Technical Analysis Report: Gold a safe-haven no more (March 28, 2011)

With the disaster in Japan reaping havoc on global markets, investors may well be looking to the past to get a better understanding of what investments held up in such uncertain times.

The natural place to begin looking would be the stock market reaction to the Chernobyl meltdown of 1986. Unfortunately for chartists, however, since the catastrophe took place behind the Iron Curtain, in an economy mostly cut off from trade with the West, outside of falling uranium stocks, markets barely even blinked at the news.

Still there are other correlations worth examining in the present day context.

For instance, the long-held notion that gold is the refuge for investors fleeing risk didn’t seem so reliable when the price of gold fell over the few days when the threat of a nuclear meltdown in Japan was at its peak.

Such a scenario begged for the assumption that gold is a safe-haven to be challenged, and sure enough, by some key measures gold has not been the risk aversion play over the last 10 years.

Using the CBOE Volatility index (VIX) as a proxy for risk – the index rises when investors fear a drop in equities as the index charts the price of derivatives used for hedging against equity losses – it can be seen that investors have not piled into gold at their most worried moments.

Instead there has been a negative correlation between the two. From mid-2002, as gold began its steady upward climb, the VIX was falling into a sustained lull – signaling robust investor confidence.

The situation persisted all the way into the financial crisis of 2008. When the crisis struck, predictably the VIX spiked, and as we all know, the price of gold fell. 

In a state of panic, investors had chosen the U.S. dollar as the safe-haven over gold, and the gold price fell as a result.

Since then, the VIX has resumed its downward path, as investor confidence has grown and the markets rallied along with the gold price – that is until the Japan crisis, where once again the negative correlation between gold and VIX surfaced.

The situation supports the view that gold is trading almost exclusively as currency play and has all but shed its former safe-haven role.

As the economic crisis of 2008 and the recent situation in Japan have both shown, when investors are paralyzed by sudden and unexpected fear, U.S. dollars are what they want to hold.

What has been driving investors to the yellow metal then?

Perhaps it is the increasing talk in some circles of a third round of quantitative easing on the horizon. The U.S. administration is showing that its primary concern is a stubborn unemployment rate, and it is showing no shyness in its attempts to stimulate growth via loose monetary policy. Of course the devaluing of debt that such easy money will bring via inflation also has
some perks for a country with such a massive trade deficit.

Provided such thinking continues to hold sway in Washington, gold bugs may well be able to rest easy for some time. Indeed the strength of the metal’s climb has been such that it has even rendered normally strong bearish indicators all but meaningless.

Before its latest rally, the gold chart showed the dreaded triple peak – a formation that chartists have long taken to be a strong signal of the end of a bull run and the beginning of a reversal.

But while the price of gold did correct slightly after the formation, it quickly regained its momentum and forged on to new heights.

With all that positive momentum investors may be wondering how to best play the metal.

Traditionally gold miners have offered a leveraged way to play rises in the price of gold but a look at the charts challenges this long-held assumption as well.

While gold miners, as represented by the Global Gold index on the TSX, outperformed the price of gold in terms of percentage gains from the beginning of 2001 until mid-2007, just before the crash and subsequent to it, the price of gold has outperformed gold miners.

The change may well have been the result of a sustained change in psychology brought on by the crisis. With the value of equities falling far more than the price of the metal itself at the time of the crisis, investors may well be adding a more robust equity risk premium to gold mining stocks due to market volatilities that the metal itself is not subjected to.