Enhancing Long Term Portfolio Returns with Gold

December 15, 1998

For many younger investors, the potential for political and economic events to lead to a demise in our national economic well being seems unlikely because they have never experienced such events. In fact, what most investors expect, based on their experience is that "stocks will always rise, over the longer run." History tells us that markets do not always rise even though at their peaks, most investors expect they do. In fact, during this century we had two very significant and prolonged bear markets in stocks that wiped out the vast majority of investors. Only those smart enough to pick the top or those who insured their portfolios by allocating at least a small percentage to gold in their portfolios were spared and positioned to benefit from the next market upswing. The market "wipe outs" of this century took place during the 1930's and the 1970's. Few people could envision these bear markets or the level of carnage they would create in part because our elected officials, then as now, uttered self serving predictions that had little to do with the growing dangers of their time. Because of the political bias of elected officials, investors would do well to place at least as much stock in the lessons of history as political propaganda any politician.

What is certain is that history repeats itself, never exactly in the same manner, but the rhythm of repetition and cycles is unmistakable. While the majority of investors now project the bull market of the past 16 years to infinity, students of history know these good times are not likely to last too much longer. A few savvy students of history, like those who read this letter, recognize the present period of national deceit provides an opportune time to buy some very low cost portfolio insurance. They understand that by so doing, they may be able to protect most of their investment portfolios against the ravages of longer-term repetitious financial ruin just as a distinct minority of investors did during the Great Depression and the period of political and economic meltdown of the 1970's.

1929 Stock Market Crash & Great Depression

The first event of this century that wrecked financial devastation on millions of Americans was the 1929 Stock Market Crash. As is currently true, investors came to believe that stock prices only rose over the longer term. But when the Dow Jones Industrials (DJIA), plunged 90% (from 300 to 41) between 1929 and 1932, huge numbers of Americans lost virtually everything they owned. About the only stock market investors who managed to escape devastation were the relative few who owned gold shares like Homestake Mining which rose by a factor of 600% to 700% in those years. Investors who might have allocated just 10% of their portfolios to Homestake Mining and 90% to the DJIA prior to the 1929 crash, would have lost around 21% of their overall portfolio value rather than the 90% that was lost in the stock market.

The Dollar Panic of January 1980

The second major time this century when investors were devastated as a result of a bear market in stocks was during the late 1970's. With the impending impeachment of Nixon, the oil embargo, skyrocketing budget deficits that led to double digit inflation, international confidence in the U.S. dollar was lost. Investors around the world dumped the U.S. dollar in favor of gold, causing the yellow metal to skyrocket to $850 per ounce from $35 by January 1980, before the U.S. defaulted on its promise to exchange gold for Dollars. While gold was rising from $35/oz., the DJIA remained in a bear market to sideways market for most of 14 years, never being able to sustain a height above 1000 until the early 1980's. Again, individual investors, except those who diversified their portfolios with gold shares, were brutalized.

Gold's Stocks For Portfolio Insurance

A picture of how gold and in particular gold shares enhanced portfolio returns for the 30 year period ending December 31, 1997 is provided from the following hypothetical example of a $1,000 investment in 1968. Investors who allocated 10% of their portfolios to gold bullion and 90% to the DJIA on January 1, 1968 saw their investment portfolios grow to $10,007 compared to $8,916 for those who placed 100% in the DJIA. However the biggest gains were for those who allocated 10% of their portfolio to gold shares and 90% to the DJIA. Such a hypothetical portfolio grew from $1,000 in 1968 to $19,631 by 1997 mostly because of the fact that gold shares are leveraged to the price of gold. At the end of each year, an allocation adjustment was made so that the two portfolios containing gold both started the year with a 10% exposure to gold and a 90% exposure to the DJIA.

Actual DJIA and gold values were used in our model. With respect to the gold share performance, we assumed, based on historical data, that a portfolio of gold shares would be leveraged to gold bullion by a factor of 3.5 times. Thus, if the price of gold were to rise by, say 10%, on average we would expect a portfolio of gold shares to rise by 35%. Experienced gold share investors are very aware of this relationship because it means that a small rise in price of gold can result in a much larger rise in the price of the gold shares. A recent example of gold share leverage was seen this past October when the price of Newmont Mining's shares more than doubled (from over $14.50 to $30) on a 10% or 15% rise in the price of gold.

