This "Capital Ideas" article is the second in a series of bi-monthly articles we plan to write. At the beginning of each month we will focus on general concepts related to using the futures market to trade and invest in gold. The second piece of each month, like this one here, will discuss ideas being presented in various gold-related research papers. Our objective is to be informative and build a body of knowledge.
Numerous research papers on gold begin by establishing that of all the commodities gold is a distinct asset. Themes include the idea that human civilization has long been enamored with gold going back to ancient times, as well as the fact that, unlike most other commodities, bullion can be stored almost indefinitely and requires very little maintenance. These attributes are given as the reason gold has throughout history been used as a medium of exchange and maintains its purchasing power.
In Research Study No. 22, Gold as a Store of Value, published by the World Gold Council in 1998, author Stephen Harmston relates the oft-heard story that "an ounce of gold bought 350 loaves of bread in the time of Nebuchadnezzar... still buys approximately 350 loaves of bread today." Notwithstanding that we have been unable to identify an archeological or biblical source for this tale,1 let us assume that this bit of trivia is true, along with other stories involving an ounce of gold buying a nice suit., armor or otherwise.
Assuming gold does have the unique ability to maintain consistent purchasing power over an extended period of time, such asset would seem to fit the definition of a zero-beta asset. This is the conclusion of a paper by McCown and Zimmerman (2006) titled, Is Gold a Zero-Beta Asset? Analysis of the Investment Potential of Precious Metals in which they analyze gold returns using three different frameworks.
In their first study, McCown and Zimmerman use the Sharp (1964) and Lintner (1965) capital asset pricing model (CAPM). Running a regression analysis from 1970 to 2003 where the risk free rate is the yield on the US T-Bill, they use three different proxies for the market portfolio: MSCI US Index, MSCI World denominated in local currency, and MSCI World denominated in US dollar.
Acknowledging that the CAPM is "limited in usefulness as a tool for investment analysis," the authors observe that "all of the estimated beta coefficients for gold are statistically indifferent from zero," and therefore gold does not reflect "much, if any, systematic risk". In this study their conclusion is that gold effectively behaves as a zero-beta asset, yet it also "has a positive risk premium".
Next, McCown and Zimmerman evaluate the investment potential of gold using the arbitrage pricing theory (APT) of Ross (1976). APT looks at an asset's exposure to multiple sources of risk simultaneously. The study considered various types of market risk including the MSCI World Index denominated in US dollar; bond default spread; bond term spread; change in US industrial production; and change in the log US CPI inflation rate. Regressions were run both with and without the market risk factor.
The result of this analysis shows that gold has positive, statistically significant coefficients on industrial production factors and change in inflation risk factors. As to market risk, for the quarterly and monthly data "the R-squares for gold are all close to zero". McCown and Zimmerman conclude that gold is a good hedge against inflation and a useful addition to portfolios based on APT as a framework.
To verify their findings, the authors test for cointegration by using two random variables to validate whether their unpredictable movements are related. Thus, if gold and consumer prices are cointegrated, there is additional evidence that the metal is a good hedge against inflation risk. Two different types of test methodologies were used: the Dickey-Fuller-GLS test of Elliott, Rothenberg and Stock (1996) and the so-called KPSS test of Kwiatkowski, Phillips, Schmidt and Shin (1992).
McCown and Zimmerman test for a cointegrating relation between gold prices and the CPI, and conclude from these tests that there is evidence in the ability of gold to hedge against inflation risk. As an aside, all of the above studies, including cointegration, were also analyzed using silver prices.
The paper concludes that gold shows "the characteristics of zero-beta asset," and that the "mean return is just slightly higher than that of T-Bills". Further, "estimates of CAPM and the APT show that both gold and silver bear virtually no market risk, and their estimated betas are statistically indifferent from zero". All studies showed evidence of inflation-hedging ability when added to an investor's portfolio.
Obviously, the analysis doesn't take into account the rise of gold since 2003, which brings up the "old saw" that "correlation does not imply causation". Given that gold is priced today much higher than 2003, yet inflation has been generally tame, raises an interesting question as to the perspective of this study. Perhaps a better framework for studying gold is that is acts like a currency proxy?
Over the course of our lifetime we are trained to value assets from a US dollar-centric perspective, and it is hard for US-based investors to think differently. In Europe one views prices from a euro-centric perspective. However, it is also possible to revalue the economy and markets from the perspective of preserving purchasing power. When assets such as stocks are revalued in gold as a unit of account, we gain a completely different outlook on whether or not such assets have risen or fallen, and to what extent.
If we were to value the Dow Jones Industrial Average, not in US dollars but in ounces of gold, it would have cost around 30 ounces of gold to buy the Average at 10,000 when the index first crossed over that line in 1998. When it crossed over that line again back in October 2009, it would have cost less than 10 ounces of gold. In other words, zero-beta implies the idea of relative valuation when measuring variance based on a stable exchange rate which consistently maintains purchasing power. Well, it's a thought...
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Footnote:
1) Dr. Claude Mariottini, Professor of Old Testament, Northern Baptist Seminary, states that no where in the Old Testament does it say that "in the days of Nebuchadnezzar an ounce of gold bought 350 loaves of bread." Further, Dr. Mariottini logically points out that "one must assume that the ounce, a unit of weight in the avoirdupois system, once used in the United Kingdom and still used in the U.S. system of weights, was also used in Babylon. Since the Babylonians did not use imperial units, this statement is false." Source: "Gold and Bread" http://doctor.claudemariottini.com/2008/06/gold-and-bread.html
The analysis and opinions expressed in this commentary have been reviewed Every effort has been made to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. There is no guarantee that the forecasts made, if any, will come to pass. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Further, this material does not constitute a solicitation to invest in any program including any program of Cervino Capital Management LLC which may only be made upon receipt of its Disclosure Document. Past performance is not necessarily indicative of future results. Investment involves risk. The risk of loss in trading commodities can be substantial.
About the author: Michael "Mack" Frankfurter is a co-founder and Managing Director of Operations for Cervino Capital Management LLC, a commodity trading advisor and registered investment adviser based in Santa Barbara, California.
For more information contact: Capital Trading Group. Click for Free report on our GOLD program -http://www.capitaltradinggroup.com/promo/gcc.cfm
Mack Frankfurter, Cervino Capital Management LLC
and Nell Sloane, co-author
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The analysis and opinions expressed in this commentary have been reviewed and is approved by the principal of Capital Trading Group LP as of the date of this issue. Every effort has been made to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. There is no guarantee that the forecasts made, if any, will come to pass. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Further, this material does not constitute a solicitation to invest in any program offered by Capital Trading Group LP including any program of Cervino Capital Management LLC which may only be made upon receipt of its Disclosure Document. Past performance is not necessarily indicative of future results. Investment involves risk. The risk of loss in trading commodities can be substantial.
About the author: Michael "Mack" Frankfurter is a co-founder and Managing Director of Operations for Cervino Capital Management LLC, a commodity trading advisor and registered investment adviser based in Santa Barbara, California.