I am finally back home after three weeks on the road (made more interesting by not having a photo ID for the last five flights). While exhausting to say the least, one of the major benefits of travel is getting to connect with other money managers, writers, and friends to share ideas and swap stories. I hope to share some of the research ideas that grew out of these meetings in the coming weeks and months. Now that summertime is fast approaching I’m ready to put my writing hat on and get some of this long overdue research out…
One such lunch meeting was over gyros in Washington D.C. with Eddy Elfenbein from Crossing Wall St. We got to chatting about asset allocation, and more specifically what economic conditions (factors) drove returns. And of course, the discussion meandered towards everyone’s favorite precious metal (now that silver has taken a tumble), gold. Eddy has a great post here titled “A Possible Model for the Price of Gold“.
In it he takes a look at how real interest rates drive gold:
Whenever the dollar’s real short-term interest rate is below 2%, gold rallies. Whenever the real short-term rate is above 2%, the price of gold falls. Gold holds steady at the equilibrium rate of 2%. It’s my contention that this was what the Gibson Paradox was all about since the price of gold was tied to the general price level.
Now here’s the kicker: there’s a lot of volatility in this relationship. According to my backtest, for every one percentage point real rates differ from 2%, gold moves by eight times that amount per year. So if the real rates are at 1%, gold will move up at an 8% annualized rate. If real rates are at 0%, then gold will move up at a 16% rate (that’s been about the story for the past decade). Conversely, if the real rate jumps to 3%, then gold will drop at an 8% rate.
My intern and I have built (still in progress) an Excel sheet that analyzes market returns for asset classes based on any factor. Below is a look, since 1972 at a few of these factors. Below is a similar study as Eddy’s but split into quartiles for real rates (90day – CPI) for a whole host of asset classes. As you can see our numbers are very similar…
(click to enlarge)
Below are assets segregated by deciles for each indicator. While we have a lot more factors built in, we are demonstrating two below – the yield curve and real interest rates. We take the next month average returns and then annualize them. For the second table, we take the returns net of inflation (real returns). We also have the data for sectors back to the 1920s.
I haven’t decided what to do with the findings yet (publish in some form, likely), but I think it is a very useful exercise for taking a broad economic litmus test for “where are we now?”
It looks like, at least according to these two indicators, that small caps and emerging equities, long duration and high yield bonds, and real estate and gold are the best asset classes to own.