THE BLOG
08/13/2011 12:18 EDT | Updated 10/13/2011 05:12 EDT

Golden Opportunity, or Just for Fools?

Nothing like a good old fashioned panic in global stock markets to give the gold bulls yet another second wind.

Just over a month after the yellow metal punctured the $1600/oz level, and only a week after taking out $1700, spot gold prices broke above $1800 this past week at the worst point of the equity shake-out. This represents about a $400 move since the start of the year and $500 from the January lows. What was different in the past few weeks is how vertical the climb in gold has been -- so extreme, in fact, that the Chicago Mercantile Exchange (CME) raised its cash margin requirements on gold futures by 22 per cent, which covers initial and maintenance requirements. Speculators will now have to increase the cash on deposit from $6,075 to $7,425 per contract (one contract equals 100 ounces); while hedgers will need lift cash on deposit to $5,500 from $4,500.

For those of you that watch silver, you'll remember that the CME increased margins five times earlier in the year as the cheaper cousin to gold experienced a speculative surge in price. These actions ultimately sapped the market of strength and sparked a hefty correction. The risk now would be if the CME delivers multiple margin increases on gold which is possible given that prices have quickly stabilized after Thursday's announcement. I would argue that, while this risk is real, there is a greater threat to gold from simply a sustained recovery in equities on improved sentiment regarding the U.S. and European political initiatives.

A 10 per cent pullback from the recent high would take spot gold back to the low $1600s, which also coincides with the 38.2 per cent retracement of the rally from the lows in January. Given the levels we're dealing with, the dollar swings could look incredibly large to many investors, but this is the kind of volatility one should expect from a commodity. For example, the 10-day historical volatility for gold hit 30 this past week -- the highest since February 2010 -- and, while this is still less than half the volatility seen during the 2008 credit crisis and equity sell-off, it's still high. That said, it's not as volatile as the overall stock market. The same 10-day measure for the TSX broke above 40 this week, and reached close to 100 back in 2008.

Should investors infer from this that gold is less risky than buying a diversified basket of Canadian stocks? The short answer is no. First of all, when we invest in a risky asset we expect to get a return. In the case of gold, we are betting strictly on price appreciation. If the world remains in a chaotic state, then that might keep gold going higher, but if things stabilize gold could tumble or simply move sideways. There will not be any interest or dividends earned, unlike stock holdings.

It's for that reason that gold remains part of an overall investment strategy -- not the whole enchilada. A prudent allocation would be about 5 per cent of your total portfolio, which might come from direct investment or through gold stocks. To go beyond that weighting, one is venturing into speculative territory -- and the higher we grind, the more speculative that decision is. Unfortunately, there are firms out there who would like us to believe that we should collapse our nicely diversified accounts and move it all into gold. The end result could give us another definition for 'fool's gold.'