Bullion bounces back with record bull run

Gold on a record-breaking roll! Gold hits record high! Gold Keeps Climbing!

Newspapers around the world are running screaming headlines as the fickle yellow metal continues its longest winning streak in modern memory. The timing, therefore, couldn’t be better for some sobering advice to bedazzled gold bugs.

Somewhere lost in the rush for gold is the fact that the current bull run in bullion has set the stage for gold equities. Gold equities haven’t really participated in the rally but are expected to play catch-up as the markets bounce back, said Alfred Lee, vice-president and investment strategist, BMO Asset Management.

That said, gold is a commodity while gold equities are, well, equities. In other words, depending on how the markets are behaving the performance of the two may diverge and converge periodically.

“What happens is that even though sometimes gold equities tend to behave like commodities, at other times they behave very much like equities,” said Lee.

While not averse to gold equities, Lee can’t stress enough how important gold can be as a diversifier in an investment portfolio.

“When markets do well, there is an inverse correlation between equities in general and the U.S. dollar,” he said. “When markets do well, the U.S. dollar sells off and because gold and commodities are a hedge against the U.S. dollar, gold also does well during the risk-on trade.”

That is why bullion, and not the shares of its producers, has a very low correlation to both traditional paper assets such as fixed-income and equities.

Part of the reason why bullion is so popular is that it’s a multi-purpose hedge. There are a multitude of concerns in the current global economy—the ongoing European sovereign debt issue, the softening of the U.S. economic data, fears the global economy is running out of steam, rising inflation and disruptions in the Middle East and Japan.

A general loss of faith in both of the two key reserve currencies—the U.S. dollar and the Euro—has historically driven investors to gold, boosting it to record highs. That’s the fundamental factor that drives it up, says Patricia Mohr, vice-president, economics, and commodity market specialist at Scotiabank.

“Gold is one of the alternative assets and [its rise against fiat currencies] has actually been the story for the past two years,” she said, adding that concern over the debt crisis in peripheral eurozone countries continues to weigh on the market.

“Assets are generally defined as risk assets, which means when markets rally the risk assets do well, but when things sell-off there’s a risk-off trade where the safe haven assets like the U.S. dollar, the Japanese yen, and bonds in general, do well,” said Lee.

Gold, he said, is one of the very few asset classes that have the ability to do well both during the risk-on and risk-off trade. While most other assets tend to follow a cyclical pattern, gold in general tends to go through long phases of outperformance, vaulting over such traditional assets as bonds and equities.

Lee classifies gold’s current climb as a secular bull run “This rally in gold particularly has lasted for over one business cycle and by definition secular is more than one business cycle,” he said. “Historically, it changes over time and when gold starts selling off, more traditional financial assets [including gold equities] will start to outperform commodities.”

He expects gold mining stocks will join the rally as the risk appetite returns, as temporary solutions to the Greek debt crisis causes markets to rally and U.S. Treasury yield come up.

Mohr points out that while gold stocks should benefit from rising bullion prices, the equities expose investors to other risks, and therefore tend to lag the commodity.

“It has a lot to do with risk associated with management, particularly production guidance and production gains,” she said. “Analysts are always looking for increase in gold production, so if there’re any disappointments on gold mine production then the equity doesn’t perform very well.”

That kind of risk, she said, is eliminated when investors simply hold gold or a bullion fund.

When asked about the growth potential of gold equities, Mohr is far from dismissive. “I would imagine some of the gold mine stocks are a bit of a buy, provided you think the bullion will continue to rise, because these stocks are probably not fully reflecting the very strong gold price.”

As for bullion, there doesn’t appear to be any disagreement over the direction of the price in the near term. “I suspect that gold will continue to perform quite well,” said Mohr. “I find it interesting that gold hasn’t yet quite gone over $1,600, but I assume that will happen in the next while.”