Financial Alchemy

Since reaching a high on August 22, gold prices have staged an occasionally wild trip lower—dropping roughly -18% in total through Friday. And last week was an exceptionally volatile one, with prices falling by about -7% through Thursday, prior to rebounding somewhat Friday. Rocky!

All this volatility in gold has seemingly surprised some and triggered a good bit of puzzlement. In some folks’ view, it’s odd if gold’s rocky when many fear a weak economy. And that price action doesn’t match gold’s long-rumored status as a hedge against equities.

Mythology regarding gold is truly nothing new. In centuries past, much of the lore surrounded alchemy—the idea one could convert base metals (think lead) into coveted Au via a quasi-magical process. Today, the advent of modern chemistry and better understanding of elemental principles has largely done away with alchemy. But some myths remain—and seemingly underpin much of the media’s current fascination.

We’ve documented many times the fact gold is a commodity. Not a magic one. Not one where fundamental capitalist truths—like the power of supply and demand in determining prices—don’t apply. A commodity . . . like pork bellies! Except less tasty. As with alchemy, science can help put current mythology around gold into perspective. But not chemistry—statistics.

For gold to be considered an effective hedge against equity markets, one might look for a long-term negative correlation to stocks. For a brief primer, correlation measures of the relationship between two items, ranging from -1 (perfect negative correlation) to +1 (perfect positive correlation). If it’s your theory gold hedges equity volatility, then it should rise when stocks fall (and vice-versa). Yet the actual directional correlation between monthly returns for gold and the S&P 500 since gold began trading freely in late 1973 is 0.02.ⁱ (Close to Blutarski’s GPA.) And the last year illustrates this: At times, gold and stocks have moved in opposite directions; at others, they’ve moved in lockstep directionally. Now, that’s to be expected with two such non-correlated assets, but that’s not necessarily a desirable relationship if it’s truly a hedge you seek.

What’s more, the idea gold isn’t volatile puzzles us. In fact, at 5.92% the monthly standard deviation in returns is higher than the S&P 500’s 4.56%.ⁱⁱ Meaning more variation or gyration. And gold’s long-term returns are lower than stocks’. So add the two: Gold is a more volatile asset than stocks that compensates you less for the relatively rockier trip. To us, that diminishes gold’s shine and makes a whole lot of theories about gold’s nature seem like financial alchemy.

2011 has been a rocky road for many assets—gold, silver, stocks and some fixed income instruments. Looking forward, it’s important to recall volatility isn’t predictive for any of these, though. And recent performance, as we often note, isn’t predictive of future returns. (For example, gold’s hot start to 2011 didn’t tell you much about it’s cold last three months.)

But here’s a difference: In stocks, there are myriad inputs and ways to assess future supply and demand for equities. Once you get beyond the mythology, we think you’ll find gold is an even harder asset to assess. Since gold supply is relatively fixed in the short run, assessing expected demand is a key. Will Indian gold imports likely rise? Or Chinese? Or is it likely investor demand—nearly half of total gold demand—picks up the slack if relatively high gold prices shift jewelry and industrial demand to substitutes?

The rhetoric around gold simply builds up expectations the facts haven’t historically met. Gold is far from a cure-all investment—and learning that sooner rather than later helps cure the bewilderment brought by gold price volatility.

[i] Sources: Thomson Reuters, Global Financial Data.