Why Gold Provides Good Portfolio Insurance

What makes gold exceptionally unique in the universe of investment opportunities is that its value, over long periods of time and especially at major economic turning points such as during the 1930's and 1970's, tends to move in opposite directions to the values of stocks. The chart on the upper right hand side of this page illustrates this. The annual returns for gold (dotted line) and for the DJIA (solid line) was negatively correlated at - 427 during the 1968 through 1982 time frame. (Perfect positive correlation would be +1.0. Perfect negative correlation is -1.0). Thus, on average during this time frame if the DJIA decline by 10%, gold bullion rose in value by 4.27%. And, if the DJIA were to rise by 10%, gold would be expected to decline by 4.27%. This relationship between returns for gold and stocks helped those 10% exposure to gold because the inclusion of gold reduced losses for stock portfolios during years when stocks declined significantly. The 3.5 leverage factor resulted in the portfolio allocated to gold shares performing far better than the other two. During the Great Depression, investors lost confidence in the U.S. dollar, so President Roosevelt was forced to "devalue" the dollar in relation to gold by 25% to $35 so that citizens would be satisfied holding dollars rather than demanding gold in place of dollars. With this boost in the price of gold along with cost advantages inherent in deflation, Homestake Mining's share price turned into a "moonshot" during those years.

Negative correlation between gold and stocks does not always exist. For example during the 1982 and 1988 time frame, based on our data, gold and the DJIA were positively correlated at 0.82. More recently, with stocks rising strongly and with gold entering a period of sustained weakness, the negative correlation has again been obvious. In fact, between 1993 and 1997, a negative correlation (-0.859) has been calculated from our data.

As always, insurance policies are the least expensive when they are not considered to be much in need. With most American investors now once again assured that all is well with the stock market and with gold selling at around $290/oz., it is not likely you will be able to buy a less expensive insurancepolicy than you can now. Let us suggest you start with a gold fund like The Midas Fund ($1.61) or a quality gold company like Newmont Mining ($21) or Anglo Gold ($24).

Our Resultant Investment Strategy

As this year draws to a close, our strategy for 1999 is beginning to take shape. As with life insurance, portfolio insurance in the form of gold is intended to reduce risk and enhance the long term value of your estate. Without needing to worry so much about the downside, we can become more aggressive as we focus on the upside potential of some hugely exciting technology stocks. There are some enormously underpriced stocks in the mining industry, which we will continue to tell you about. But there are also a variety of high tech companies unrelated to resource that your editor expects to bring to your attention in the next few weeks. For example, there is a well-capitalized global cellular phone company that is gearing up to serve global travelers. Though this company is far from being a penny stock (it trades in the $40's) the growth of enormous size of the markets it will be serving make this company a moonshot possibility.

OUR MODEL PORTFOLIO

With the major averages all piercing new highs, we increased our allocation to the S&P 500 (SPY's) to 60% from 33% on November 27th, 1998. We accomplished this by using all our cash and decreasing our bond portfolio from 33% to 15%.

Bear Market Still in Effect?

This move is certainly not without its risks. As Richard Russell noted in the November 30th issue of Barrons, according to Dow Theory, we remain in a bear market because the two averages (Industrials and Transports) struck their last joint highs on April 16. At no time since then have both been higher. Russel went on to say that if he is correct, "we are drawing closer and closer to a second round of trouble, both in stocks and the economy."

Federal Reserve Governor Warns of 1929 - Also worth noting was an interview in the November 30th issue of Barrons, in which former Fed Governor, Lawrence B. Lindsey warns that unless the U.S institutes a tax cut and soon, we could be in for a 1929-style depression abroad and a painful recession at home. Lindsey, who is a conservative, worries that balancing the budget at this time is the wrong policy because only by continuing to import ever increasing amounts of goods will Asia and other parts of the world avoid a 1929 style Depression. Lindsey says that fiscal policy must take some of the burden off of the Federal Reserve by putting money in the pockets of Americans. He sees great risk in continuing to rely on the Fed lowering interest rates because doing so leads to still more absurdly higher stock prices against which people are borrowing money to buy things. Given the great overvaluation of stocks, Mr. Lindsey sees the continuation of this policy as potentially disastrous.

Yet it is exactly because of these kinds of concerns that we recommend allocation of at least 10% of your portfolio to a portfolio of gold shares or a gold mutual fund like the Midas Fund. Based on historical data, we believe a diverse portfolio like the one displayed on the left side of this page, will perform well thorough all kinds political and investment climates. Jay Taylor

Gold weighs 19.3 times as much as an equal volume of water.