See gold above US $500 an ounce. See investors clamor for gold above US$500 an ounce. See how analysts make that case that gold will go higher. To US $600, US$700, US$900 an ounce?

It is pretty hard to miss the news about gold. After years of languishing, the precious yellow metal has now breeched some serious resistance points, and keeping above the magic US $500 mark could, according to some, set the stage for further upside movement.

To which we say, what does that have to do with a portfolio? The clamoring for gold and gold stocks is the way traditional investment managers seek opportunities. For someone who is seriously interested in portfolio building the real question is what is the current rally in gold telling us about the broader economy. And perhaps equally important, should gold play a role in a portfolio and if so, what is the role?

On the surface, let’s understand why gold is rallying. While there are various opinions, we think is has more to do with weakness in the US dollar than it has to do with inconsistency in the supply demand balance for gold and gold products. Doubters need only ask Canadian investors, who have to translate the value of gold back into loonies. When looked at in Canadian dollar terms, the gold rally has been more of a whimper than a roar. Which explains why Canadian gold companies have also not moved significantly. At least, not in Canadian dollar terms.

We think that gold is being subjected to the same pressures that are driving up the value of our loonie relative to the US dollar. Issues such as a US real estate bubble, a widening trade gap, the potential for a US consumer lead recession, perhaps by the second quarter 2006 should interest rates go much higher, and the outside chance that inflation might re-surface sometime in 2006. So the real question might be, should a portfolio hold US equity assets?

First of all, we are not putting a lot of stock in the inflation debate, which has drawn support from those who witnessed the last great inflationary outbreak that began in the 1970s and ended in the mid-1980s. As much as we hate to say it, this time will probably be different. And not because of economic circumstances but because of the ability of corporate management to deal effectively with price increases in the supply chain.

The main reason inflation took hold in the 1970s was because corporate America was caught off guard. At a time when companies carried large inventories (something we do not see in today’s marketplace), unexpected price increases along the supply chain had to be passed along. Their survival depended on it.

In today’s competitive economy, efficiencies make it harder to pass costs along. Further, corporate managers, unless they have not read a newspaper or watched a financial channel for the past ten years, are keenly aware of inflationary threats. It is hard to imagine that anyone would be caught off guard.

We are not nearly as sanguine about the other risks. There are no signs that the widening US trade gap will abate. We are also seeing signs that real estate is slowing, and we will be watching closely the Christmas sales patterns which will tell us a great deal about the resiliency of the American consumer. But again, as with the euphoria surrounding gold, this information is only useful if we can apply it within a portfolio context. And how we apply it within a portfolio depends on whether we are using a strategic or tactical asset mix.

On a strategic level, a global portfolio cannot ignore the US stock market and its 45% market cap weighting. No matter the risks, a global strategic asset mix should probably have some weighting in US equities Because of its sheer size, weakness in the US stock market will spillover into the rest of the world.

When we talk strategic, we are really talking about asset mix as it pertains to the individual investor. A balanced investor, for example, might have an asset mix that looks something like 10% cash, 40% income and 50% equity. Of the equity component some percentage should be directed to US equity. That’s an asset mix that has been adapted based on the profile of the individual investor, and a long time horizon, not on a view about the underlying economy.

Tactical asset allocation, on the other hand, is a strategy where the portfolio’s asset mix is defined by the portfolio managers view of the world. A tactical manager who was concerned about the short term risks in the US economy, might opt to keep assets outside the US. Tactically then, the asset mix is determined by an economic view, rather than the objectives and risk tolerances of the individual investor.

In terms of building a portfolio, we are not coming down on one side or the other. However, when you talk with professional financial advisors, they are usually more concerned about the strategic asset mix, than with the tactical asset mix. Mainly because a tactical asset mix could at some point be 100% in equity, and that may not be suitable for many investors, under any condition. One could argue that maybe the best of both worlds is to have a portfolio that has a little of both, a strategic asset mix, with a part of the portfolio invested in a tactical model.

Coming full circle we end with gold at US $500 an ounce. Within a portfolio context, gold is considered a hedge. As an asset class, it tends to move, as does oil, counter cyclical to the general economy. But unlike oil, gold does not typically influence economic activity, instead simply acting as a barometer of economic activity.

As a barometer, gold can have a small role in a portfolio. A counter cyclical asset class moving opposite the general economy, can smooth out short term fluctuations within a portfolio. But to do so requires that you have the ability to move in and out of the asset as the economy moves through a typical business cycle. As a long term buy and hold growth asset, gold has historically had very little value. Nor do we think it will have much long term value going forward.