over the next year with data stretching back over 50 years.
This said, I don’t believe we should trade fundamentals in isolation. I believe that the best trades come from taking a robust fundamental view and then using technical analysis as well as quantified strategies for entering and exiting the commodity around this core view.
From a technical perspective, I believe the market is in a textbook pullback within a larger established uptrend.
As I read the market, we are currently in the midst of a pullback which started in early August and has carried forward through today. This pullback, as measured by the bearish momentum indicator beneath the chart, is the longest pullback in over a year with price demonstrating negative momentum for over two months straight. Of historic note, there’s actually a moderate correlation between the future 6-month change in gold and the length of time that the MACD spends in a momentum pullback.
At present, we are in the midst of a 37 day momentum pullback in the MACD (in other words, the MACD histogram has been negative for 37 trading days at the time of writing). Historically speaking, there’s a moderate correlation between the length of pullback and subsequent return witnessed in gold over the next 6-months. What this study essentially shows for today is that when this pullback ends (which it likely will sometime next week), then data since 1968 would show that a rally of 10-15% over the next 6-months would be right at the average expectation for similar pullbacks of comparable lengths. The returns look even better 1-year out, with gold historically rallying an average of 20% (with some data points as high as 50-80%) in the year following pullbacks of around this length.
I believe the fundamental picture and technical picture are firmly in the bulls’ favor at this point. However, before exiting this piece, we need to discuss a few different ways of trading the coming rally and show the return of some different approaches for holding gold.
In the previous section, I detailed the different fundamental and technical reasons for which I believe gold will rally over the next year. In addition to these reasons, there are a few broad-based investment strategies which are supportive of continued strength in gold. In this section, I’ll detail a few approaches investors can use for participating in the coming gold rally.
The first investment strategy is based on using the VIX as a trigger for an entry into gold. One of the first studies in the prior section relied on using an elevated VIX reading as a trigger for entering gold. This simple strategy uses the clear statistical tendencies seen in the market to formulate a trading strategy in the commodity. The strategy rules are simple: when the VIX is elevated, investors should hold gold for the next year.
This chart shows the cumulative return investors would have earned should they have parked capital in gold in every 12-month period following times in which the VIX is above 25. Given that the VIX is currently over 25, this investment strategy is currently giving a buy signal with at minimum a 12-month holding period from today.
In terms of return, this strategy actually wins by delivering less volatility than an investment in gold. What I mean by this is that across my dataset, I calculate the average monthly gold return to be somewhere around 0.75% with a standard deviation of about 4.92%. This strategy only increases the average monthly return to 0.78% but it drops the standard deviate of returns to 1.77% which significantly improves the Sharpe ratio as compared to buy and hold. I believe these consistent returns capture the underlying fundamental dynamic of investors fleeing to gold during turbulent times in the market.
The second investment strategy relies on our momentum study of gold. If you recall from the prior section, gold exhibits positive momentum – that is, past strength begets future strength. We can use this pattern of return to build and examine a momentum strategy. The rules are simple: hold gold as long as its trailing 12-month return is positive. In other words, buy and hold gold until it turns negative on a year-over-year basis.
Again, very consistent results with a demonstrated track record of profits. While our last strategy reduced monthly volatility as a means of delivering strong performance, this strategy shines by capturing strong monthly returns. While the baseline gold average monthly return in my dataset is 0.75% per month, following this strategy has an average monthly return of 1.36%. It also does reduce the monthly standard deviation of returns from 4.92% to 3.59%, but the clear performance driver here is the added monthly return.
And for a third investment strategy based around the quantified studies above, here is an approach that uses changes in the dollar as the trigger. This strategy is similar to the prior one except under this approach we are looking at the dollar for our signal. The rules are simple: hold gold as long as the dollar has been falling on a year-over-year basis.
This strategy delivers stronger returns by increasing the average monthly return to 1.21% (versus 0.75% as the baseline) and decreasing the standard deviation of monthly returns to 2.68% (versus 4.92% as the baseline). In other words, it returns better reward and risk which greatly improves overall performance versus buy and hold.
Each of these three strategies captures the fundamental relationships at work in the data at the time of writing. As discussed in the prior section, there are very clear relationship between market volatility, gold’s past performance, and the dollar which are all suggesting that gold is heading higher over the next year. These strategies give quantified and backtested approaches for trading gold. In the next section, we’ll discuss some of the more popular gold investment options.
Most gold traders and investors seeking return likely do so through purchasing gold exchanged-traded products like ETFs or ETN. There is a wide variety of options available to investors and in this section I’ll discuss a few issues for consideration prior to trading gold as well as give a few of my recommendations.
