Good Morning,

Battle lines were drawn around the psychological $900 figure in gold overnight, as sellers duked it out with buyers amid rising congestion and technical signs indicating a possible resolution to the pattern by week's end. Bullion made several forays into sub-$900 territory despite mild dollar declines and small advances in crude oil. The headwinds the metal faced at the $930 intensified roughly at the same time the markets discovered that deleveraging was alive and thriving. Money markets, in fact, are indicating a scarcity in the US dollar similar to the one that propelled it when it notched a 15% rise against the euro in Q4 2008. Such conditions could be signaling a pop to the upside, rather than the top that some analysts envision as forming.

Tuesday's spot New York gold dealings opened amid nervous conditions as focus remained on the dollar and an equally nervous stock index futures ticker. A light decrease in open interest and perceptions of overbought conditions had players pondering whether to commit to the market or await to see the $895 support level (which has thus far held overnight) being tested. On the upside, the $915-$920 area presents some hurdles at the moment.

Gold opened with a $3 gain at $907.80 per ounce, while silver also turned positive at the start - rising 3 cents to $12.46 per ounce. Platinum dropped $4 to $966 and palladium fell $1 to $194 per ounce. Car sales data might be impactful for the noble metals as the day wears on. Otherwise, participants are Dow-watching - in more ways than one: Dow Chemical lost $1.55 billion in Q4, raising the prospects that the other Dow might erode further in value when it opens this morning. Some analysts saw a Dow Theory sell signal on Monday. 7552 anyone? Going once...

Other currencies appear to be facing larger hurdles at the moment. Take the British pound. Please, just take it. Comments such as Reykjavik-on-the-Thames surfaced of late, and currency pros see further BoE interest cut sacrificial offerings in the making. The mantra of the day is 1 by 5 as the specs expect a half-point slash to 1% on Thursday. Meanwhile, in the land of Oz, rate cuts and a $26.5 billion stimulus package yielded the lowest interest rate level in 45 years (3.25%) and highlighted the severity of the worldwide recession that is now contaminating places far away from the eye of the maelstrom.

That eye, - the US real estate market - continues to show few signs of breaking up and dissipating, as American homeowners 'lost' $3.3 trillion in market value last year. A quick glance at several markets reveals that despite 'adjustments' ranging from 10 to 30 percent, there is room for more declines, of at least equal magnitude. One in six Americans is living in a home that is worth less than the outstanding loan they owe on it.

Yesterday, we brought you World Gold Council studies on gold correlation (or lack thereof) with various asset classes. Today, we offer the view of one mainstream money manager and former Bay Area neighbor, Sam Olesky, who finds that the presence of gold in a diversified portfolio adds up to investment MSG - that is, it enhances the winning flavour without adding too much of a potential headache. Such behavior was the focus of previous WGC studies, and it merits attention. So long as you (and as any chef) do not overdo it. Play it now, Sam (courtesy of Seeking Alpha, that is):

Many investors have been thinking about gold recently. Some have considered it because it has been a relatively strong performer with the iShares COMEX Gold Trust (IAU) closing up 5.4% in 2008. It’s up 2% year-to-date as of Wednesday’s close. The iShares S&P 500 Index ETF (IVV) was down 36.94% in 2008 and is down 6.17% year-to-date as of Wednesday’s close. Other investors or traders have bought or considered gold as a classic safe haven.
My inclination is to refute the efficacy of buying or holding gold for security either in the form of an ETF or, more so, in the case of gold bullion bars or gold coins. However, as the financial crisis became more severe last year, a couple of clients approached me about adding gold to their portfolios. Rather than diplomatically rejecting the proposal, I told them that I would investigate the historic effects of holding gold in a portfolio. Long story short, I found that adding a small, reasonable allocation to gold reduced portfolio volatility substantially and increased return slightly.
A simple diversified portfolio consisting of 1/3 S&P 500, 1/3 Real Estate Investment Trusts (REITs), and 1/3 10 year U.S. Treasuries would have produced a compound annual growth rate (CAGR) of 8.47% with 11.15% volatility (standard deviation – SD) from 1993 to 2008. For comparison, the S&P 500 produced a 6.67% CAGR with a 20.16% SD. Although few investors would implement this 1/3 – 1/3 – 1/3 allocation, diversification is proving its strengths here. All of these statistics incorporate rebalancing annually.
Let’s take the same 1/3 – 1/3 – 1/3 portfolio and alter it to include a relatively small allocation to gold. That allocation will be 30% S&P 500, 30% REITs, 30% Treasuries, and 10% gold. Over the same timeframe the portfolio with gold produced an 8.49% CAGR with a 9.86% SD. The portfolio with gold produced a slightly better CAGR with volatility that was 11.6% lower than the 1/3 – 1/3 – 1/3 portfolio.
The diversified portfolio with gold produced a CAGR that was 27.3% higher than the S&P 500 and 51.1% less volatile than the S&P 500. The S&P 500 had 4 losing years with the worst being a loss of 37% last year. The 1/3 – 1/3 – 1/3 portfolio had 3 losing years with the worst being a loss of 18.15% last year. The portfolio with gold had only 2 losing years with the worst being 15.74% last year.

In constructing sound and productive portfolios we would like to include assets that have high returns, low volatility, and low correlation to the other assets in the portfolio. Looking at gold’s average annual returns, relative volatility, and relevant correlations, one should expect that gold would be a constructive addition to many portfolio allocations. In fact, gold even has a relatively low correlation with commodities in general (S&P Goldman Sachs Commodity Index).
However, we should learn from the past but not expect it to repeat itself exactly. There is much to be learned from historic returns, volatilities, and correlations of asset classes. With all due respect to history and math, we must use reason when constructing portfolios. I view gold as a very narrow and idiosyncratic asset. So, I do not feel that it is wise to strategically allocate as much as 10% to the asset although the historic, mathematically optimal amount would be higher in the context of some portfolios.
Sam Olesky is the Managing Member of Olesky Capital Management, LLC, an independent investment advisory firm that conducts principal investing and trading, manages a hedge fund, and separately managed accounts for trusts, partnerships, individuals, endowments, and foundations. Sam is a Lecturer in Finance at U.C. Berkeley’s Haas School of Business. He teaches Portfolio Management and Financial Institutions and Markets in the MBA program. He is an affiliate of the Center for Innovative Financial Technology (CIFT) at the Haas School of Business. His research interests include dynamic global asset allocation, synthetic index investing, statistical trading systems, and volatility based trading.
Keep eyes on the ($900) prize. In the meantime, some of us are heading over to Denny's for the free Grand Slam breakfasts. What is the world coming to?