Gold prices have been in a slump these past few months. But investors who own the metal shouldn't be sad.
In fact, quite the opposite. They should be thrilled.
Here's why: Prices for gold futures on the CME's Comex have tumbled more than 14% since the second half of 2016, to $1,173 a troy ounce recently, down from $1,372 in August. The SPDR Gold Shares (GLD) exchange-traded fund, which holds bars of solid bullion, followed the same pattern. It had been down even further until a small rally over the past few weeks.
The pullback comes amid a chronic underperformance for the metal compared to stocks. In the past five years (through early Jan. 5) the SPDR S&P 500 (SPY) , an ETF that tracks the S&P 500, gained 78%, while the SPDR Gold Shares ETF (GLD) lost 27%.
That's a big difference in returns (more than 100 percentage points), but it points to something up lifting for investors.
"Gold is largely a panic asset that you buy when you don't know what else to buy," says Robert E. Wright, professor of political economy at Augustana University. "It means people are selling some gold and buying something else."
Put another way, when investors buy gold, it is often because they want a form of financial insurance.
When things go wrong there is always a ready market for the metal. That is quite unlike some other securities that can be difficult to shift during times of tumult. (If you doubt this, consider how the credit markets ceased to function in the financial crisis.)
Falling bullion prices means investors are not panicking now and are selling gold. Instead they may be purchasing stocks because they are optimistic about the future of U.S. businesses. Certainly the recent rally in the U.S. stock indexes indicates increased bullishness about the earnings power of corporate America.
Falling gold prices point to a strong greenback.
"I think it's a very good thing that gold prices are down," says John Tamny, author of the book Who Needs the Fed? "The price drop signals that we have a stronger dollar, which in turn is a magnet for investment that stimulates economic growth."
What he means here is that one dollar now buys more gold than it would have purchased six months ago. Ergo, the dollar is stronger, at least in terms of gold.
He's also correct about the strength of the currency being a magnet for capital. Who wants to invest in a country that has a currency spiraling downward? Nobody smart, anyway.
We already see capital fleeing countries that have weak currencies, such as emerging markets, according to a recent report from the Institute for International Finance.
Where's the money going? Developed markets. And with the U.S. being far more attractive than the eurozone currently, it will take the lions share. As the capital flows into the U.S., economic growth will boom. As the money flows into the U.S., expect the greenback to stay strong and keep a lid on gold prices, which are denominated in dollars.
Keep the Gold Holding Small
The current situation of falling gold prices and rising stock prices also shows why savvy investors consistently suggest a relatively small allocation of a portfolio should be in precious metals. Usually, they suggest between 5 and 15%.
"It's not a bad idea to have some gold in your portfolio especially if you are a younger person," says Peter Morici, professor of business at University of Maryland School of Business. In line with other experts he suggests around a 10% allocation.
That amount works in two ways. First a small percentage of precious metals holdings helps diversify the portfolio so reducing overall volatility. Lower volatility equals lower risk. It works because gold price movements are not correlated with those of other assets such as stocks. When stocks rally, gold prices may go up, down or stay put.
Second, a small gold holding means that you can invest the remainder of your assets in other securities such as stocks and bonds. If gold does badly then it is highly likely over the longer term that other holdings will more than offset the decline. It works vice versa: Periods in which gold prices skyrocket, then other assets don't tend to do well.