In general, the first question gold investors should ask is what is the ETP actually holding or tracking. This is a material question which has ramifications for returns. The two general approaches are physical holding of gold and tracking of gold futures.
ETPs which hold physical gold are the best option in my opinion. The reason why I say this has to do with roll yield and its associated impacts for futures holders. Put simply, roll yield is what you get when you’re holding a futures contract and it convergence towards contango. To understand this concept, here’s a chart of the recent gold futures curve.
This chart shows what is called “contango” – that is, futures increase in value along the curve. In gold markets, contango is the normal state of things. The reason for this is that the futures curve is basically priced by compounding the spot price of gold by the borrowing cost available to traders across a certain timeframe (give or take a few basis points). This means that if gold were to trade differently than the compounded spot rate anywhere on the futures curve, gold traders could buy or sell the spot commodity while simultaneously entering into a futures contract position to make or take delivery of the commodity – and this process would lock in a risk-free profit (all else equal).
This process basically means that gold futures are almost always in contango. And it means that gold futures holders are almost always losing money to roll yield. Roll yield is what happens when you buy a futures contract and the time remaining until expiry diminishes. Since interest rates are a function of time and since interest rates are the backbone of pricing gold futures, this means that gold futures will gradually slide down towards the spot price at around the borrowing rate.
What this means for gold investors utilizing futures is that at today’s rates, you can expect to lose about 2% per year simply from futures converging towards spot. Gold futures are in contango and the numbers essentially come out to this 2% figure. This is why I believe investors are advantaged trading the spot physical commodity. Here are a few ETPs I favor at this time.
First and foremost, I believe that the SPDR Gold Trust ETF (GLD) reigns supreme in gold markets and for a good reason – it’s relatively cheap, and it holds physical gold. At present, GLD has a 0.4% expense ratio and it is holding about $78 billion in gold. I believe the key benefit for trading GLD is its size – since it is the most active gold ETF, you can always find liquidity, even for relatively sizable orders. Indeed, over $2.5 billion in volume trades every day on average which means that even up to the institutional level, orders can be worked without too much issue. There are cheaper alternatives, but if you’re trading size and/or looking for the plain-vanilla option, this is most likely the ETP for you.
The second ETP I would suggest is actually a bit of a nuanced vehicle and that is the Credit Suisse Gold Shares Covered Call ETN (GLDI). This ETN requires a bit of an explanation and is only suitable for certain investors. GLDI is an ETN which is actually a strategy built on top of the GLD ETF. It is delivering the return of GLD but selling covered calls against the position on a monthly basis which are 3% out of the money. This covered-call position results in a dividend yield that is about 10-12% per year at the time of writing. In my opinion, this ETN is suitable for investors who are primarily interested in dividends – since gold is likely going to rally over the next year, then GLDI is likely going to increase in value as well. However, the covered call strategy means that you are capping your monthly upside to 3% in exchange for a dividend check. If you’re after dividends primarily, then this ETP is a good way of trading gold for the next year.
And finally, for those who are aggressive traders I suggest the ProShares Ultra Gold ETF (UGL). This ETF is pretty simple and straightforward: it holds gold futures and targets a 2x leveraged return. I’ve already explained why I believe gold futures make for returns which lag physical holdings, but this ETF is a very clear vehicle for aggressive gold investors. In the prior sections I have demonstrated why I believe gold will rally up to 30% over the next year – if we see this rally materialize, then UGL will possibly deliver about 60% in returns minus about 4% for roll yield (2 times the 2% per year roll yield present in the futures curve). Of course, remember that leverage cuts both ways and that leveraged ETPs can suffer from leverage decay so this option is certainly not suitable for all investors.
These three ETPs represent the best of the options available for investors depending on what your objectives are. Looking for a no-frills gold investment? Choose GLD. Interested in gold but only looking for dividends at this time? Use GLDI. Seeking high levels of volatility and willing to embrace sizable risk? UGL is likely the best choice for that.
In this piece, we’ve covered a lot of ground spanning all the way from fundamentals to trading strategies and into appropriate investment vehicles. I believe this piece can be summarized by three main points and that these are important takeaway for all gold market participants.
- Gold fundamentals are strongly bullish with historic studies suggesting that investors could see potential gains as high as 30% over the next year.
- Several gold trading strategies are currently triggered which have a demonstrated track record of delivering strong performance and reduced risk versus a buy-and-hold approach.
- Consider your situation prior to making an investment in gold and use the instrument most appropriate for your circumstances and objectives.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.