SGOL: Buy The Pullback In Gold

ETFS

As you can see in the following chart, the Aberdeen Standard Physical Gold Shares ETF (NYSEARCA:SGOL) has taken a bit of a hit in line with the recent selloff in gold.

It is my belief that this selloff represents a solid buying opportunity. I believe the key drivers of the price of gold have lined up such that buying SGOL at this time is a good play. Not only is this the case, but SGOL is backed by physical gold ownership, which removes the roll yield concerns of competitor ETPs.

Gold Markets

This has been a very turbulent year for global markets. While that may seem like a bit of an understatement for those who have held exposure to equities during this year, stock prices are actually only somewhat changed on a year-over-year basis. And this small change is fairly good for the future price of gold.

This chart shows a very interesting relationship at work in the pricing of gold. What it shows is that, when the market doesn’t really go anywhere over the course of a given year, it is actually setting up for a strong rally in gold over the next year.

At present, the S&P 500 is sitting at a 9% year-over-year gain in performance. While this isn’t quite a complete lack of outright performance, the past 50 years of data would say that, on average, we can expect gold to rally by around 14% over the next year.

However, that’s not all – the S&P 500 is currently giving out additional signals, which are suggestive of a higher gold price over the next year. One of these signals is the outright level of the VIX, or volatility index.

The VIX is a metric which is calculated from options on the S&P 500 index. It tends to increase in value while the market is falling, and decrease in value while the market is rising.

While this is interesting in its own right, the key point of interest for gold investors is the relationship between future changes in gold and the outright level of volatility in the market.

What this chart shows is that, when global equity markets become fearful (as evidenced by a rising VIX level), gold tends to appreciate in value. This makes sense in that, during fearful times, people search for places to park capital to preserve wealth, and gold is commonly considered to be such an asset. This investment in gold during scary times ultimately leads to a price appreciation.

At present, the VIX is sitting at 27 (but it was recently as high as 38 over the past three weeks). Using the last 27 years of data, we can say that, on average, when the VIX is in the territory that it has recently been, gold has rallied by anywhere between 9% and 20% over the next year – on average.

It is important to note that these are just market averages – the actual return of gold could be higher or lower depending on variables beyond the ability to forecast. However, clear relationships exist in the data, which suggest that gold is likely headed higher – or at least, in the past when we’ve seen these variables line up the way they are now, gold tended to rally.

Another interesting variable which is suggestive of higher gold prices over the next year is the dollar. Over the past year, the dollar has actually fallen in value by a little over 1.6%. Typically, there’s a moderately strong relationship in which declines in the dollar are associated with gains in gold (since it takes more dollars to buy the same amount of gold).

However, there’s also additional data which suggests that changes in the dollar are also predictive of future changes in gold.

Given that the dollar is off about 1.6% over the past year, the past few decades of data would say that gold may rally by about 8% over the next year. In other words, the dollar’s change is indicating that we’re likely going to see gains in gold going forward.

We’ve got a few different indicators which are all generally saying the same thing: gold is likely going to rise. Changes in the S&P 500, the VIX, and the dollar all are lining up at this moment to suggest that buying and holding gold for the next year will likely prove to be a sound trade. However, when we trade gold, we need to factor in the methodology of the ETP we track – because methodology can have material impacts upon holdings.

About SGOL

In the classic commodity ETF space, a fund tends to hold the futures of the underlying commodity and roll at some time before expiry. This process is fine for tracking a commodity – however, it subjects investors to something called roll yield.

Roll yield is what you get when you’re holding futures while they converge towards the spot market for the commodity. The general concept here is that, on average, there are differences between the price of a futures contract and the actual spot market for any given commodity. And through time, this difference erodes to be zero with the futures contract moving to approach the spot market.

The bad news for gold investors is that gold futures are almost always in contango. The reason for this is pretty simple in that the actual futures price of gold tends to be just the prompt price of gold compounded by the interest rate earned on storing gold net any borrowing costs. This results in a fairly predictable pattern of futures increasing in value along the forward curve.

The reason why this is bad news is that the futures converge to spot. Since gold futures tend to be priced above the spot market, this means that investors tracking gold will lose money at the pace of about 2% per year (at today’s levels). This “loss” is actually just underperformance – that is, if the market is flat, you’ll lose 2% of your holdings per year. However, this is just as material and impactful as though someone were to charge a 2% holding fee on your ETP.

And here’s where the benefits of SGOL come into light. SGOL is a trust which is actually holding physical gold bullion bars in storage. Aberdeen marks the position daily using the London Bullion Market Association’s benchmark. Not that it particularly matters for long-term holdings, but all of the studies in this article were based off of this same gold index.

Since SGOL is holding physical gold, it is not exposed to roll yield. This means that, all else equal, investors in SGOL will likely outperform popular alternatives by around 2% per year. I believe that this is a strong reason to hold the ETF. Also, of note, SGOL’s expense ratio is only 0.17% at the time of writing, while its competitor GLD’s ratio is at 0.40%. In terms of ETFs, I believe SGOL is a clear win at this time.

Conclusion

SGOL has taken a small hit in line with a drop in gold – but this pullback makes for a solid buying opportunity. Changes in the S&P 500, VIX, and the dollar all suggest that now is a strong time to buy gold. SGOL is holding physical gold at a cheaper expense ratio than alternative ETFs, which should lead to outperformance through time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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