wealth. Gold stands in the way of thisinsidious process. It stands as a protector of property rights . . .”.Gold topped $1000 an ounce in March 2008 as investors bid gold prices up amidworries about the falling dollar and the sub prime financial crisis. In fact, investorswho bought gold in 2003 have more than tripled their initial investment, enjoying anannualized return of over 20 %.One of the reasons gold has surged so much is that it’s much easier to buy.For many years it was difficult for ordinary investors to trade gold. The minimumamount needed in order to buy gold bullion was $1 million. Buying gold coins orjewellery was also a problem because of the hassle of storing and reselling them.An alternative way to buy gold was to trade gold futures on the New York Commodities Exchange (COMEX). Most investors, however, do not have a futures account or prefer to trade only stocks because of the volatility and also the rollovercosts. Investors can now buy shares of SPDR Gold Trust, an exchange-tradedfund that can be bought and sold like any stock under the ticker symbol GLD.Each share represents one-tenth of an ounce of gold, and the shares are highlyliquid.
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In times of a financial crisis, rising inflation, or a weak dollar, gold does well butis it a good long-term investment? Gold peaked at about $840 an ounce in 1980and was in a continuous decline until 2002. Anyone who invested in gold in 1988would have made only 72 % on his initial investment and with inflation factored inwould have made next to nothing over the 20 years from 1 January 1988 until theend of 2007. Meanwhile, a $1000 investment in the S&P 500 would have grown ata compound annual return of 10.6 % a year to $7500 in that time. Taking inflationinto account the stock investor would still have made a 360 % profit and his initial$1000 investment would have grown to $4600 at an annualized rate of 7.4 % a yearduring the past 20 years. Investing in stocks generally does better against inflationover the long term because companies raise prices when inflation goes up. Growingproductivity also helps stock prices keep ahead of inflation, which is not the casewith gold.Another reason for gold’s mediocre long-term performance is the most fundamental concept of economics: supply and demand. Unlike other commodities whichare used in industry and need to be continuously replenished, gold stays in themarket.
7.1
CORRELATIONS WITH EQUITY AND COMMODITY ASSETS
Gold was traditionally uncorrelated with equities until a character change occurredin 2003. Gold started moving in the same direction with the S&P 500 and otherinternational equity indices (see Fig. 7.1).Before making any hasty conclusions, however, we should examine what theother asset classes were doing at the time. During that period the dollar was fallingprecipitously, inflation was rising and the rest of the commodities were also rising. Ibelieve that the contemporaneous gold–equity appreciation only happened by chanceand gold’s gain had nothing to do with rising equity prices and more to do with thedollar’s demise and the commodity-induced inflation.Gold has been moving in lock step fashion with major averages until the summerof 2007 when fears of melt down in US financial markets triggered flight-to-safetydemand for the yellow metal which decoupled from the S&P and moved to new highsin the following months.In Tables 7.1 and 7.2 I list the correlation of weekly and two-week (10 working days) percent changes between gold and related equity indices, currencies andcommodities. You can see that the correlation of weekly yields between gold andthe S&P 500 changed from near zero to over 0.20 during the most recent 2-yearperiod ending on 31 December 2007. For the reasons discussed above, I believethat this is only temporary and the correlation with equities will revert to themean.
Gold
95
Figure 7.1 Weekly composite chart of the World Gold Index (thick black line with thescale on the right Y-axis) and the S&P 500 (thin grey line with the scale on the left Y-axis).Negative correlation is shaded in a gray background and positive with no background. Noticethe correlation reversal in April 2003.
