Precious metals present one of the most difficult challenges in the market. That may seem like an odd statement, considering how gold rocketed to $1,800 an ounce a few years back. But remember that it went nowhere for three decades before that.
So here we are in a mega-bull market. If trying to figure out how to play precious metals wasn’t difficult enough, one has to deal with the fear of missing out on the big bull run in stocks. Then one has to weigh the possibility of the second-most expensive market in history correcting by 30% or more, and how precious metals plays into that.
Why is this so difficult to deal with?
The main problem with precious metals is that they are fundamentally different from equities. The latter represent part ownership in companies. History has proven that the price of stock increases in correlation with earnings growth. Good companies are always growing, generating increasing wealth. When they stall out, they still generate ongoing cash flow. Thus, we invest in stocks because we expect our investment to grow over time.
There is a long-term positive return expectation for stocks.
Precious metals, however, have nothing supporting their value other than psychology and alleged scarcity. It’s a hard asset that is considered a store of value. Yet that value can shift dramatically over time without any rhyme or reason. Thus, we do not invest in a precious metal because there is no expectation that the value of precious metals will increase over time. They could go up or down.
There is no 30-year rolling period in which the Dow Industrials have gone down. There are many such down periods for precious metals.
But do precious metals have a place in a long-term diversified portfolio, such as I am putting together in my stock advisory newsletter, The Liberty Portfolio?
I would say they do not. Here’s why:
Nobody discussed risk when it comes to investing. We measure risk through volatility. One of the ways we quantify volatility in The Liberty Portfolio is with standard deviation. Ideally, we want an investment that has a robust return with a low standard deviation.
Volatility of Precious Metals
The 10-year average annual return for SPDR Gold Trust (ETF) (NYSEARCA:GLD) is 4% with a standard deviation of 19. That means, in any given year, there is a 95% certainty that GLD will have a return between -34% and +42%.
That is a gigantic spectrum of possible returns, which means GLD is extremely volatile, which means it is extremely risky.
If you think things might be better if we diversify with silver, think again. The PowerShares DB Precious Metals Fund (ETF) (NYSEARCA:DBP) has a 10-year average annual return of only 2.4% with a standard deviation of 21.4.
Contrast that with a very conservative mutual fund like FPA Crescent Fund (MUFT:FPACX) with a 10-year average annual return of 7.25% and standard deviation of 10. That means, in any given year, there is a 95% certainty that FPACX will have a return between -13% and +27%.
I prefer that spread. Wouldn’t you?
Bottom Line on Precious Metals
The only real way to play precious metals, in any market, is to trade them. Even that is risky, because psychology and emotion can change in a heartbeat. Trying to trade using technical analysis doesn’t even work.
I think the only real way to make precious metals work is to trade the Credit Suisee X-Links Gold Shares Covered Call ETN (NYSEARCA:GLDI). GLDI holds a notional long position in gold and sells covered calls against the position to generate income. It has a 3-year average annual return of 1.1% with a standard deviation of 11.
I’m not crazy about it, but if you insist on having precious metals involved in your life, I think this is the “safest” play.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market, and has written more than 1,800 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.