Investment Idea

What is your next big trade?

Mikael Syding
03/11/2022 | 5 min read

What will be your next really important decision in the stock market? Does it apply to what percentage of your capital you should risk more or less immediately; in other words, what percentage of "dry powder" do you have ready for better conditions? Or is it about what this dry powder should consist of. Is a bank account an option? Or to repay loans? Or buy some kind of interest-bearing instrument, perhaps a corporate bond, preferred stock or a company with a high dividend - a bank, for example. Then, of course, there is always gold as an alternative...

However, gold has a couple of big problems. The physical product is e.g. difficult to store. It simply costs money to store the gold in a sufficiently secure manner. You hardly want it at home, for example. If you buy gold, you also have an opportunity cost in the form of what you pay for interest on your most expensive loans that you could have amortized a little. USD-focused institutional investors typically compare the cost of holding the gold to the interest rate on a 2-month US Treasury bill. The difference is approximately 4.5% per year. If you have a positive belief in the gold price, e.g. based on previous money printing and CPI inflation of 8%, one might think that should compensate for the interest rate differential, but there is a difference between an actual cost and a theoretical profit. Investors know that others think the same; this means that the trend away from gold and into fixed income instruments is rather reinforced.

The idea with the high interest rates is also that inflation should be pushed down, which speaks for an even worse calculation for gold in the near future. This makes investors even more likely to reduce gold holdings in favour of fixed-income investments, simply because of the price trend even though gold itself is clearly becoming cheaper, and even more rapidly gaining a lower portfolio weight.

If you look back in time, a little gold in the portfolio has resulted in a higher return than for shares alone, alternatively much lower fluctuations than for the stock market despite the same total return. An annual rebalancing to 10% gold and 90% S&P 500 has made the portfolio about 25% better, compared to stocks alone - so the standard deviation, the swings, have been that much lower. One cannot count on getting the same results in the future; because backtracking has its limitations. But one can rely on the intuition that a countercyclical, uncorrelated asset with inverse risk characteristics will over time act as a counterweight in a portfolio. This means in practice that you can buy more gold when stocks have done better one year, and then sell some gold when the stock market is relatively lower.

Over time you get more units of both gold and shares. It's a kind of free lunch that hides between the differences in asset classes.

Gold's biggest problem is that it doesn't produce anything. It's a rock. It just lies there. It does nothing, while the listed companies build factories and more and create values that are reinvested in even more growth in an explosive interest-on-interest process. On the other hand, listed companies are sometimes far too expensive and sometimes too cheap. You want to be able to sell when it is too expensive, park the money in something counter-cyclical and reliable in order to be able to buy many more shares when the companies become too cheap. That's what a gold investor can do now. So exchange some gold for more shares.

A kilo of gold (+19% last year) buys much more OMX units (-15%) today than a year ago. The dry powder in gold thus buys 40% more OMX now (1.19/0.85 = 1.40). This means that you get a much greater potential in OMX if the rise takes hold now. And about the development of both e.g. were to be repeated in the coming year, you can increase your holdings in OMX by another 40% per unit of gold and be even more ready for the future if the relative strengths were to reverse - which historically they have always done sooner or later. Usually quite "before".

Shares rarely fall more than 2-3 years in a row, and gold rarely rises much more than the stock market several years in a row. In addition, they often tend to move in different directions, as investors either want risk or safety. This means that every year you can calmly take new steps from gold to stocks and vice versa, suggested rebalancing each year to around 5%-20% gold (5% if the stock market has crashed for several years and there is not likely to be strong inflationary pressure upward for gold in the near term; and 20% if the stock market reaches such crazy valuation levels as a year ago when a sales krone in the S&P 500 cost 4 times as much as it usually does!)

So, gold is a good addition to an investment portfolio over time. But the model doesn't really say much about what to do right now - just that about 10% gold has been good over time. Now we are faced with, on the one hand, a cheaper stock market than in a long time, and on the other hand, a number of known threats. World War III could be seen being in full swing with the battle for Ukraine and Taiwan respectively, weaponized currencies and commodity prices, not to mention deglobalization, inflation, interest rate hikes and impending recession at the same time. After a large appreciation usually comes a large devaluation. After large profit margin revisions, there is usually a reversion to the mean. That is likely what we have before us now.

As expected, the reporting period started well. The sentiment was so weak that even a less negative image in the rear-view mirror for the third quarter was better than expected and enough to create a so-called "clearing rally" where short sellers temporarily cover their positions, and some speculators buy in the hope of a quick profit streak. But now the market is starting to recognize reality instead. First you looked left along the street and saw an ok summer for the companies as well as potential pivots for both the Fed's interest rate policy and China's Zero Covid Policy. But when the gaze is now turned to the right, largely due to catastrophic figures from Meta, Adobe, Alphabet, Spotify and several tech companies, the recession train comes relentlessly rushing.

Lowered earnings forecasts, reduced confidence reflected in weak ad sales, and higher interest rates in the wake of high inflation sit particularly poorly with high profit margin expectations and valuation multiples. Given historical patterns in time consumption and appearance, for both macroeconomic figures, profit forecasts, business cycles and interest rate policy as well as the purely graphical appearance of the stock market, one can expect another six months when highly valued growth companies do much worse than low valued slightly more tired sectors that form the backbone of the economy. Yes, it is still banks, oil and green minerals that look most interesting, while ad sellers in the tech sector, admin software, consumer durables, travel and the like are expected to continue sharply downward. In this environment, I expect continued strong outperformance for gold and silver, even if the real rise for these lies after future pivots from Xi and Powell.

For me, the most important decision now is to make sure not to be in a weak decision position when the big panic bottom for stocks occurs sometime after the Q1 reports in April, May 2023. That is when both hands could go to the buy button for the stock market. But on the way there, of course, there are plenty of individual special cases with fantastic potential even now.

This information is in the sole responsibility of the guest author and does not necessarily represent the opinion of Bank Vontobel Europe AG or any other company of the Vontobel Group. The further development of the index or a company as well as its share price depends on a large number of company-, group- and sector-specific as well as economic factors. When forming his investment decision, each investor must take into account the risk of price losses. Please note that investing in these products will not generate ongoing income.

The products are not capital protected, in the worst case a total loss of the invested capital is possible. In the event of insolvency of the issuer and the guarantor, the investor bears the risk of a total loss of his investment. In any case, investors should note that past performance and / or analysts' opinions are no adequate indicator of future performance. The performance of the underlyings depends on a variety of economic, entrepreneurial and political factors that should be taken into account in the formation of a market expectation.