Table 7.1 Long- and short-term nonparametric correlation of weekly percentage changesbetween the World Gold Index and related commodity and financial indices up to 31December 2007. TNX is the CBOE 10 Year Treasury Yield Index, XAU is the PhiladelphiaGold/Silver Stock Index, CRB is the Commodity Research Bureau Index, Yen is the USD peryen exchange rate (JPY.USD) and TSX is the S&P Canada Composite Index.Years S&P 500 XAU Silver TSX CRB Dollar Index Euro Yen251015
0.200.100.020.00
0.780.740.710.71
0.820.740.660.66
0.460.310.180.18
0.630.550.450.43
−0.55−0.57−0.47−0.38
0.540.540.43NA
TNX Crude Oil
0.240.030.32 −0.080.26 −0.100.23 −0.07
0.410.230.170.14
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Table 7.2 Long- and short-term nonparametric correlation of 10-day percentage changesbetween the World Gold Index (gold spot) and related commodity and financial indices up to31 December 2007. TNX is the CBOE 10 Year Treasury Yield Index, XAU is thePhiladelphia Gold/Silver Stock Index, CRB is the Commodity Research Bureau Index, Yen isthe USD per yen exchange rate (JPY.USD) and TSX is the S&P Canada Composite Index.Years S&P 500 XAU Silver TSX CRB Dollar Index Euro Yen251015
0.160.090.020.01
0.800.740.720.73
0.800.710.640.63
0.470.340.200.21
0.710.590.470.45
−0.63−0.57−0.49−0.39
0.610.530.47NA
TNX Crude Oil
0.320.000.37 −0.100.25 −0.110.23 −0.09
0.510.250.190.15
But this is not the only change in gold’s intermarket relations, and whether theywill also revert to the mean is doubtful. A close inspection of Table 7.1 reveals that,during the last 5-year period since 2003, gold started moving closer to the entirecommodity complex as represented by the CRB Index.The traditional positive correlation between gold and silver has also recently increased significantly from 0.66 (strong) to 0.82 (very strong).Gold and silver have always been positively correlated markets and their pricestend to move in the same direction. Their relationship, however, is not fundamental.The price of one does not move in a particular direction because the other market ismoving the same way, as both markets are driven by the same fundamentals. Thisdoesn’t mean, however, that their relationship cannot be used in exploiting short-termmarket inefficiencies as the fundamental reasons (like the price of the US dollar) mightnot be reflected fully in the price of both at the same time.Also, since gold is denominated in US dollars, it is reasonable to assume that itwill be affected by the Federal Reserve monetary policy. In 2004 the Fed createdexcess liquidity. In the following 3-year period gold broke out from historical pricesto new 10-year highs. After all, unlike paper money, gold cannot be printed. Longterm bullish factors for gold include explosive money supply growth, the US dollar,negative interest rates in the US, inflation and high commodity prices. Negativefactors include Central Bank selling which can affect the yellow metal negatively inthe short term.Commodity prices may get seriously distorted by the underlying currency fluctuations and it pays to examine them with international eyes. Gold offers the bestexample in recent history.To illustrate my point I have prepared two charts (Fig. 7.2). They are both ofgold, the only difference being the currency gold is priced in. The first one (boldline) is in US dollars, and the other in euro. For the 31/2 -year period from thebeginning of 2002 and until about the middle of 2005 the first gold chart (in dollars)showed a strong up trend but this was not the case with the second chart (in euro)
Gold
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Figure 7.2 Weekly chart of gold spot prices in US dollars (thick bold line with the scale onthe right Y-axis) and gold in euro (thin line with the scale again on the same axis). As you cansee, European gold investors didn’t profit from the 2002–2005 rally in gold.
which moved in a sideways range, finishing in April 2005 lower than it started inJanuary 2002.The gold’s (in dollars) uptrend was caused by a bear market in the dollar, not a bullmarket in gold. During this period, the correct position for an international investorwas a short dollar position, not a long gold position.Gold is also tracking the crude oil market, for signals about futures inflation trends,and speculative sentiment towards the US dollar. Although its long-term correlationwith crude oil futures is not as strong (ρ = 0.41 in Table 7.1) as it is with the CRBIndex (ρ = 0.63), silver (ρ = 0.82) or the dollar index (ρ = −0.55), it can increasedramatically, in periods of rising volatility and sharp dollar declines (Fig. 7.3). Duringthe preceding 3-year period there were four such incidents of market sentiment shiftresulting in extremely close correlation between gold and crude oil (marked A, B,C and D in the chart in Fig. 7.3) which happened to coincide with the start of asharp dollar decline. This is because, during periods of undisciplined dollar decline,their correlation with the dollar became the dominant price moving factor for both.Notice also that gold decoupled from oil two to three weeks before the dollar actuallybottomed out as the market is always forward looking and discounted the end of thedollar’s decline in advance.
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Figure 7.3 Daily composite chart of gold bullion spot prices (thick bold line with scale(divided by 10) on the right Y-axis), the dollar index (thin line) and NYMEX crude oil futures(grey price bars with the scale on the left Y-axis) from June 2005 to April 2008. Notice that inperiods of sharp and uncontrollable dollar decline (bounded by vertical lines and marked A,B, C and D in the chart) the gold and oil charts coincide, indicating a market sentiment shiftand resulting in a stronger correlation between the two commodities.
