Managing Volatility With Gold

It’s been said that the market can manage bad news; It's the uncertainty that kills. For investors, uncertainty carries the name volatility. In recent months volatility, as seen by the CBOE “Fear Index," has been flat. This calm presumably permits investors to embrace the market rally without trepidation, right? Maybe not.

There is an unseen phenomenon at work. “Days when the VIX or VStoxx goes up have normally in the past been days when the stock market falls, as higher expected volatility shows more risk is anticipated,” remarks Wall Street Journal Author James Mackintosh. However, “That link has partially broken down, with stock prices often rising when implied volatility rises.” This bravado among investors may be explained by blindness to volatility because “big swings by sectors within the S&P 500 have largely offset each other,” explains Mackintosh.

Volatility is rising even if the VIX isn’t. 

Such nascent volatility underscores the need for investors to remain proactive in their risk mitigation. Gold has shown effectiveness in achieving this end. Research from BlackRock dating back to 1994 illustrates that “In months when volatility rose, gold outperformed the S&P 500 price return by roughly 2% on average.” This relationship amplifies during periods of excessive volatility. That is when the VIX rises above already heightened levels gold becomes an even more effective hedge. The same data from BlackRock shows that when the VIX pushes north of 20 gold delivered performance 5% above the S&P 500. These are valuable lessons for investors who, perhaps unknowingly, rest their portfolio above a fault line in the U.S. and global economy.

Additional research has reinforced the connection between gold and periods of heightened investor anxiety. There is a clear correlation between the price of gold and the spread between the 3-month interbank rate and the 3-month T-Bill rate. The divergence of the interbank rate and the T-Bill rate is called the “TED Spread.” The measurement is an internationally accepted gauge of credit risk in the overall economy. An increasing 'TED' spread indicates greater risk in the market. Decades of measurements show that as credit risk grows gold rises thereby proving its hedge characteristics. Periods of pronounced uncertainty elucidate this correlation particularly “in the 1970s when massive spikes in the ‘Ted’ spread were associated with sharp rises in gold,” according to research from Oxford Economics. This same body of research determined that gold “has a zero or negative correlation with other assets, so its inclusion in the portfolio reduces the overall volatility.” The authors posit that even an allocation of 5% towards gold in a portfolio allows investors to benefit from the stability offered by an asset that responds differently to market conditions.

Investing is a long game. However, in the long-term volatility is inevitable. Investors are wise to embrace this truth rather than fight it. The smart way to withstand the rise and fall of the market is to buttress your portfolio with a diverse asset allocation that ventures beyond the traditional mix of stocks and bonds. Historically, gold fulfills this role by rising amid periods of anxiety and uncertainty. As topics like overvaluation in the equities market continue to escalate, it seems likely that gold will once again prove its mettle.