- Since the beginning of 2017, gold has traded on an upward trend, with a high correlation to the Trump stock market rally.
- You may be surprised that in the eight worst stock market corrections since the early 1970s, gold is not always a “safe haven”.
- This article assesses the relative attractiveness of gold as an investment today to preserve portfolio value should a market correction occur.
Many investors I have spoken with recently share a common point of view:
“Stocks are expensive and I fear an upcoming correction. But, it is hard to sell shares and go to Treasuries because rates are going higher. What would I buy if I sell?” I share the view that Treasury yields are going higher and will lose value in the intermediate future. Trading into the 10 year Treasury or other longer duration bonds as a move to preserve stock gains is not a good option right now in my opinion.
Many investors also ask about gold as means to preserve investment value moving forward. Given the interest, it seems like a good time to review the market.
Since the beginning of 2017, gold has traded on an upward trend, with an increasing correlation to the Trump stock market rally. The USD price action in gold is now clearly reversed off the lows set in the early 2016 oil profit recession.
Does the price trend in the gold market provide any signaling information to market participants in other securities such as stocks and bonds? There is one situational signal that in my assessment of the historical relationship of gold and the US stock market that investors must be particularly aware of at this time:
Increasing ownership of gold when US stock markets are surging to all-time highs is historically an indicator of investors trading out of the US dollar correlated assets to avoid upcoming monetary and/or fiscal policy changes that may have destructive effects on a portfolio valued primarily in USD.
This article reviews the current market factors driving the relative price of gold higher within the context of a very strong stock market rally. Today’s market is compared to 8 stock market corrections since the US officially ended the Gold Standard in August of 1972. In 4 corrections, gold clearly out-performed in the market downturn. However, in other cases short and even long duration Treasury securities out-performed.
Historical data show that when it comes to trading into gold as a “safe haven” play to hedge against a potential future stock market correction, the relative market situation must be fully assessed. Knowing whether gold or cash is going to be king is a critical part of the evaluation.
Does Gold always shine in Stock Market Corrections?
There is no better asset to hold than holding gold in a stock market crisis, right?
Historical data going back to 1972 tend to support this widely held market belief, because in the really big stock market crashes recorded in 73–74, 00–03, and 07–09, gold clearly outperformed. However, you may be surprised that in the eight worst stock market corrections since the early 1970s, gold outperformed holding cash or very short-term (1 month Treasury) securities only 4 times.
And, in the case of the two market declines in Ronald Reagan’s first term (Nov80–Jul82, Jun83–Jul84), gold actually performed even worse in the downturn than stocks, and was highly correlated to stocks in the downturn. In the majority of the major market corrections over the past 45 years, however, the reflective property of gold, where the precious metal appreciates in value as stock values collapse, has shined.
Testing the Gold “Safe Haven” Hypothesis
The reason gold is so widely believed to be a good “safe haven” play in a stock market crisis is that its return tends to be very negatively correlated to stock market returns when the market collapses, as the above data show in 5 out of the 8 major market corrections since 1972.
But, how does gold perform when the market is not in a steep decline? To get a better understanding of this question, I have actually tested the correlation of the returns of each asset mathematically using data going back to the 1970s. The answer I found was that stock and gold returns are consistently non-correlated, or only slightly negatively correlated. They by no means are highly negatively correlated as happens in many stock market corrections.
The test I performed used 12 month return data for gold and the S&P500 over the last 45 years, calculating end of month yearly returns for both assets, giving 536 observations in the data series.
In the time series the S&P500 increased from 104 in January 1972 to its August close of 2472, up 7.18% compounded annually plus dividends. Gold through this time period increased from $46 per ounce to a traded value of $1,328 per ounce at the end of August 2017, an increase of 7.65% annually. Through time, the two assets have tended to hold their value in relation to one another, in other words positively correlated. However, the change in the value month to month or year to year of each asset through time is not correlated. Comparing gold returns to stock returns over a 12 month interval through time shows a negative correlation coefficient R of –0.14.
By contrast, as you might expect, the Dow Jones Industrial Average and the S&P500 have highly correlated 12 month returns through time, exhibiting an R-Value of 0.92, or almost a perfect correlation. The data show that if you own the US stock market, whether the DOW or the S&P you are going to experience virtually the same returns through time. Trading in and out of one to the other through time is like changing lanes on a busy freeway to try to get ahead — sometimes it works, sometimes it doesn’t, but on average you end reaching your destination at the same time as the driver that did not change lanes.
