Markets are nearing a critical moment in the year as earnings season draws to a close. After a strong first quarter, a number of blue chip firms are reporting strong earnings, keeping optimism levels high for the time being. But with euro debt problems arising in countries like Ireland, Spain, and Portugal, it seems like 2012 may repeat last year’s performance. After a strong beginning of the year, stocks were battered as the Greek debt crisis and a downgrade of U.S. debts wreaked havoc on trading. Those who were unfortunate enough to have equity-heavy portfolios were invariably slaughtered to close out the year, leaving frustration where there had been strong gains [see also Three Reasons Why Gold Is Overvalued].
But there’s an easy fix to that, and it comes in the form of a more diversified portfolio. While it seems rather obvious to encourage portfolio diversification, a number of investors are uncomfortable with diversifying assets. For example, recent debt issues around the world make it very hard to trust fixed income funds which are staple diversifying agents. This is where commodities come into play. These hard assets present an investment that many can wrap their heads around while offering low correlation to equity markets. Over the past few years, a number of commodities have become popular for this reason, but few have amassed the attention of gold.
Gold’s And Its Correlation.
After soaring in price to $1,900/oz. gold quickly became everyone’s favorite commodity, as the precious metal was not only used as a safe haven, but also as a speculative tool for trading. But that was 2011, and this year is a different animal. Last year, gold as a safe haven investment made perfect sense; it featured a correlation of -0.64 to the S&P 500, allowing it to prey on choppy markets and deliver handsome returns to a number of investors. With a correlation like that, gold made for a perfect safe haven, as it would rise as equities fell. This year, however, gold’s has become much different, as its correlation with the S&P 500 year-to-date is sitting at an almost perfect 0 (0.003 to be exact) [see also Why Warren Buffett Hates Gold].
With a correlation score like that, gold has now become more of a diversifying agent, rather than a safe haven. A score of near zero means that gold’s movements are not the least bit impacted by the S&P 500, meaning that one could be up for a trading session while the other is down. Holding an asset like gold will protect your portfolio from sudden spikes (either up or down) in equities, a phenomenon that seems to have resurfaced as recent weeks have watched major benchmarks move by as much as 2% in a single day. That being said, investors currently using gold as a safe haven are not necessarily in the wrong, a 0 correlation is still a safe haven, but it should be noted that for the past four months, the asset has not featured the same inverse relationship with equities that it boasted throughout last year [see also Why No Investor Should Own GLD].
What About QE3?
Of course, the above premise becomes almost entirely irrelevant if there is an announcement of a third quantitative easing program, as traders and investors will see it as a good sign for the future of gold and the asset will spike. If and when that happens, gold’s correlation figures will look completely different than they do right now. But analysts have been calling for a QE3 for quite some time now, and while the Fed has not ruled it out, they certainly seem hesitant to pump more money into the economy. Bernanke’s recent comments suggest that if the economy begins to head south, he will ride to the rescue, but nothing is set in stone of course.
Disclosure: No positions at time of writing.