Gold Glitters as a Hedge Against a Stock Market Crash

· US stocks are dangerously overvalued: The P/E ratio is 30, so the earnings yield (E/P) of 3.33% is below bond yields, and prices are more than 3 standard deviations above historical norms—conditions that have led to sharp corrections or crashes in the past.

· Fear is shifting money into gold: While FOMO keeps the stock rally alive (especially in AI names), investors are simultaneously hedging by buying gold at a record pace; gold is now outperforming stocks even during a bull market, an unusual warning sign of expected trouble ahead.

· This bull market cannot last forever (Stein’s Law): We are in the longest bull market in history with classic late-cycle overvaluation; history shows these conditions do not end well.

· Baby Boomers are most at risk and should act now: Holding roughly one-third of all US stocks and currently living in the “Retirement Risk Zone,” Baby Boomers cannot afford a 30-50% crash. Target-date funds offer no real protection. Moving to gold, T-bills, and short-to-intermediate TIPS is the prudent step before the crowd panics, not after.

Investors are concerned about inflation and the looming threat of a long overdue stock market correction. Warren Buffet is defending against a correction with a record $380 billion in cash, which at 55% of his portfolio is his largest cash position ever.

But cash does not protect against inflation. Gold is the go-to inflation hedge, and it also protects against a stock market correction. That’s why the price of gold has skyrocketed 133% so far in this decade and is up a whopping 60% in just this year through November.

The main trade-off is currently between the prospects of AI-based stocks in a very expensive stock market, and the safety of gold.

Advisorpedia observes that “Every major innovation cycle creates a divide between skeptics who see overvaluation and optimists who see a new era of growth. The challenge for investors is not to take sides, but to understand what bubbles do, why they’re so hard to identify in real time, and how to benefit from them without being destroyed by them.”

Gold strikes a balance between skeptics and optimists—hold both gold and AI while you gauge the future of AI and seek to benefit from them without being destroyed by them.

US stocks have lost their dominance, but haven’t slid far, yet

US stocks are tipping under the weight of very high prices, but AI is saving the market, at least for now. US stocks were dominating asset class returns until this year when they slipped into third place behind gold and foreign stocks.

Investors are beginning to realize that US stocks are very expensive, but they are not yet ready to cash in on their profits because the AI story is seductive and young investors have never experienced a stock market crash so they’re not afraid of one. By contrast, Baby Boomers should be afraid and move to safety.

The very high prices of US stocks, especially AI stocks

The US stock market’s current P/E ratio is 30, placing it at the very high end historically. Ben Graham said: “Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio (earnings yield)—the reverse of the P/E ratio—at least as high as the current high-grade bond rate.” Using an AA yield of 4.53% and P/E of 30, the stock market earnings yield (E/P) of 3.33% is below Graham’s minimum; Graham would view the market as rich by his rule.

P/Es need to decline below 22 (E/P = 4.53%) to reach a Ben Graham fair price, which generates a 20%+ loss in stock prices. And if P/Es return to their historical norm of 15, the stock market will lose 40% even if earnings growth is high in the 14-18% range. That’s just the arithmetic of future returns.

Return = Dividend Yield + (1 + Earnings Growth) X (1 + P/E expansion/contraction) – 1

And other measures of expensiveness are also very high. As shown in the following, stock prices are more than 3 standard deviations above their norm, a level that cannot be sustained. As you can see, previous highs (that weren’t as high as the current level) were met with regression toward the mean, as investors wearied of paying high premiums, replacing greed with fear.

Stock market investors should be afraid of a correction and concerned by the fact that paying a high price today reduces the subsequent return tomorrow. But instead of abandoning the stock market entirely, investors have moved some of their assets to the safety of gold. They’re hedging their risks at this time. Why gold instead of cash? Read on.

Gold is a hedge against stock market losses and inflation

Warren Buffet has criticized gold as being an asset that “produces nothing, but you hope someone will pay you more for it in the future.” But gold is a unique form of money—one of the oldest forms. “Money” is a means of exchange and a store of value. Fiat paper money is a means of exchange, but it is not a store of value when inflation occurs. Gold is a store of value, even in the face of inflation, although exchanging it has frictions that can be greased with gold-based ETFs.

If you fear inflation—as you should—gold is a better hedge than cash. With the national debt continuing to grow beyond $38 trillion, inflation is a serious concern. Taxpayers are paying more for interest payments than they pay for national defense, and there’s no way out. Also, central banks—managed by very smart people—are increasing their holdings in gold.

Importantly, and interestingly, gold performs well when stocks are crashing because gold protects, as shown in the following:

Over the past 30 years, gold has earned more than DJIA stocks by winning when stocks are losing, and as shown in the following, gold is currently winning while stocks are also winning—an unusual situation. In fact, the 133% return on gold over the past 5 years has more than doubled the 57% return on DJIA stocks. Holding both risky US stocks and safe gold has not diminished returns—just the opposite.

The current “gold rush” is a clear indication that investors see danger ahead in the stock market, but they want to hang in there on stocks, at least for a while. Baby Boomers should not wait for a crash, as explained in the section below on “Danger Ahead.”

Gold is more than just an investment asset

Gold is used for jewelry, technology, central bank reserves and investing. Investing is the primary usage of gold, but the World Gold Council reports that investing is only 43% of the demand for gold, as shown in the following. The Council also reports that the recent surge in gold price is generated primarily through the purchase of gold-backed ETFs, growing 134% over the past year.

The appeal of gold extends beyond its hedge against a stock market crash, addressing Warren Buffet’s concern. Gold is in fact both a productive asset and money.

Danger ahead: Boomers beware, especially TDF participants

We are continuing to enjoy the longest bull stock market ever, bringing Stein’s Law to mind: If something cannot go on forever, it will stop.

The warning signs are there and include the rush to buy gold, but nothing has changed in target date fund investments, although some—like Vanguard – have  recently reviewed their glidepath and decided to not change it. 

Target date funds remain high risk for those near retirement. TDF glidepaths do not even come close to addressing concerns about an impending stock market crash. They are 90% in risky assets throughout their glidepaths and it’s only a matter of time before they crash when the stock market crashes.

Baby Boomers in particular are exposed to lifestyle altering investment losses because they are currently in the Retirement Risk Zone when investment losses can ruin the rest of life. They should not take this risk—that’s what academic theory says. They should sell their stocks and their TDFs and move to the safety of gold, Treasury Bills and short-to-intermediate TIPS.

Baby Boomers hold around $23 trillion in stocks, which is a third of the stock market. Their move to protect their savings could lead to a crash, but they will not move en masse; unfortunately, most won’t move at all.

Stock market investors need Baby Boomers to stay in the game, but Boomers should not risk their lifetime savings at this time in their lives because they cannot afford to lose this game—not now.

Conclusion

Fear of missing out (FOMO) continues to drive the US stock market higher, motivated in large part by the emerging big advances in artificial intelligence that are changing the world. But this will end. Think dot-com bubble. Concerns about the AI bubble are bigger than ever.

Baby Boomers need to  get out of the stock market because they might not recover from the next crash. They should be safe in the Retirement Risk Zone that spans the 5 years before and after retirement. As Edith Bunker explained in the 1970s TV show All In The Family, “I don’t want my money to work. I want it to relax.”

In particular, Baby Boomers in TDFs need to get out because TDFs do not follow the academic theory that they say they follow. If they did, they would protect Baby Boomers because Baby Boomers are currently near retirement.

SEE ALSO:

• Surz: Baby Boomers in TDFs Need to Get Out – NOW