However, if you hold gold and the stock market simultaneously, the 12 month returns you experience in your portfolio will be skewed more positively sometimes, more negatively at others, but rarely the same as if you owned only stocks.
It is the non-correlated rate of return properties of gold over the short-term that make gold a valuable hedge in many market crisis situations. But the movement of the gold market relative to stocks may be equally important to investors because of the signaling information that is typically transmitted leading up to a stock market crash.
When Gold and Stock Annual Returns Surge at the Same Time — Watch Out
Most, if not all investors struggle most with identifying when a market becomes grossly overvalued and therefore should be sold. Selling for many investors is harder than buying. But the key to successful selling in my assessment is making a decision about what you are going to trade into, and having conviction that the trade will produce higher relative returns once it is completed.
In the case when stocks are at an all-time high, the alternatives to trade into usually seem relatively scarce as every asset becomes perceived as being overpriced. Investors seem to begin to jockey for position on the road to the same outcome. The question that should be asked when stocks become aggressively priced, as is the case today, Is there is a non-correlated alternative which can be traded into which is relatively undervalued?
To assess how investors have made this call with respect to gold and stocks since 1972, I have plotted the trailing 12 month returns of the stock and gold market over the time period. In addition I have added the stock market correction period for the 8 major corrections in the last 45 years. (See red bar on the graph.) These correction periods are easily discernible on the graph because they start (see green line) from a peak year over year return, and then fall rapidly to a low point where returns year over year are negative. [Author note: The market definitely “sold-off” strongly at other times during the time series; however, unless year over year returns go negative, a true market correction has not been experienced.]
In the above graph you will also see the trailing 12 month returns [TTM] from holding gold as an investment over the 45 year period. (See gold line.) When you look closely at the TTM return pattern of gold versus stocks leading up or just after stocks peak, two interesting patterns emerge.
First, gold visibly surges in value and is highly correlated with stock returns as stocks hit new all-time highs. This pattern is most pronounced in the big corrections starting in ’72, ’80, and ’07; and, less pronounced in ’83 and ’87, but still visually striking. And in the case of the big corrections in ’72 and ’07, gold continued to perform very well as stocks collapsed in value by over 50% in both cases. In the 3 scenarios in 1980 gold traded off quickly after the stock sell-off, most likely flowing quickly into Treasuries which because interest rates were so high at the time, were good risk reward alternatives.
The second gold trading pattern that can be discerned in the data is a clear reversal rally (surge higher) in gold prices as a stock market correction took hold and then worsened. (’76, ’90, ’00) This pattern occurred most recently in the elongated stock market decline which lasted from Aug’00 to Feb’03. As the chart shows, initially gold, which had been depressed in value for many years throughout the 1990s, experienced a short rally as the stock market began to roll over in 2000. In reviewing the data, longer duration Treasuries in this time period were a very good relative buy, so this probably muted any initial surge in gold prices as stock sales flowed into bonds. However, as Greenspan and Congress responded to 911 and the increasingly jobless recovery from the dot com boom with lower interest rates and lower taxes, gold increasingly became a favored investment. Eventually gold began to surge in value and stocks broke down further as Treasuries became less attractive as a store of value, and stocks corrected in value for several years.
Is Now the Time to Trade out of Stocks and into Gold?
Market evidence, in my assessment, is growing that gold is now a very good alternative play relative to the increasingly higher priced shares of US stocks and poor prospects for Treasuries. As the following chart shows, gold and the S&P500 have become increasingly correlated since Trump was inaugurated in January.
Currently the YTD return in both markets is around 12%. As the table below shows, however, the strength of the gold surge signal warning of an impending stock correction is still faint. If the pattern of positive correlation of TTM gold and stock returns becomes stronger through the 4th quarter, particularly if gold moves to a level that outperforms stock returns for the year, the market top for stocks has probably been set for the next 2–3 years.
Investors face limited alternatives to preserve value in US based assets today should the stock market lose favor as an investment. The long duration Treasury market is very vulnerable to higher yields and lower prices as the Federal Reserve unwinds its balance sheet and the US Treasury embarks yet again on a borrowing binge to finance an ever growing National Debt. Investors who want to preserve value in the event the market correction scenario unfolds could move to cash, as happened in the 1980s, and many probably will. Gold, however, as it did in the last 2 market corrections since the year 2000, is likely to again be the clear out-performer for the duration of any upcoming market correction.