A New Look at Portfolio Protection

Andy Waldock |

gold prices, gold mining stocks, investing in goldThe financial markets are back to their news event driven, schizophrenic selves. The European Union concerns remain even after Greece’s recent election. Cyprus is on the short list for coming defaults. Spain has formally asked for a bailout. Meanwhile, here in the U.S. the Federal Reserve has just expanded Operation Twist by another $267 billion. The expansion of Operation Twist goes into effect two weeks after we discussed the steepening of the U.S. interest rate futures yield curve. The increasing volatility of the stock and bond markets make the buy and hold mantra a much tougher proposition to follow. However, the full, “risk on, risk off,” nature of all hard asset classes makes alternative investments just as volatile.

This volatility has extended to the precious metals markets. Those who’ve bought gold as a hedge against falling equity prices, dollar depreciation and higher interest rate expectations have been disappointed as both equities and gold have declined in what has morphed into a deflationary environment. The European situation appears as though it will drag on forever. China is doing what it can to provide a soft landing for their slowing economy. India is forecasting much lower growth as well as a stalemate in political reform. Consequently, we’ve seen the S&P 500 decline by nearly 7% since the March highs. Meanwhile, the gold hedge has lost slightly more at 7.5% over the same period. Ugh.

It is time to rethink the idea of hedging portfolio risk through outright ownership of alternative asset classes. A deflationary environment negates the negatively correlated price structure we expect out of the gold vs. Dollar and equities relationship. This becomes especially tricky when the long-term outlook becomes increasingly inflationary as the direct result of government and banking policies being enacted both domestically and globally.

A top in the silver market preceded the recent decline in the gold market by five months. This also coincided with the peak in the gold versus silver ratio, which priced gold at 32 times the price of silver. Silver was trading at just under $49 per ounce while gold was at $1560. The last time gold was that cheap relative to silver was 1981. The recent high for this spread was 80 during the height of the financial crisis in October of ’08.

Commercial traders also appear to be moving to a silver biased position. Commercial traders doubled their net positions when it appeared that the metal markets were building a saucer base and the markets’ participants had favorable expectations of the first Greek elections and Eurozone resolution. However, as June approached and Greece was unable to form a coalition government after the first round of elections and Spain’s interest rates began to climb on the open market, it became clear that, “risk off” was the correct play. As expected, commercial traders shed approximately 16% of their gold. The shift to silver became obvious when the Commitment of Traders Report showed virtually no change in their corresponding silver position. This places them squarely in camp of, “silver to gain on gold.”

Silver is far more volatile than gold. Silver will appreciate more in a, “risk on,” environment and will also decline more in a, “risk off,” scenario. It is the added volatility of the silver market that allows us to price it competitively. The highest price gold has reached may be 80 times the price of silver but, a more realistic number is somewhere just north of 60. In fact, there have only been 17 months out of the last 96 that gold has closed at a value greater than 65 times the price of silver. Therefore, the current ratio of 58 places the spread well within the value area.

Thus far, we’ve discussed the gold and silver relationship on a 1 to 1 basis. The ratio that we’ve been using is based on an ounce of gold and an ounce of silver. However, the futures markets do not trade single ounce contracts. Therefore, we must construct a spread that equalizes the contract sizes and meets the goal of owning silver and selling gold on an ounce for ounce basis. The least common denominator in the futures market is 1,000 ounces. The NYSE Liffe exchange offers a 1,000 ounce silver futures contract, which is the smallest listed silver contract. This can be paired with 10 contracts of the standard COMEX, 100 ounce gold futures contract to create a spread owning 1,000 ounces of silver and selling 1,000 ounces of gold. This spread will help ensure inflation protection as well as safe haven concerns and diversification away from the equity markets while limiting the schizophrenic effects of a, “risk on/risk off,” news and political environment.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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