Gold as Protection in Bear Markets

During downtrends in stock markets, bear markets as they are known, people do tend to move to gold more. There is only one reason why gold markets tend to outperform stock markets when stock markets are underperforming, and this has to do with the relative flow of money in and out of these markets.

The reverse is often true as well, as bull markets in stocks will also tend to influence gold markets, where the two may also be going in opposite directions, as people move money out of gold and into stocks more.

There is only so much investment money out there at any given time, and while this does tend to increase over time, driving up prices in general, there are peaks and valleys involved. Within this system, involving inflows of money into investments and outflows to elsewhere, there are also inflows and outflows between types of investments, gold and stocks for instance, or stocks and bonds.

Prices are set by the interaction between those looking to buy an investment in comparison with those who are looking to sell, and when more people are looking to buy than sell, the price goes up, and vice versa. The buy side constitutes the inflow pressure, with the sell side producing the outflow pressure.

When people sell stocks more, the money needs to go somewhere. It may go into cash, it may go into another investment like bonds, or it may go into precious metals like gold. Gold is by far the biggest market in precious metals investing so while this may influence the price of other metals like silver and platinum, gold gets the lion’s share of this.

The relationship between stock prices and gold prices isn’t a direct one though by any means, but there is a correlation of sorts, more so at certain times than in others, and more so in larger moves downward with the stock market.

The Relationship Between Stock and Gold Prices

If the stock market gets hammered enough, it is at this point that we can really see this effect in action, although both markets can move in the same direction as well, and both have their own internal dynamics, a bull run with gold for instance that can last many years and can attract a lot of additional investment in itself.

This is why the correlation between stock prices and gold prices isn’t a very strong one overall, because there are other things that influence the price of gold, and its price will depend on the influence of all of these factors, including whatever influence stock prices may have on it.

If there is a lot of money flowing out of stocks though, this in itself can drive gold prices up. As it does so, the upward movement in the price of gold can create its own momentum, where people look at the stock market and groan but see gold rising and the rising price of gold can get them more excited about it at a time where there is far lesser competition from the stock market.

It doesn’t work quite the same way with rising stock markets, mostly because people may invest in gold for other reasons besides trying to be in a better performing asset. They may want to invest in gold as a hedge for instance, where if stocks are going up, they see the need for this hedge as being similar as if the market was flat.

Whether or not this is the best way to use gold as a hedge is a separate matter, and while we could say that our hedges should be more adaptive, where we may increase or decrease our hedging depending on the circumstances, that’s not how many people use this. People don’t generally flee gold during good times in the stock market as much as they may flee stocks and turn to gold during bad times.

If investors were looking to act more optimally, they may indeed move out of gold more than they do when the stock market is rising and the gold market is falling, but they generally don’t as they approach this problem far too statically, and want to set these hedges more as a once and done effort rather than seeking to adapt them to current outlooks for each.

Using Gold to Protect Against Downside Risk in Stocks

If we are looking to protect your stock positions with gold, there are two main types of risk that you are seeking protection from, those which manifest themselves over time and those which do not.

In spite of what some people think, risk in the stock market really doesn’t come out of the blue, aside from things like the very short term losses incurred as a result of program trading gone wrong, which very quickly stabilizes and is of a duration far too short for investors to ever worry about.

Other than so called flash crashes, even the most dramatic movements in stocks do tend to take time, or at least are telegraphed. We can see some single days that do a lot of damage from time to time though, and can take us from being below our threshold to well exceeding it, depending on how much tolerance we have with our positions.

This sort of risk can be seen on its face as something that we may need to well prepare for ahead of time, but it’s not that people start panicking with their stock positions and join the selloff and immediately buy gold the same day, and far from it.

During the October 15, 2008 crash for instance, the largest single decline percentage wise in the history of U.S. stock markets, the price of gold was in itself falling, and if you held both stocks and gold during that time you would have been losing money on both. Gold was in the middle of a bull run during this time but did experience a significant dip throughout 2008, which only started to turn around at the end of the year, a couple of months after this historic black day in stocks.

At the time though, stocks were already in free fall, for a whole year at this point in fact, starting in October of 2007, and those left in the market in October 2008 already had lost half their positions anyway, which these big down days just added to.

We do see some anomalies here though, where we may get a big down day without as much warning, at least one of a magnitude that longer term investors should heed, like the crash that occurred in October 1997, as a result of a crisis in Asian markets.

In spite of this producing the largest one day loss percentage wise we’ve ever seen at the time, this was merely a blip within a long and very strong bull run which lasted for 17 years, which saw the market increase almost 8 fold, and did not produce very much to have long term investors wanting to exit their positions, and not even close.

Even the infamous stock market crash of 1929 took quite a while to play out, almost 3 years in fact, where the market went pretty much steadily down over this time and investors had plenty of opportunity to exit, and many did.

While there is the potential for us to be blindsided and sustain huge losses without enough time to react, this potential is almost non-existent, especially with limits that we now see on stock markets where large movements to the downside will trigger the market to shut down.

To sum up, a movement of the magnitude that we don’t have time to react to has never happened, and is less likely to happen now, so making protecting against this a meaningful part of one’s strategy in using gold to hedge against these unforeseen events is quite dubious indeed.

Using Gold as an Allocated Hedge Strategy

The main argument, and perhaps the only one, for holding a static amount of gold and a static amount of stocks in one’s portfolio is to seek to protect against these unforeseen events, otherwise we could just manage the allocation according to need.

There’s no real need to plan ahead though because these bear markets don’t just appear out of nowhere, and this is especially true given how inefficient such a strategy is, but inefficiency doesn’t bother most investors or even come up, although it certainly should.

We need to see using gold this way as not a means to protect against bear markets, but instead, a way to manage them. It’s not even a secret at all when we’re in a bear market with stocks, every investor knows it, even people on the street know it.

Of course, if we actively monitor market conditions we can have an even better idea of what sort of market we’re in and the near term outlook of it at least, for instance by looking at a monthly chart of a stock index and seeing if the trend is up or down.

Looking at today’s chart for instance, we can see that it is up, bottoming out in early 2009 and moving upward since overall. There are always dips in any bear market, but the overall monthly chart is clearly upward.

What sort of protection do we need from a bear market if we’re not in a bear market? The sensible answer would be very little if any, and the correct answer is actually none. We are not experiencing one, and if one does come we will know it, and at that point we may want to look to hedge against it.

This is far from the thinking that almost all investors use, where they have been led to believe that we need a static hedge here, and deciding things such as when to use a more dynamic approach, one that seeks to align itself with reality, is far too difficult and therefore should not even be contemplated.

This is nonsense though and you can even teach a child to tell the difference between bull and bear markets, by showing them lines on the chart going up or down and tell them when it moves down that’s called a bear. You could then show them random charts and they would be able to pick out the bears.

Investing can be complicated indeed if we want it to be. There are some things that are easier than others though, and it doesn’t get any easier than looking at longer term trends, the ones we want to invest in, and decide if the market is going up or down.

It’s not that we even have to be right all the time here either, as just being right more than wrong provides us an advantage. We pay a price when we blindly hedge with gold, and we need to pay attention to both the trends with what we’re looking to hedge, stocks in this case, and also look at the trends of the hedge, the gold market in this case, to be well prepared at all to make these decisions.