Gold Silver Reports – Gold bugs point to a myriad of reasons to own their favorite metal, from fiat currency debasement to gold’s history as a monetary unit. Among the favorites, however, is gold’s utility as protection against a market or political crisis.
In August, for example, Bridgewater Associates LP’s Ray Dalio suggested investors should hold 5 percent to 10 percent of their portfolios in gold to hedge against rising political risks. I’m a macro strategist who writes Bloomberg’s Macro Man column, and I found myself wondering: Is gold really an effective hedge in periods of risk?
I decided to take a Mythbusters-style approach to find the answer. My first step was to search for evidence of a statistical relationship between risk aversion and the gold price. I used the CBOE Volatility Index (VIX) as a proxy for market risk aversion and ran a series of multifactor regressions to determine whether equity volatility is statistically significant as an explanatory variable for gold.
The answer, somewhat to my surprise, appears to be yes. I used monthly data from 1990 to 2015 and modeled the level of the gold price. Although the VIX wasn’t the most important driver—that would be inflation, followed by real U.S. 10-year yields—the t-statistic, a gauge of the importance of explanatory variables, shows up as highly significant. Interestingly, gold’s relationship with inflation over the past three decades has been sharply negative, suggesting the metal could drop as inflation rose. So its reputation as an inflation hedge appears somewhat exaggerated, though the results would likely look rather different if the 1970s were included in the analysis.
But there are usually problems with modeling the level of an asset—particularly over the long term—because two trending variables will show a high correlation, even if there’s no causal relationship between them. I therefore also modeled the year-over-year change in gold vs. the level of the VIX and yearly changes in the other variables.
Modeling changes usually result in weaker statistical relationships, and that turned out to be the case here. Still, the VIX appears to be a significant statistical driver of changes in the gold price over a meaningful period of time. Based on this evidence, it looks as if claims of gold as a risk-aversion hedge might be true.
But what if we drill down into specific episodes? I identified 10 notable episodes of risk aversion over the past three decades, defining the duration of each as the peak-to-valley move in the S&P 500 index. I then calculated the performance of U.S. stocks, Treasuries, and gold during these episodes.
“Again, on this metric, gold looks pretty good as a risk-aversion hedge. By definition, equity market performance was poor, with an average loss of almost 20 percent per episode. Treasuries proved a useful offset, returning an average 3.4 percent and performing positively on seven occasions. Gold, meanwhile, was a star performer, rising almost 7 percent per episode, with gains in 8 of the 10 periods.”
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This analysis doesn’t capture price action that occurs after an equity trough, so it may not be the full picture. For instance, Treasuries rallied sharply in the weeks after the 1987 crash, which isn’t captured by this methodology. Still, this analysis provides pretty strong anecdotal evidence that gold offers solid contemporaneous protection from asset market dislocations.
But how does including gold in a portfolio over long periods of time change the risk and returns? I constructed two sample portfolios: a simple 60/40 asset mix calculated using the S&P 500 total return index and the Bloomberg Barclays US Treasury Total Return Index, and a 55/35/10 mix that reduced the stock and bond weightings by 5 percent apiece and replaced them with gold. (I used the spot gold price to calculate gold returns.)
It turns out that a portfolio including gold outperforms the 60/40 portfolio by about 55 basis points per year, albeit at the cost of higher volatility. (The risk-adjusted return was virtually identical for both portfolios.) Over a 30-year time frame, though, that half a percent per year accumulates into quite a tidy sum.
Of course, a cynic might say that all of the “gold portfolio” outperformance has come since the financial crisis and thus is merely a relic of easy central bank monetary policy. That may be the case, but it’s the reality of the current market environment and is consistent with the prior finding that low real interest rates are bullish for gold.
When I set out to do the analysis, my bias and expectation were to find that the putative relationship between gold and risk aversion was simply a myth. Yet the statistics appear to show a relationship, and anecdotal evidence supports the notion. Given the solid performance of a portfolio including gold and the chance that the comfort of owning some might prevent investors from panicking at the height of a crisis, I have to conclude that the notion of gold as a hedge against serious risk aversion is true.