A week ago, I got long Gold and I’ve been frustrated with my position since. Not because the investment has gone against me (I bought calls on a Gold Miner, Kirkland Lake Gold, which are up 30%), but because I’m still not clear on what I’m actually investing in. To make things more confusing, everyone seems to have their own reason for buying Gold, so I don’t even know what to root for. In this post, I wanted to run some (simple) historical analysis to try to understand what is really driving Gold and whether I still believe in this position.
10 Year Historical Correlation
I start with a list of reasons why someone might want to own gold and an appropriate indicator that captures this over a period of time.
|Why investors may buy Gold…||Indicator that reflects this|
|Fear of an existential crisis in markets (e.g. public unrest, political upheaval, panic…)||VIX|
|Hedge against a weaker USD||DXY Dollar Index|
|Hedge against a stronger Stock market||SPX|
|Hedge against inflation||CPI|
|Hedge against expansionary monetary policy||Nominal Fed Funds Rate|
|Hedge against real erosion of income||Real Interest rates (Fed Funds minus CPI inflation data)|
I correlated the above indicators with Gold over a 10 year period. This is how it looks.
Unsurprisingly, the results are:
- Fear does indeed lead to safe haven Gold buying as Gold has historically worked well at protecting against this (+47% corr)
- A weaker dollar is supportive Gold, most likely because its cost in foreign currency terms decreases as a result (stimulating more foreign demand) (-35% corr)
That being said, Gold has done relatively poorly at hedging against a stock market correction or against inflation (likely because those two have been on an upwards trend over this period).
Have these indicators changed?
Running the same correlation down from 10 years to the last year gets interesting as it shows how these relationships have evolved over time.
As we can see, the DXY has become the strongest indicator for Gold prices over this period and during the last year, it has performed the best out of the bunch. Meanwhile, the relationship between Gold and Fear (as measured by the VIX) has become significantly worse over this period, even moving to a negative correlation for the last year. This coincides with stronger correlations between XAU/SPX.
If Gold has lost its edge hedging against fear, has it been replaced by another asset class? This is how Bitcoin stacks up…
So fairly similar results in the short term but over a longer duration, Bitcoin clearly less effective.
When you buy Gold today, what are you really trading?
So we know that XAU/SPX has historically been positively correlated. What this tells me is that the composition of investors betting on Gold also likely bet on the stock market. So don’t own Gold if you think the SPX is going to collapse.
There is a (negative) correlation between Gold and Expansionary Monetary Policy. That being said, with the Fed Funds rate already at the lower bound, it is hard to see much downside on Nominal Interest Rates (unless we step into negative territory). Inflation is likely also limited so long as demand is hampered by COVID (and correspondingly money circulation remains limited – as more people save, hold back spending, try to keep up with debt payments etc.). So a scenario where real interest rates start to creep higher in 1-3 years rests on an incredibly optimistic rebound in the US economy and a hawkish Fed, both of which we have not yet seen signs of.
So this tells me the DXY will emerge as the key indicator for Gold prices for the next 1-3 years. This can be driven by excessive monetary expansion via quantitative easing/debt monetization, or the relative decline of the US economy compared to largely unscathed Asian peers. Both of which I would argue are a high possibility.
The biggest risk to this proposition is a substitution effect away from Gold in favor of Bitcoin or a new emerging asset class. I see a gaping hole to find an uncorrelated asset class to truly buy some insurance against an economic collapse. Unfortunately, the most commonly proposed alternative, Bitcoin, is less effective than Gold in that respect. So we still have time before we see this transition.
So that being said, I’m happy to stay long.