Using Gold In a Strategy to Outperform the Market

Can gold be more than a safe haven and actually beat the S&P 500 over the long term? One researcher believes the answer is yes.

In a paper from the Lead-Lag Report, researcher Michael Gayed, CFA tested a theory. He wanted to know if the performance of gold relative to lumber could give an investor insight into the future of the market.

His idea was simple: When lumber futures outperform gold, investors can take a more aggressive stance and move into small-cap equities, higher beta stocks, and cyclical sectors. In contrast, when gold outperforms lumber, investors should be less aggressive and move into Treasury bonds, use a buy-write strategy, or move into lower beta/volatility equities.

The basis of this strategy rests on two beliefs. The first is that rising lumber prices indicate that the economy is growing. The author suggests that lumber is especially sensitive to economic cycles given that the average new home in the US requires 16,000 board feet of lumber. This idea aligns with research from the National Bureau of Economic Research and their conclusion that “of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession.”

The second belief is that gold is a reliable and consistent store of value and that it is largely disconnected from so many other investment instruments. Data from the World Gold Council supports this assertion. Their research, covering more than 25 years of data, shows that “there is no statistically significant correlation between returns on gold and changes in macroeconomic variables, such as GDP, inflation, and interest rates.” Pivoting to gold when the economy suffers makes sense because “returns on gold are less correlated with equity and bond indices than the return on other commodities,” the World Gold Council explains.

So does this theory yield results?

According to the data in the paper, it does. The research shows that investors outperform the S&P 500 by a wide margin by moving into lower beta/volatility equities when gold outperforms lumber.

In fact, between November 1986 and November 2020, the S&P 500 yielded a return of 3,028% while a strategy of rotating into lower beta/volatility equities when gold outperforms lumber returned 4,076%.

While this strategy might not be practical for long-term buy-and-hold investors it does offer an important message. That message is that even over a period of decades, gold is remarkably consistent at signaling where the economy is headed. This reliability illustrates just how useful gold is for investors who want the assurance that at least some of their wealth is held in an asset that has prevailed across many downturns of different types.

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