With the gold price in dollars breaking decisively the 200 day moving average but with volatility across a broad range of asset classes close or at historic lows (including gold) we thought it would be instructive in this week’s commentary to conduct an historical review of the patterns, if any, in the gold price as the gold price has been in an up-trend up as well as when the gold price has been in a down-trend.

Turning first to the equity markets, historically there has been a very well defined relationship between the trend in equity prices and the volatility of equity prices. For the purposes of this quick discussion we use the S&P 500 index as our market proxy and define the prevailing trend in equity prices as the level of the current index level relative to the 200 day moving average.

The index is said to be in an up-trend when the current level is above the moving average and the index is said to be in a down-trend when the current level is below the moving average. Note that the 200 day moving average is used here as an indicator of market trend simply on the basis that it is a widely watched trend indicator by market participants but in any case, it can be shown that the general results presented here are not particularly sensitive to the specific choice of trend indicator.

The equity market is a good reference point from which to begin the analysis given the strength of the relationship between the trend in prices and the volatility of prices, on a historical basis. We look at the 20 year period from 1994-2014 and also break the period into 5 year intervals to help identify any potential changes in trend.

The most immediate and striking pattern is the significantly higher market price volatility, defined as the standard deviation of returns, when the equity market is trending lower (the index is below its 200 day moving average). For the full observation period volatility was over 100% greater during periods in which the market was trending lower and this pattern is also evident in each 5 year sub-period. This phenomena of greater volatility in falling markets has been widely researched and is also known as ‘volatility clustering’.

A detailed discussion of why this effect occurs is beyond the scope of this commentary but much of the discussion in the literature has focused on the observation that large falls in equity markets tend to be associated with large rises in risk aversion and that this collective fear of loses amongst market participants might trigger irrational behavior. This is further evidenced by the largest daily up and down moves in equity prices which both tend to occur when the market is trending lower (in other words the market’s largest daily moves – either up or down – tend to happen during periods when the market is moving lower).

Turning to the gold (priced in US dollars) market, the relationship is less defined. Over the full 20 year period, the volatility of gold prices was approximately 8% higher during periods in which the gold was trending up which is the reverse of what was observed in equity markets. When we look at the individual five year periods we note also that there was less consistency over time with higher volatility being experienced in both up and down trending markets.

This is a surprising result as most assets would be expected to demonstrate what we can call “positive volatility clustering”, with higher price volatility tending to be associated with falling prices. The rationale for why gold might exhibit different behavior could be related to its characteristics as a “defensive” asset during periods of market stress. During these periods of extreme uncertainty investors have often sought to buy gold as a temporary store of value and as a way to protect the value of their portfolios as equity markets are generally falling. With investors potentially buying gold as equity markets trend lower (with high volatility), this might explain some of the observed increased volatility in gold prices as they in turn trend higher. Of course we cannot definitively say what might be causing these relationships but the intuition with regard to gold’s defensive qualities would seem to fit with observed investor behavior.

Chart 2

We have noted in the previous commentaries that buying gold in dollars might potentially reduce the defensive qualities of gold as an investment. Historically the dollar has also demonstrated defensive qualities with many global investors choosing to switch from other currencies into the US currency during crisis periods. When an investor buys gold in dollars they are not just expressing a bullish view on gold but also a bearish view on the dollar. If the dollar rises in value during a period of market stress this would hurt the price of gold in dollars and thereby reduce its effectiveness as a defensive asset. To investigate this relationship further we conducted the same trend/volatility analysis using the price of gold in euro terms.

Chart 3

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