Finally don’t forget that gold, like every other commodity, is subject to seasonalchanges. Demand for gold is driven mainly by the jewellery industry. Gold pricesusually spike up during the September through December period as jewellers stockup in gold prior to the year-end holiday shopping season.Although seasonal patterns tend to recur each and every year in a more or lesssimilar fashion, something that is more macro fundamental might override them. Inthe case of gold this factor was the dollar’s weakness. In the bar chart in Fig. 7.4you can see how gold’s long-term (20 year) seasonality has been distorted by therecent (since 2002) bullish secular trend. Although the normal seasonal pattern isstill there, the recent bullish trend that has been in place since 2002 pushed towardhigher prices. As a result, the normal seasonal low is not as pronounced as it might
Figure 7.5 Weekly chart of the World Gold Index (in bold with the scale on the Y-axis), theWorld Silver Index (thin line in gray), and the CRB Index (normal line). Vertical lines weredrawn at major peaks. No lead or lag is apparent from the charts as all three indices seem topeak at the same time.
Figure 7.6 Weekly chart of the World Gold Index (thick line in bold with the scale on theright Y-axis), the XAU Index (in gray), and the dollar index (normal line with the scale on theleft Y-axis). Vertical solid lines were drawn at major peaks and dashed lines at major bottoms.No lead or lag is apparent from the charts as gold peaks at the same time that the dollar bottomsout and the XAU makes a top.
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99
Figure 7.4 Average COMEX gold near-term contract percent changes for the 20-year periodfrom 1988–2007 are shown in black, and for the most recent 6-year period from 2002–2007in grey. Notice the seasonal strength in the September to December period when the jewelleryindustry is busy acquiring inventory for the holidays.
be otherwise. A secular bullish trend in energy and agricultural commodities has alsocaused anomalies in normal seasonal patterns, at least temporarily.
7.2
LEADING OR LAGGING?
It is very difficult to establish whether gold bullion prices are leading or laggingother related commodities by inspecting a composite chart visually (Figs. 7.5 and7.6). Sometimes it leads, other times it lags, sometimes it moves coincidentally andat other times it does not respond at all to other correlated commodities. A rigorousmathematical analysis, however, reveals some repetitive persistency in gold’s elusivemaneuvers. This was contrived by calculating, in Table 7.3, lagging and leadingcorrelations of weekly yields between gold and related commodities by shifting gold
Gold
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Table 7.3 Pearson’s correlation coefficient of weekly percentage changes between theWorld Gold Index and the XAU, the dollar index, Canada’s Venture Index and theReuters/Jefferies Commodity Research Bureau Index (CRB). The correlations (except for theVenture Index) were calculated for the 15-year period from 1992–2006. Column 1 depicts thenumber of days that the gold data was shifted in time. A +1 day lag indicates that yesterday’sgold weekly change was correlated with today’s XAU, and dollar, CRB or Venture data and alag of −1 indicates that tomorrow’s gold weekly change was correlated with today’s of thecorresponding commodity. Therefore higher correlations with positive lags indicate a goldlead and higher correlations for negative lags indicate that gold lagged. Lag avg. (at the top ofColumn 1) is the weighted average of the lagging correlations and lead avg. is the timeweighted average of the leading correlations.Lag days
XAU
Dollar Index
Silver
Venture
CRB
lag avg.−10−9−8−7−6−5−4−3−2−1012345678910lead avg.
0.291−0.012−0.0020.0180.0390.0550.0960.2500.3750.4780.5890.6790.4760.3280.1960.058−0.070−0.066−0.068−0.068−0.070−0.0630.150
−0.0980.0240.0260.0280.0230.015−0.003−0.067−0.126−0.191−0.249−0.315−0.233−0.187−0.129−0.082−0.028−0.033−0.030−0.032−0.021−0.013−0.113
0.209−0.033−0.035−0.029−0.017−0.0070.0210.1580.2750.3810.4950.6120.4540.3340.2180.091−0.026−0.036−0.040−0.042−0.040−0.0440.167
0.256−0.011−0.0030.0330.0770.0930.1340.2350.3200.3840.4740.5740.4170.3100.2220.1180.0270.0130.0150.009−0.003−0.0130.179
0.142−0.018−0.031−0.028−0.017−0.0100.0140.1030.1890.2610.3440.4280.3300.2440.1610.074−0.015−0.036−0.045−0.043−0.047−0.0420.120
yields from one to 10 days forward (positive values) and up to 10 days back in time(negative values). The leading/lagging correlations between gold and every otherrelated commodity were then plotted individually in Figs. 7.7 to 7.11. For predictivepurposes, we wish to detect which commodities have stronger leading correlationswith gold. These relationships can then be used to predict the future course of eventsin trading systems or forecasting models.
