Gold - Not So Precious

Three different assets: gold, bonds, and metals. There is a significant relation between them. Deciding which one is the best investment depends on the phase of the business cycle.

Which one should we buy – gold, bonds, or metals? Which one is likely to give the best return, say, over the next one or two years? This is not a simple decision. Especially when one considers that the choice to buy must be associated with the choice to sell. This article is about the relationships between the three so different assets - when to buy them and when to sell them.  

Source: The Peter Dag Portfolio Strategy and Management

The business cycle is what drives the relative attractiveness of these three investments. And the business cycle is driven by business decisions to keep inventories at levels needed to meet demand and generate a profit.

The dynamics of the decision-making process is not simple. In fact, it is so difficult that mistakes are often made. These mistakes cause turning points in the business cycles, and these turning points create unique opportunities for investors.  

In Phase 2 (see above chart) the business cycle reflects a strengthening and overheating economy. Business is focusing on replenishing inventories because of strong demand. Purchases of raw materials, hiring of workers, and borrowing to finance capital improvement and expansion are fast growing activities. For this reason, in this phase investors experience rising commodities, strong growth in employment and wages, and increasing inflation and interest rates.

In Phase 3, business ignores the fact inflation is rising in an alarming way. The outcome is purchasing power decreases and demand slows down. But business believes this weaker demand is a transitory event and decides to keep production humming to keep unit costs low. Earnings, however, start declining as inventory levels increase to high levels when compared to demand. The decision is eventually made to cut inventories, thus signaling the beginning of Phase 3.

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