What can research tell us about the relationships between recessions, investment risks, and gold? Quite a lot, actually. In short, it tells us if we want to decrease our risk and increase our investment returns during a recession, it makes sense to include gold as part of our portfolio. Today, we will discuss the factors indicating a recession is likely near or here, and the optimal allocation of gold in a portfolio that has proven to lower risks and increase returns during 7 previous recessions that have occurred over the last 50 years.
Recession Today ??
Before a discussion about recessions and gold can be meaningful for us today, we need to discuss the likelihood that we are near or currently in a recession. The National Bureau of Economic Research is tasked with officially calling a recession a recession, but they often will not do so until after the recession has ended. For this reason, we have to be more proactive in analyzing economic data if we want to position ourselves to do well financially during and following a recession. If we wait for the official announcement and acknowledgment that a recession began, it will likely be nearly over before we are alerted to prepare. Many of the tell-tale signs are already here. We have already had two consecutive quarters of negative growth in 2022. 50% of CEOs plan to lay off employees by year-end, and house prices have begun to drop in major markets across the United States (see graphic).
While no one wants a recession, one may have started or is getting ready to start. Since 1980, a reading of the top 10 leading indicators has correctly indicated a recession 100% of the time (see graph). Either the model has suddenly broken, or we are entering a recession. Armed with this information, how can we respond? When it comes to investing, there is plenty that we can do. Even when funds seem tight on a cash-flow basis due to inflation, there are prudent steps we can take with other investments or retirement funds, to help limit losses and keep our assets growing during and after a recession.
Bonds No Refuge
Often when stocks go down, bonds help cushion the blow by rising. Not so this year. Bonds are having the worst year in history, down over 10% so far YTD (see graphic). With another interest rate increase likely next month, the trend seems set to continue for now. This makes finding an alternative even more important this year, during this recession. This is where gold comes in. Using the Dow Jones Industrial Average (DJIA or the Dow) as a proxy for stocks, it is useful to consider and contrast the performance of the Dow versus gold during previous recessions and see if there is an optimal combination that has led to the best results. It is essential to note the difference between a recommended allocation of precious metals in an overall portfolio, which might be 5-20%, and an optimal allocation of gold to a stock portfolio during a recession.
When evaluating the recessions of 1973-75, 1980, 1981-82, 1990-91, 2001, 2007-09, and 2020, we can see that gold is a good diversifier. While the Dow performed better than gold during the 1981-82 recession, only gold had a positive return for every recession. Gold was also the best performer overall during the recessions combined. Silver occasionally performed the best, such as during the 1981-82 recession, but is also more volatile than gold.
Some definitions might prove helpful when discussing the optimal gold-Dow ratio during a recession. There is what is called an “Optimal Portfolio” (OP), which offers the highest return combination with the least amount of risk. The OP is for those looking for the highest return allocation of risky assets. Then there is the “Minimum Variance Portfolio” (MVP), which is an allocation offering the lowest risk when combining risky assets. By “risky” assets, I mean an asset that can go up or down in price, such as gold or the Dow. A more thorough discussion of these concepts and in-depth reading about recession/gold research are available here. To summarize, there are some recessions when the OP was a 100% allocation to gold, with 0% allocated to stocks. A portfolio seeking to minimize risks (MVP) required a gold/Dow allocation ranging from 5-65% gold, depending on the recession.
In a general sense, the recessions in which gold excels seem to be those accompanied by uncertainty and inflation. The best recession for gold was the stagflationary recession of 1973-75 (+87%). With all the tell-tale signs of stagflation rearing its ugly head today, we may enter another recessionary period in which gold outperforms. It is also often the case that gold continues to climb after a recession ends. This implies an allocation to gold today can be a good place for several years after the recession we are likely entering.
How much gold do we need? Obviously, the more, the better. While it is not possible to know precisely how the current/nearby recession will impact gold, 35% is squarely in the middle of the 5-65% gold/Dow ratio that has minimized risk during previous recessions. But in terms of a stock portfolio, it would make sense to consider a 35% allocation to gold to minimize risks. If you already own stock or stock-based assets such as ETFs or mutual funds, you already have the assets needed to transition a portion to gold without tapping into your emergency cash. If the assets are in an IRA, consider the advantages of a precious metals IRA to help increase your allocation to gold.
Replacing some stock exposure with precious metals, and replacing some bond exposure with insured annuities, can help increase overall stability and enhance investment returns during a stagflationary recession and beyond. Depending on your current level of wealth, a 35/65% allocation of gold/stocks might mean your overall gold allocation represents 8-12% of your total assets. This would provide room to include more gold, silver, platinum, or palladium elsewhere in the portfolio to help get your overall exposure to precious metals up to 20% of your total assets.