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Figure 7.7 Correlation of weekly percentage changes between the World Gold Index andthe XAU, for 1 to 10 day lag or lead. Higher correlations for negative values on the X-axisindicate that gold lags the XAU, and higher correlations for positive values on the X-axis thatindicate that gold leads the XAU. In this case the gold correlations were higher for negativelag, indicating that it is lagging the XAU. The correlations were calculated for the 15-yearperiod from 1992–2006.
The moment of truth has arrived for gold since the leading/lagging correlationanalyses shed some light on the existence and nature of the predictive capabilityof related markets in forecasting the yellow metal’s next move. Keep in mind thatthese indicate only the average short-term tendency and are not appropriate to use forlonger-term trends. Important conclusions are summarized below.• The XAU There was a strong positive contemporaneous (zero lag) correlationbetween the XAU and gold (r = 0.68 and r = 0.62 for weekly and daily yields
Gold
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Figure 7.8 Correlation of weekly percentage changes between the World Gold Index andthe dollar index, for 1 to 10 day lag or lead. Gold’s initial lag reversed to a lead after the firstcouple of days. The correlations were calculated for the 15-year period from 1992–2006.
respectively). Based on the lag analysis, the XAU is leading gold for both weekly(Fig. 7.7) and daily yields (Table 7.4). The weekly yield weighted average of10-day leading correlations was 0.29 compared with 0.15 for lagging correlations(Table 7.3). A longer-term lead of gold stocks over gold bullion was also noticed by John Murphy and mentioned in his book on intermarket analysis (seeBibliography).• The dollar index had relatively weak coincident negative correlation when takingdaily percent differences but this improved on raw price correlations (Table 7.5).It is reasonable to assume that, as gold is denominated in US dollars, it should lagthe dollar. This was confirmed, however, for only the first two days of lag beforegold took the lead. Notice the correlation actually turned positive for more thanfive days of lead (see Table 7.3 and Fig. 7.8).
Figure 7.9 Correlation of weekly percentage changes between the World Gold Index andthe World Silver Index (XSLV), for 1 to 10 day lag or lead. Silver correlated slightly betterwith leading (negative shift) gold values, suggesting that it is leading gold. The correlationswere calculated for the 15-year period from 1992–2006.
Figure 7.10 Pearson’s correlation of weekly percentage changes between the World GoldIndex and Canada’s Venture Composite Index, for 1 to 10 day lag or lead. The Venture Indexcorrelated slightly better with leading (negative values on the X-axis) gold prices suggestingthat it is leading gold. Data for the Venture Index were available only for the 5-year periodfrom 2002–2006.
Gold
105
Figure 7.11 Pearson’s correlation of weekly percentage changes between the World GoldIndex and the Reuters/Jefferies CRB Index, for 1 to 10 day lag or lead. The CRB correlatedslightly better with leading gold values, suggesting that it is leading gold. The correlationswere calculated for the 15-year period from 1992–2006.
• Silver had the second best (after the XAU) correlation of weekly and daily yields.Silver moves more or less coincidentally with gold. A slight lead is barely evidentin the graph in Fig. 7.9.• Canada’s Venture Index had the best coincident correlation based on rawprices (r = 0.965 in Table 7.5). The Venture Index is also leading gold prices(Fig. 7.10).• The CRB Index had the worst positive coincident correlation for both weeklyand daily yields. No significant lead or lag was apparent in Table 7.3 orFig. 7.11.We can therefore conclude, based on the correlation analysis above, that gold eitherlags or moves concurrently with other related commodities or indices. It is thereforebetter to use related markets in order to forecast gold rather than the other way around.The inferences drawn from this analysis are only useful for short-term predictions asthe lag interval was limited to 10 days or less.
