August 1, 2019
How to Use Cheap Gold Options to Hedge Your Portfolio
The financial markets over the last 30 years have been greatly influenced by central banks in their effort to smooth out the business cycle and reduce the pain of recessions. At any sign of economic weakness, they have lowered interest rates and flooded the system with extra money hoping to kick start growth. This has worked to a limited degree, but for all this effort the resulting growth has been relatively modest, and I would argue not worth the added risk these actions have created. Instead of normal recessions that rebalance the economy, we now experience periodic bouts of high volatility - the last being the Financial Crisis in 2008. When the next economic slowdown comes, it is very likely that these methods will be deployed again but will not have the desired effect and instead could make things much worse.
When lots of money is made available at very low interest rates, the result is naturally more loans. This routine over and over has exploded the amount of debt carried by all sectors of the economy - private, corporate and government. This huge overhang of debt must be serviced and paid back some day which will tend to slow future growth and reduce investment returns. In fact, this is exactly what has been happening in Japan for 30 years now. Even though slow growth and poor market returns are an important topic, I will save those for another blog post. I want to focus here on a more worrisome issue - a potential risk in the confidence in paper money (fiat currency).
A crisis of confidence in the financial system sounds extreme, but it has happened many times in history. It has just not been an issue in the United States since the early years of the republic and not for any modern economy since WWII. But the pattern is well established, when people feel the government is printing money way beyond what is needed, they reach a point they do not want to hold that currency anymore. The process of losing trust is sped up if printed money is directly used to fund government spending. When the currency becomes less desirable, interest rates will go up too - compounding the problem. This is what is happening in Venezuela and Argentina now. But these are small economies with unfair systems and governments that are openly printing money in excess. The U.S. economy has been well managed and works well by comparison which explains why the risk of the system breaking down has been basically non-existent for generations. The central bank (Fed) has been given plenty of slack to pursue easy money policies without any worry. The charts below will show how far the Fed has stretched this trust.
This first chart shows how much corporate debt (non-financial) there is in the U.S. Since 2008, it has increased by 85%; the accelerating upward trajectory is obvious beginning post-crisis.
Interestingly, the U.S. Federal Reserve (U.S. central bank) itself issued the following statement of warning just last May:
“Borrowing by businesses is historically high relative to gross domestic product (GDP), with the most rapid increases in debt concentrated among the riskiest firms amid signs of deteriorating credit standards.”
Total private debt has declined some since the Financial Crisis, but even after more than 10 years of making extra payments, the average household still holds quite a bit compared to the past.
And here are the government’s debt totals, up about 2.5X since the Financial Crisis.
And the central bank’s own balance sheet of money (that they create themselves) is often used to buy government bonds (in essence, printing money to fund the government) increased as much as 5-times pre-crisis levels.
There are plenty of more charts I could show, but it should be obvious with just these 4 that the financial system is more than a little bloated with debt and money. This weight of debt and money could “just” be a drag on growth, but if there is recession these numbers will grow and things could be worse. In a recession, the Fed is very likely to print more money and lower interest rates to induce more companies and the public to take on even more debt. How likely is a recession? The government’s data suggests more likely than you probably think; the N.Y. Federal Reserve Bank’s internal indicator for the likelihood of a recession soon is now nearing multiyear highs.
The government itself will need to borrow a lot more in a recession to make up for lost tax revenue. This is compounded by the fact that the government for years been running big deficits even though the economy has been strengthening. The following chart again comes from the U.S. government itself. The Congressional Budget Office (CBO) predicts the federal deficit would nearly double in the next recession.
Here is what Ken Rogoff stated in an article published in the online economics magazine, Project Syndicate, on Feb 5, 2019. Mr. Rogoff is generally considered one of the leading experts on the cause of the Financial Crisis.
"Unfortunately, an inexorably growing financial system, combined with an increasingly toxic political environment, means that the next major Financial Crisis may come sooner than you think."
This entire picture becomes even more worrisome when considering the current political trends. Trump has been very vocal in pressuring the Fed to keep interest rates low and has threatened to replace the current chairman if need be. Nearly all the Democratic presidential candidates endorse printing money and handing it directly to the government to spend on social programs (MMT). One side wants more debt piled on a very indebted system and the other wants to risk devaluing the currency itself in short order.
So how do you hedge your portfolio? Since every major country in the world has some versions of these problems, hiding out in another currency is not an option because even in the worst-case scenario, the “value” of the Dollar versus other currencies might not change much. But the change should be apparent versus physical assets. Real estate might work but years of cheap money have inflated prices. Bitcoin is the answer for some people (though not a physical asset), but it is unproven. (Interestingly, the rise of alternative currencies themselves demonstrates one aspect of the growing distrust in the current economic system.) To hedge your portfolio, gold has a long history of being a good hedge during the period’s extreme financial upheaval. There are some ETF's and specialized funds, one should choose carefully since the structure of the entity, legal jurisdiction and method of gold ownership are all important.
If there is really a breakdown of trust in paper money and especially in the U.S. Dollar, a more serious hedge is needed – something with a high payout versus the cost which is to buy call options on the price of gold. The most liquid choice are options based on the SPDR Gold Shares, the symbol is GLD (which some flaws at an investment vehicle, but it will suffice in this case). The price of gold has traded within a range mostly between $1,200 and $1,400 for several years. Before that, it nearly reached $2,000 based on many of the same fears outlined in this article when the central bank was just getting started promoting more debt right after the crisis.
Since we are trying to hedge a radical change in how investors and the public view the financial system, it is not crazy to expect the price of gold to surpass $2,000. Let's look at some specific options as examples, these are recommendations. If you are not well versed in options and understand the strategy being presented here, please seek professional assistance. The quotes below are for GLD options expiring on January 15, 2021, 539 days from now. The 245-strike price roughly equates to $2,500 in gold. (Side note, logically, the 250 strike should correlate with $2500 gold, but the fund’s management fees have siphoned a bit of the fund of each year. Not great, but this should not be a factor for our purposes.)
They are offered for sale at 0.47, but let’s assume 0.50 each including commissions or $50. Each option represents 100 shares of GLD. If gold were to reach $3,000, assume GLD would trade at or near 300 (probably 295-ish really). Assuming the option would be 50 points “in the money” (meaning the GLD price is that much above the option strike price), it should have a market value of at least $5,000 each (50x100).
Let' tale a look at another option with a lower strike price closer to the current price of gold. The 200-strike price would cost about $120 each (1.20 x $100). The “open interest” column shows over 55,000 have been purchased already. A move in gold to $2,500 should value this option at about $5,000 each and $10,000 if gold reached $3,000. Depending on how much you feel you need for your portfolio size and at what level you would like the insurance to kick-in will dictate the right number of options to buy. Regardless, they are cheap versus the potential if the price of gold really appreciates substantially. There are also ways to do the same using options on gold futures contracts for those comfortable and so inclined to use that market.
I know this hedge really comes into play only if the gold price doubles - but this is insurance against the worst-case scenario which is not so far fetched anymore. A lesser crisis in confidence might generate a smaller rally in gold in which the normal portfolio allocation of gold suggested should suffice. The stock market is at all-time highs, unemployment is at multi-year lows, it might seem excessive to worry so much but there are some real imbalances in the underlying economy. It is only sensible to own a bit of insurance.
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