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The Midas Touch

Written by Gregory Bartolomei

Should long position portfolios hold gold as a hedging asset class?
With the world markets being shocked by unprecedented events such as:
  1. America’s credit rating downgrade from AAA to AA+ by one of the major credit rating agencies – the S&P.
  2. Europe’s one-of-a-kind debt problem resulting from its unique economic structure.
  3. Civil Strife in Southeast Asia where a man, Anna Hazare, is being hailed as the new Gandhi in India – challenging what he sees as a corrupt government with, as of today, an eleven day hunger strike.
  4. Japan’s recovery from a series of natural disasters it experienced earlier this year.

At the very least it’s something to scratch one’s head about and ponder – so let’s ponder.
All of this news, called headline risk, is forcing investors to look for safe places to put their money. However, this news has caused traditionally safe investments, such as large cap equities and US treasury notes, to seem not as safe as they’ve been in the past. The ‘Street’ is treating everything – all equities and bonds – as risky.

This treatment is shown by the volume of trading in the equities’ markets over the past three weeks. Traders are not investing for long positions in equities but buying and selling on the swings. There has been an 8% sell-off in US equity markets, 11-15% in European markets, and 13-20% in Southeastern Asia markets. These sell-offs do not have an end in sight.

Bonds and T-notes are subject to the same short position issues. Because yields on federal bonds are at all time lows (in addition to the FED keeping the prime rate at all-time lows), investors fear interest rate risk; thus, they are cautious about putting money into bonds in long positions. If the yields go up, which they might because yields are at historical lows and can’t get much lower, bond holders in long positions will lose value.

As a result, investments such as Gold, Silver, and Platinum have increased in value over the past three years with gold hitting an all-time high earlier this week. These precious metals are seen as traditional holders of wealth and thus are being treated as a new asset class for hedging against the risks the Street perceives in the market. Plenty of investors elected to increase their positions in gold, but does GLD really act as a hedge for long positions?

Let’s perform a correlation analysis of AGG, GLD, and the S&P 500 TR. Please note that AGG is chosen because it is an index trying to match the Barclay Capital Aggregate Index for fixed income, GLD is a large EFT gold fund, and the S&P is a measure of the equities market as a whole.

 
GLD
S&P
AGG
GLD
1
0.028294
0.340201
S&P
0.028294
1
0.106687
AGG
0.340201
0.106687
1
We can see with the above correlation table that AGG very weakly correlates with S&P and slightly higher with GLD over the past four years. Also, GLD and the S&P have no correlation – with AGG and GLD having the highest correlation. This analysis suggests that over the long position GLD has no correlation with equities and a weak positive correlation with bonds.

Because there is a marginal correlation between gold and the market, it does not make sense in a long position to invest in the asset class. There is no hedge (no negative value in the correlation matrix) provided thus the risk of bearing gold does not payout in a long position.

Therefore, the answer to the opening question is a resounding – no.

_____________________________________________________________

**Due to technical difficulties we recently had to switch domains and transfer all of our website content.  Please keep in mind that while we have been publishing articles for two years, the published dates shown may not reflect the initial publish date.

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