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Tuesday, February 12, 2013 - 08:30

Crisis Investing 101: Everything You Need to Know About Gold and Oil

Tuesday, February 12, 2013 - 8:30am

Protecting profits and preparing for an economic crisis is likely the furthest thing from your mind right now. The stock market is on a tear higher and the economic picture is looking brighter by the day.

Thanks to an unfettered quantitative easing policy of the Federal Reserve combined with ultra-low interest rates, it appears that the U.S. economy has finally averted a major crisis. This massive intervention is unprecedented in U.S. economic history. No one really knows whether it will successfully serve to kick the economy into high gear so that the cash infusions can be scaled back or will only serve to create the next crisis.

This is why wise investors are using these boom times to design portfolios that can withstand and even profit from the next economy crisis, regardless of when it strikes.

As I wrote in this introductory article, no one knows for certain what the future holds. The only sure thing is that diversification into various "crisis-proof" asset classes is the smartest move.

Two of the most popular crisis investments, gold and oil, are known to stand strong during an economic crisis.

[See also: Crisis Investing 101: 5 Assets That Could Save Your Portfolio]

Gold is the traditional way to hedge against an inflationary or monetary crisis. Many bearish pundits are now saying that the aggressive cash printing of the Fed will result in hyperinflation. Gold's physical characteristics and its perceived storehouse of value keep its status as the No. 1 asset for crisis investing.

Why invest in both?

Well, the relationship between gold and oil is the result of two economic forces. As oil increases in cost, it results in costlier goods and services across the board as transportation and production costs move higher. This increase in prices leads to inflation and, as we know, gold prices increase in inflationary times.

The second and perhaps less well-known correlation is governments purchasing oil with gold. Iran, for example, is notorious for avoiding U.S. sanctions by trading billions of dollars in oil for similar amounts in Turkish gold.

Take a look at the correlation chart below...

But besides these well-known reasons for investing in gold and oil as hedges against inflation, there are three other reasons that reinforce my confidence in these two assets.

First, central banks have been on a buying frenzy for the past several years. In fact, since 2010, central banks have purchased about 10% of the total worldwide gold supply, according to the World Gold Council. In other words, the fact that governments are accumulating gold should support its value in different crisis scenarios.

But what if central banks start to dump gold during a crisis? The answer to this question leads me to the second reason...

Central banks have agreed not to ever dump their holdings on the market. The Central Bank Gold Agreement was adopted in September 1999, during the International Monetary Fund's annual meeting. Although not a law or a treaty, this contract assures that central banks will only sell their gold in an orderly fashion. The agreement adds an extra layer of stability and confidence in the gold market.

Finally, gold has been experiencing increased relevance within the electronic financial system. Not so long ago, investors voiced concern these electronic trading systems would make gold irrelevant. This has been proven to be untrue. ICE Clear Europe, a leading derivative clearing operation, JP Morgan Chase (NYSE: JPM) and LCH Clearnet, among many other financial institutions, now accept gold as collateral, adding to its widespread safe-haven appeal.

With all this information in mind, how can investors utilize gold and oil effectively in a well-designed crisis portfolio?

The easiest and most effective way for stock traders to diversify into gold and oil is through exchange-traded funds, or ETFs. Remember, oil and gold generally have a strong correlation with each other, therefore it's important not to overweight your crisis portfolio with both of these assets.

The general rule of thumb for a well-diversified crisis portfolio is to have no more than 25% of it dedicated to both of these assets. If you strongly believe the next crisis will be of inflationary nature, then slightly increasing this allocation makes sense.

While some crisis investors insist that physical gold is the only true hedge against troubled times, there are liquidity, storage and fee issues with gold bullion. (I will explore gold bullion and coins in another article in this six-part series.)

Here are two of the popular gold ETFs:

1. SPDR Gold Shares (NYSE: GLD)
This granddaddy of the gold ETFs is designed to represent fractional, undivided ownership interest in the trust, which holds only gold bullion and a small amount of cash.

2. PowerShares DB Gold Fund (NYSE: DGL)
This ETF is based on the DBI Optimum Yield Gold Index Excess Return, which is a rules-based index created from gold future contracts to follow the performance of gold.

Crisis investors wanting to diversify away from precious metals yet maintain the same correlation should consider oil ETFs. Here are two of the most popular:

1. iPath S&P GSCI Crude Oil ETN (NYSE: OIL)
This is actually an exchange-traded note that reflects the performance of the Goldman Sachs Crude Oil Return Index. It follows the returns of the oil futures comprising the index in addition to Treasury notes.

2. United States Oil ETF (NYSE: USO)
This ETF follows the performance of the spot price of West Texas Intermediate light, sweet, crude oil. It also includes other types of crude oil, heating oil, gasoline and natural gas.

Risks to Consider: Using gold and oil ETFs to build a hedge against a pending economic crisis has very little risk. While prices of both these commodities can fall sharply, history has proven that they both make smart investments during inflationary times.

Action to Take --> The key to building a crisis portfolio is diversification. Placing no more than 25% of correlated crisis assets such as gold and oil in your portfolio makes solid investing sense.

P.S. -- The abundance of natural gas in the U.S. could lead to a third industrial revolution. One analyst is predicting a stock could rise 1,566%. Another stock has already jumped more than 1,000% and is expected to keep going. To learn more about investing in the natural gas boom, click here.

David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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