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Why is gold an effective hedge against equity market falls?

Topics [ gold analysis ]

A key reason many investors include a permanent allocation to gold in their portfolio is its historical ability to balance out overall portfolio returns. 

This characteristic remains relevant for many astute investors today as we face ongoing fears about global economic growth alongside geopolitical tensions in the Middle East and the US-China trade dispute.

Gold has helped provide balance because its returns have been typically uncorrelated to those generated by financial assets in general. More importantly it has been negatively correlated to the equity market when that market has fallen, providing diversification when it has been needed most. A look back at last year demonstrates this point.

In Q4 2018, the ASX 200 suffered an almost 10% decline as investor confidence was rattled by fears of a global economic slowdown and indications that the US Federal Reserve would further tighten monetary policy in the world’s largest economy.

Over the same period, the price of gold in Australian dollars rallied more than 10%, helping to protect the portfolios of investors with an allocation to the precious metal.

The performance of gold during this time was not an anomaly.

Instead it was a continuation of a trend that has been in place for more than 40 years, with gold typically serving as an excellent hedge against falling equity markets. Historical studies highlight the fact that gold has typically outperformed all other single asset classes in environments where stock markets have fallen fastest.

For evidence of this consider the table below, which looks at the performance of various asset classes and investment strategies in the quarters that global stock markets suffered their largest losses.

Global asset class returns when global equities suffer their largest quarterly falls

Source: AQR Capital Management, Good strategies for tough times, Q3 2015

The AQR report from which the above table is drawn examined the worst 10 calendar quarters for global equity market returns between 1972 and 2014. As the table makes clear, global equity markets fell by almost 20% on average during these periods.

Hedge funds also performed poorly, as did a 60/40 (60% equities, 40% fixed income securities such as bonds) portfolio.

However what the table above also makes clear is that gold was the highest performing single asset class when equity markets fell fastest, delivering returns averaging 4.20% during those quarters. 

The above findings, which look at global equity markets, are just as applicable to Australian investors.

The table below highlights the same calendar quarters that global equities suffered their largest falls. However instead of looking at global markets, it instead shows the average returns for Australian equities, Australian cash, Australian bonds and gold priced in Australian dollars.

Australian asset class returns when equities suffer their largest quarterly falls

Source: The Perth Mint

There are two key insights that can be drawn from the table above. The first and most important is that for Australian investors, gold has been, by a considerable margin, the highest performing single asset class when equity markets have fallen by a significant amount. 

The second is the degree of correlation that exists between equity markets across the globe. In all 10 quarters referenced that global equities fell, Australian shares also declined significantly. 

Therefore Australian investors who buy international shares for alternative sources of returns are unlikely to achieve true diversification because global equity markets tend to move in the same direction concurrently. 

Gold, on the other hand, has provided more robust portfolio diversification because it is generally uncorrelated to equities and performs best when equity markets are weakest. 

This can be seen in even more detail in the chart below which shows returns on the equity market (dark columns) and gold (gold columns), during the five worst calendar years for Australian equity markets between 1971 and 2018.

Gold and equities annual returns (%) in five worst calendar years for equities

Source: The Perth Mint 

The chart above shows that with the exception of 1990, when it was basically flat, gold delivered exceptionally strong gains in the years when equity markets suffered their largest falls, with an average annual increase across these five calendar years of almost 40%. 

What about when equities rise?

Given gold has historically performed well when equity markets have fallen, it should be no surprise that its performance hasn’t been as strong in environments when equity markets have rallied. This is because, in environments where equity markets are rising, investors are less likely to seek out safe haven assets. However, crucially, gold has still on average generated positive returns in rising equity markets. 

The graph below, which uses market data from 1971 to 2018 inclusive, helps illustrate this point. It shows the average return for equities and for gold in the months, quarters and years when the equity market has risen, as well as when the equity market has fallen.

For example, the graph is telling us that: 

  ⦁ The average return for equities in the months when equities rose was 4.21%, while in those same months equities rose the average return on gold was 0.79%.
  ⦁ The average loss on equities in the quarters when equities fell was 6.53% and in those same quarters when equities fell, the average return on gold was 3.63%.

Average gold and equity returns when equities fall and when equities rise

Source: The Perth Mint

The graph reinforces the point that during periods when equity markets have rallied, gold has tended to rise too. When equities have declined, gold has on average delivered stronger returns, which is why it has been so effective at helping to manage overall portfolio risk. 

This is one of the main reasons gold has become known as a safe haven asset and why it continues to be held by many investors within a basket of assets. 

Gold’s defensive qualities are particularly relevant given the environment Australian investors find themselves in today, with historically low and in many cases negative real yields on traditional defensive asset classes. These include cash and government bonds. 

Combined, these factors present compelling reasons to look at investing in gold.

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