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Table 7.4 Pearson’s correlation coefficient of daily percent changes between the WorldGold Index and the XAU, the dollar index, Canada’s Venture Index and the Reuters/JefferiesCommodity Research Bureau Index (CRB). The correlations were calculated for the 15-yearperiod from 1992–2006. Column 1 shows the number of days that the gold data was shifted intime. A lag of 1 day indicates that yesterday’s gold daily change was correlated with today’sXAU, Dollar, CRB or Venture prices. Therefore higher correlations with positive lagsindicate a gold lead and higher correlations for negative lag indicate that gold lagged. Lagavg. is the time weighted average of the lagging (negative shift) correlations and lead avg. isthe time weighted average of the leading (positive shift) correlations.Lag days
XAU
Dollar Index
Silver
Venture
CRB
lag avg.−10−9−8−7−6−5−4−3−2−1012345678910lead avg.
0.0290.0280.004−0.0060.015−0.0130.0330.0300.0280.0050.0920.623−0.072−0.0290.0010.0050.004−0.034−0.020−0.017−0.0070.006−0.022
−0.005−0.0090.0030.0010.0190.014−0.0230.0090.002−0.010−0.025−0.3130.038−0.0220.006−0.012−0.015−0.007−0.001−0.0200.002−0.007−0.001
0.0070.025−0.008−0.0350.013−0.0340.0430.0030.0100.0120.0140.619−0.0640.0100.003−0.0020.019−0.032−0.004−0.0280.020−0.002−0.012
0.0330.031−0.005−0.0040.030−0.0070.0610.0480.0590.0140.0440.5720.009−0.0170.0300.0100.024−0.039−0.003−0.0080.0200.0140.004
0.0080.000−0.013−0.0260.015−0.003−0.0020.0080.021−0.0070.0330.409−0.0090.0130.0010.0020.018−0.034−0.021−0.004−0.0060.012−0.002
7.3
WHICH TIME FRAME?
There are two problems when using raw price data to calculate statistical metricssuch as correlation:• Prices are not normally distributed.• Relationships between markets are not linear.
Gold
107
Table 7.5 Pearson’s correlation coefficient between the World Gold Index and theXAU, the dollar index, Canada’s Venture Index and the Reuters/Jefferies CommodityResearch Bureau Index (CRB).The correlations (except for Venture Index) werecalculated for the 15-year period from 1992–2006. Column 1 shows the number of days thatthe gold data were shifted in time. A lag of 1 day indicates that yesterday’s gold price wascorrelated with today’s XAU, dollar index, CRB or Venture prices. Lag avg. is the timeweighted average of the lagging correlations and lead avg. is the time weighted average of theleading correlations.Lag days
XAU
Dollar Index
Silver
Venture
CRB
lag avg.−10−9−8−7−6−5−4−3−2−1012345678910lead avg.
0.7660.7570.7580.7600.7620.7630.7660.7670.7680.7690.7710.7900.7690.7670.7650.7630.7620.7600.7580.7560.7540.7530.763
−0.633−0.626−0.627−0.628−0.629−0.631−0.631−0.632−0.634−0.635−0.637−0.654−0.638−0.637−0.636−0.636−0.636−0.636−0.635−0.635−0.634−0.634−0.636
0.8220.8070.8090.8110.8140.8170.8200.8220.8240.8260.8290.8560.8290.8260.8250.8230.8220.8190.8160.8150.8130.8110.823
0.9080.8920.8940.8970.8990.9020.9110.9100.9100.9110.9160.9650.9160.9100.9090.9080.9100.9010.8970.8940.8920.8900.907
0.8460.8430.8420.8430.8440.8450.8460.8460.8470.8470.8480.8710.8460.8440.8420.8400.8390.8370.8350.8330.8310.8300.840
Both problems are usually resolved when taking price differences or percent changesbut what is the optimum time segment for calculating the difference?In Table 7.6 I have calculated Pearson’s correlation from 1 to 400 days percentchanges between gold bullion, the XAU and the dollar index. This is also plottedgraphically in Fig. 7.12.The correlation variation in time is very similar for both the gold–XAU and thegold–dollar relationships. The gold–dollar correlation peaked for nine day changes,
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Table 7.6 Pearson’s correlation for different interval percent changes between goldbullion, the XAU and the US dollar index based on 10-year data from 1 January 1997 to21 December 2006. Columns 3 and 5 show the correlation % change from the previous timeincrement.Yield days
XAU
% Change
Dollar Index
% Change
123456789101112131415161718192025303540455075100200300400
0.6260.6520.6640.6700.6790.6880.6910.6930.6950.6960.6980.6980.6970.6930.6930.6920.6910.6910.69