Commodities & Dollar Cost Averaging a Simple Path to Double Digit Returns

This has been a painful month in commodity land especially for anyone who bought around May 12, the peak managed web hosting the most current gold rally. Since then, gold investors have lost 20% from its high of $730/oz to Fridays (6/8) close of $608/oz. However, those that bought on the last day of this past year have a slightly differently perspective. Gold could have then been purchased for $517/oz. Over the past five years gold has averaged a return of 15% per year. No one wants to suffer through a 20% draw down over 4 weeks, but a 41% return in 4 months was simply unsustainable. This is why I am a strong advocate of dollar cost averaging. If you made the decision to to try commodity investing and went all in on May 12, you are probably ready to give up now.

Former Treasury Secretary and current Harvard University President Lawrence Summers concluded in a 1988 published research piece that stocks and commodities are out of phase with each other (refer to link below). In one half of the cycle, stocks significantly outperform commodities and then in the second half of the cycle commodities outperforming stocks. This relationship continues to prove itself. Back in the late 90s the fastest payback of capital was in internet infrastructure companies. Venture capital companies were crawling over each other to invest in the next Cisco. Meanwhile, commodity prices were at multi-decade lows with oil at $15 per barrel and gold at $250/oz. Mining companies were going out of business and projects were delayed due to the low prices and inadequate capital. Obviously the stock prices reflected the business cycle with technology stocks at all their all-time highs and commodity stocks at their lows. The internet frenzy concluded the stock cycle in 2000 and we are now 5 years in to the commodity cycle.

A simple investment strategy can be developed using the above information combined with the fact that bull markets tend to run on average17 years (Adam Hamilton/Jim Rogers links below). For example, the last two US-based bulls markets have been technology in 1982-2000 and commodities 1968-1982. The strategy is to simply dollar cost average into the broad market using an Exchange Traded Fund (ETF) like the SPY (an ETF tracking the S&P 500) during the stock phase of the cycle. Then one should switch to a vehicle such as Central Fund of Canada (CEF) during the commodity cycle.

"Central Fund invests in gold and silver bullion and does not speculate with regard to short-term changes in gold and silver prices. As of October 31, 2005, on a physical basis, 50 ounces of silver were held for each ounce of gold held. During such time, Central Fund's net assets at market value of approximately $541 million consisted of 53.9% gold bullion and certificates, 44.5% silver bullion and certificates, and 1.6% cash, marketable securities and other working capital amounts."

Dollar cost averaging an equal dollar amount into CEF each month over the past five years would have returned the following:

 Gold vs. S&P 500
. CEF S&P 500
2005 38.1% 9.8%
2004 -6.2% 6.1%
2003 14.2% 34.0%
2002 21.8% -22.7%
2001 9.31% -16.6%
Avg.* 15.4% 2.1%

As you can see, gold has significantly outperformed stocks over the past five years (15.4% vs. 2.1% annual). Since we are in a commodity cycle, this is consistent with the stated research. The above example used CEF which is composed of gold and silver bullion. If we substitute an index of gold mining stocks - the out performance is more dramatic. GDX is an Exchange Traded Fund based on the AMEX Gold Miners Index (GDM). It just began trading on 5/25, so this comparison is simply theoretical. However, the index has been in existing for awhile. So, the comparison below is versus the index GDM. To make it more realistic I have also included data for Newmont Mining (NEM) currently the worlds second largest gold mining company.

 Gold/Gold Stocks vs. S&P 500
. CEF NEM GDM S&P 500 2005 38.1% 50.0% 67.1% 9.8% 2004 -6.2% 0.5% -4.1% 6.1% 2003 14.2% 44.5% 28.1% 34.0% 2002 21.8% 33.1% 57.5% -22.7% 2001 9.31% 42.2% 52.4% -16.6% Avg.* 15.4% 34.1% 40.2% 2.1%

The gold stocks as represented by the GDM returned 40.2% vs. 2.1% for the S&P 500. To further round out the story, large cap stocks averaged 11.7% annual versus -7.1% for gold from 1981-2000. For the average investor, dollar cost averaging into the appropriate commodity or stock cycle is a no brainer strategy for double digit returns.

* CEFs return is compounded monthly using equal monthly dollar investing. NEM, GDM and S&P 500 calculated using simple annual return.

References:

Analysis of Summers' paper: www.australiangold.org.au/docs/Gold_2002.pdf" target="_blankhttp://www.australiangold.org.au/docs/Gold_2002.pdf

Adam Hamilton boom and bust cycle: www.zealllc.com/2005/longwave2.htm" target="_blankhttp://www.zealllc.com/2005/longwave2.htm

Jim Rogers 6/5/2005 Barrons the current boom could last eight to 14 more years: www.smartmoney.com/barrons/index.cfm?story=20060605" target="_blankhttp://www.smartmoney.com/barrons/index.cfm?story=20060605

Announcement of GDX: biz.yahoo.com/tm/060525/14353.html?.v=1" target="_blankhttp://biz.yahoo.com/tm/060525/14353.html?.v=1

About the Author

Michael Dawson, is the founder, of The Time and Money Group. The company was created to encourage others to achieve their dreams through financial freedom.

www.thetimeandmoneygroup.comhttp://www.thetimeandmoneygroup.com