Gold And Silver In A Correlation Bubble?

Over the past few years, investing in precious metals has become extremely popular. Many have seen the benefit of having a “safe haven” holding in their portfolio, as it tends to help cushion the volatility when markets are chaotic. So now, more than ever, investors are turning to gold and silver to shelter them from the chaos that is our global economy. Over the past few years, these two metals have been amongst not only the best performing commodities, but also amongst the best performing assets period. But while many investors pour into these two elusive metals in search of safe haven exposure, they may not be getting the exposure, or safety, they think they are [see also 50 Ways To Invest In Gold].

In recent weeks, markets have swayed violently back and forth in response to the European debt crisis, which has formed an interesting pattern in these two metals; resulting in relatively high correlation to broad equity markets. Typically, investors opt for exposure to precious metals given their historically uncorrelated returns, as they typically gain when equities falter, but recently this has not been the case. Beginning September 23rd, the SPDR Gold Trust (GLD) has featured a 0.77 correlation to SPY. Over that same period the iShares Silver Trust (SLV) has a correlation of 0.86 to SPY. These figures should cause investors’ stomach to turn, as their precious metals exposure has been behaving like just another equity investment [see also 25 Ways To Invest In Silver].

Precious Metals Correlation: A Myth?

For the average portfolio, a correlation above 0.75 is considered high and implies that the assets are behaving in a nearly identical manner. Moving further down the scale, 0.2 is moderate diversification, -0.2 is good diversification, and anything better than -0.7 is considered excellent diversification. The past few years have seen the development of the notion that GLD and SLV represent uncorrelated plays on the market, making them safe haven bets for your portfolio. But looking at historical trends (aside from 2011), one would have to go back to 2007 to find a year where these two metals weren’t highly correlated to the S&P 500. For all of 2011, both ETFs have featured low correlation, but as recent trading weeks have shown, old habits die hard, as the two ETFs have fallen back into a highly correlated trend [see also Three Reasons Why Gold Is Overvalued].

As noted in the table above, these two ETFs have featured strong correlation to SPY in ’08, ’09, ’10, and the past few weeks. Despite 2011 YTD correlations being the best in several years, this recent trend may give investors reasons to re-consider their allocations.

A Grain Of Investing Salt

While keeping an uncorrelated portfolio is certainly important, correlation should always be taken with a grain of salt. Anyone familiar with these precious metals over the past few years is fully aware that they have been steadily outpacing the S&P 500. But how can two assets with high correlation have such different returns? The difference comes from the downside risks that each feature. Simply put, precious metals have a much lower downside risk than equities, allowing them to hold their ground. For example, if SPY drops 5% in a day and GLD drops 1%, the correlation between the two assets would still be relatively high, but the returns turn out vastly different [see also Seven Reasons To Hate Gold As An Investment].

As demonstrated above, the returns of these three assets are astronomically different, despite their fairly high correlation to one another. Note that silver prices tend to be volatile over the long term, while gold tends to be more stable. With the exception of GLD in 2009, both precious metals funds have outdone SPY each of the past four years, proving that their high correlation may not be all that big of an issue [see also Commodity Trading Trends: Silver In Focus].

In the end, precious metals are still great safe haven holdings, but it is important to understand that there has been a strong correlation to equities over the past few years, and it may prompt you to reconsider how you allocate assets within your portfolio.

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Disclosure: No positions at time of writing.