Why Not Gold as Equity Hedge?

Gold has historically been used in a variety of ways by different investors, but the precious metal is perhaps most commonly embraced as a safe haven investment that smooths out overall portfolio volatility in rocky economic environments. When signs of economic weakness appear, investors tend to sell risky assets such stocks in favor of low-risk safe havens such as Treasuries and physical currency. The relative performance of these asset classes during the most recent recession highlights the potential benefits of holding gold: between September 2008 and the bear market lows in in March 2009, the SPDR Gold Trust (GLD) added 14% while the S&P 500 SPDR (SPY) lost almost 45%.

But so far in 2010, gold hasn’t lived up to its reputation as an equity market hedge. Far from it in fact. The correlation between SPY and GLD has been nearly 0.95, compared to nearly zero historically. As shown in the chart below, GLD and SPY have moved in lockstep through the first six weeks of 2010:

Despite the recent breakdown in relationship (or lack of relationship) between these two asset classes, jumping to the conclusion that gold as an equity hedge is a thing of the past is a bit premature. There’s actually a relatively simple explanation: both U.S. stocks and gold bullion have been reactionary assets for much of the year, driven by developments in overseas markets.

Europe in Focus

Most recently, investors around the globe have been carefully monitoring the financial health of Greece. Although the European nation accounts for only a sliver of global GDP, an escalating debt crisis has stoked fears of a contagion effect and intensified concerns over public finances in larger debt-laden countries such as Spain and Portugal.

In a reversal of the cause-effect relationship that dominated markets at the start of the recent recession, U.S. stocks have taken their cue from European markets for much of the year, tumbling when a full-blown debt crisis appeared imminent and recovering slightly on hopes of an effective bailout. Gold prices have also been driven (indirectly) by the European markets. As concerns about the short-term stability and long term sustainability of the euro zone currency have popped up, the euro’s major rivals, most notably the U.S. dollar, have moved accordingly.

Because they are priced in dollars, commodities have historically had and inverse relationship with the U.S. currency. Since gold also competes with the dollar as a safe haven investment and reserve holding, the inverse relationship between these two “currencies” has been particularly strong. So negative developments in Europe have both weighed on U.S. markets and boosted the dollar (which in turn has sent gold prices lower), explaining the suddenly strong relationship between two assets that have historically exhibited very low correlations.

Disclosure: No positions at time of writing.