I have figured out a way to invest in oil and gold while mitigating down-side risk to some extent. I began investing in what I call the Big Dust Up Financial Index (BDUFI) on February 4th.
First some background on why you would want to invest in oil and gold:
Oil
Iran has long threatened to close the Strait of Hormuz if attacked by Israel or the US. The reduction in oil flow out of the Middle East would be significant. Some estimates are that up to a quarter of world production would be affected, causing the price of oil to skyrocket, possibly to $300/barrel. Long term, oil is anticipated to increase as reserves are exhausted (the peak oil concept). Over the last couple of years, I have always had some of my money in oil, anticipating that eventually the Iran problem will require a forceful fix. On occasion, I've invested quite a lot, sometimes getting burned when the unpredictable nature of world markets causes oil to decline.
Gold
Historically, gold has been a safe store of wealth -- although in the last 100 years, the price of gold has been declining when measured against what it can buy. It is widely believed that the vast, unprecedented deficit spending of the Obama administration will eventually cause serious inflation, the decline of the dollar, and possibly a time of extreme hardship in our country. If this happens, gold and other precious metals may be one of the few things that have any value, along with canned food. Don't expect gold or 1x gold funds to make you wealthy; but they may allow you to keep even with inflation.
The Linkage Between Gold, Oil, and the Stock Market
Gold and oil have pretty much followed the stock market (with various multipliers) since 2008. If it looks like the economy is improving, oil and gold as commodities will be in higher demand, and thus will be at higher prices. If the dollar declines, prices go up. If it strengthens, prices go down. Gold and oil break away from the market periodically such as in early-2008 when oil popped up to $145 on rumors of war (Bush ended up vetoing Israel’s plan to attack Iran in the summer of 2008). But as long as normalcy reigns in world affairs, this linkage should continue. Stocks go up, gold and oil go up. Stocks go down, gold and oil go down.
Splitting the Linkage
But inflation, or a reigning in of stimulus, or a Middle-East war would split this linkage, and cause the stock market to go down and oil and gold to go up:
- Inflation: Any symptom of inflation would be counteracted by tightening of the money supply, causing stocks to fall, and gold to go up as a hedge. Oil would likely go up too at first, but could go down as tightening is imposed especially if it starts looking like stagflation.
- Middle-East War: An attack would reduce the supply of oil, causing the price to skyrocket, especially if Iran makes good on promises to close Hormuz. Gold is likely to go up as well because it is a safe haven, but this is less certain.
- Prosperity Miracle: If we quickly transitioned into a growing economy without inflation and with good confidence, oil and gold would likely drop in value, and stocks would go up.
- Middle-East Peace Miracle: If a wide-ranging settlement with Iran were to occur, oil prices could be cut in half. This would be a great stimulus for the economy, and would cause stocks to rise and gold to decline as money is extracted to buy stocks.
So the question becomes: How can you manage risk if they all go down (or up), while still being able to take advantage of an event that causes oil or gold (or both) to go up and the market to go down?
My solution is to hedge investments in oil and gold ETFs with an investment in inverse stock market index ETFs.
In particular, I have recently invested in USO (1 month oil futures), OIL (1 month oil futures), UGL (double gold), DXD (double inverse Dow Jones Industrial Average), and FAZ (triple inverse Russell 1000 financials).
- USO and OIL were selected instead of the more popular USL because they are invested in 1-month futures and USL is invested in a spread of 12-month futures. The event I am looking for will likely affect 1-month futures more than 12-month futures. With USO/OIL though you have to be careful and watch for contango, which is not as much of a problem with USL.
- UGL gives me leverage in gold. While the leverage increases risk, I am mitigating some of the risk with my DXD/FAZ hedge. The leverage provides wealth-building in an inflationary environment, rather than just staying even with inflation.
- DXD provides a leveraged position in shorting the Dow Jones Industrial Average. It counteracts the USO and UGL while they are linked with the Dow. When the Dow goes down, DXD goes up.
- FAZ allows me to take advantage of my belief that the financial sector will go down more than other sectors of the economy. The 3x inverse nature of FAZ makes it highly volatile however.
If they all stay linked and properly balanced, I stay roughly even. If a Mid-East War breaks out, oil goes up making OIL and USO go up. Stocks go down and therefore DXD and FAZ go up. I get a huge gain. If inflation hits, gold will go up and stocks will go down, both making me money with UGL and DXD/FAZ -- with oil holding roughly even with inflation. If the stock market tanks, gold will go down, and oil will go down, but DXD/FAZ will make me money, hopefully staying at least even. If Europe falls in a heap, and the dollar soars in a deflationary mode, the behavior is similar to a tanking US market. The only condition where I lose money big time is if the Dow goes up and gold and oil go down. This would occur if either of the two “miracles” occur: the economy takes off with no inflation, and the Mid-East settles down. Even though this pretty much occurred during the summer and fall of 2009, I don’t see it happening again soon. If it looks like it is going to happen, I will reduce my oil, gold, and inverse stock holdings and move more to stocks.
Fine Tuning and Exiting
Based on my assessment of likelihood for various things happening, I fine tune the holdings anyway. If Iran or Israel blusters or rattles, I move more to oil. If the stock market looks bad, I move more to DXD/FAZ. If the market looks good, I move from DXD/FAZ to oil and gold. It is also important to recognize that because of Mid-East tensions, the slow economy, and general world-wide uncertainty, virtually every tank and ship that can contain oil already does. This glut of oil argues that a huge price decline is possible. I also watch for a hint that the linkage could be broken in a way I have not foreseen. Of course if oil or gold soars, I would start selling a small amount early in the run up (probably 10% the first day), selling more as the situation develops.
Initially, I did not have enough inverse stock indexes in the BDUFI. My losses in gold and oil exceeded my gains in inverse stock indexes, but at least they were mitigated somewhat. I still am somewhat biased toward oil.
This is a very inexact science. I have thought about building a spreadsheet with calculated multipliers based on past linkages, but I think I would just be fooling myself. Quantification turns into a mess.
Final Remarks
The hardest part about this investment is having the discipline to watch market and commodity swings and know that you are making no money off of them -- because you are hedged to provide zero returns until a big event happens.
The chart in the middle of the post shows the current mix of investments in the BDUFI. And here is the performance (baselined to 1000 points at the start) since February 4th. As you can see, market swings over the past two weeks have been dampened out. You can also see that the BDUFI is still biased somewhat toward oil, since it is going up instead of staying flat. I increased my holdings in FAZ (from DXD) today (in excess of what is shown above) to try to counteract that.
We’ll see how it works over the next few days, weeks, and months. I will post results periodically. If you want to make a similar investment, don’t take my word for it. Do some research and figure out if I am really making sense or not. I am not an investment counselor, and this is not intended to be advice in any way.
It is interesting that Peter Schiff has also commented on the linkage between oil and stocks recently.
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