Using Gold to Hedge Against Stock Market Illness

Gold

The stock market seems to be coming down with a virus right now, and while people aren’t that concerned about this one, we can still take a little medicine for these things.

With the threat of the coronavirus in China increasing, it isn’t really that surprising that U.S. stocks are starting to come down with a little fever as well right now. We all know how weak its immune system is, and it seems to catch every bug that goes around, both real and imagined ones.

China is not always upfront with things, and we have already seen them try to divert us from the truth with this new virus, just like they did with the SARS infection back in 2003. When you lock down a city of 11 million people as well as several others, when people are running around in panic like they are in China right now, it’s much harder to pass such a thing off as nothing.

The truth lies somewhere in between China’s looking to hide data and western media looking to blow it out of proportion, and using the term epidemic to describe the SARS outbreak speaks to this tendency pretty well

It is not that a worldwide body count of 774 deaths is anything to sneeze at, which we saw with SARS, but it is just a little sneeze compared to the 250,000 to 500,000 people that die each year from influenza viruses.

In the news entertainment business though, stories like SARS and this new coronavirus are just that much more entertaining, especially when you see a whole country the size of China in a panic Whether we admit it or not, many of us enjoy being scared, and will pay money to watch the most hideous of pandemic scenarios that movie writers can dream up and come away satisfied presumably.

Sometimes this entertainment can be replicated in real life, and while this quarter to half a million people that die each year from other viruses die virtually in silence, once in a while we can put together a good enough story to capture the imagination and the fears of the world, like SARS or this one.

The SARS breakout cost the global economy $57 billion though, so the economic effects are really nothing to sneeze a, and this one might end up costing a lot more than that when it’s all said and done, which might not be for a while. The threat of the virus itself may or may not scare us much, but the cost of containing it sure has the potential to scare the stock market, and we’re already seeing this show symptoms.

Mother Nature always has the last word with these things, and viruses like this subside in good time regardless, but to see this much intervention in China, which is spilling over to other countries now, is really something to behold. You would think that this was the black plague and not just a virus that is fairly low on the list of potential threats, according to some American officials anyway, and one that is simply overwhelmed by the massive number that the flu takes.

We aren’t looking to judge here though, and if China wants to constrict their economy this much for a time, to save lives, and this definitely does that, we wouldn’t want to put a price on such a thing. We’re interested in the financial and economic side of this, and from that perspective, this could be a much bigger deal than SARS ever was.

You can see this materialize already with China’s response to this, and in terms of the potential scope, some Chinese experts are predicting that the number of people affected and the body count will be at least 10 times worse than the SARS outbreak. The economic cost of containment could also be much higher as well.

We do need to keep in mind that a lot of this economic effect is transitory, where people’s spending gets reduced by way of the restrictions for a time. This not only returns to normal when the threat ends, some of this spending may just be delayed and ultimately counted.

This is certainly enough to cause some sort of selloff, just like most significant news does, but not the sort of thing that people who are planning on holding worry about unless things really get hairy. Those who sell based upon these temporary things aren’t voting for any sort of long-term harm, they are just stepping aside, perhaps wanting an excuse to sell and finding a convenient one.

Everyone Deserves to Have their Risk Managed Properly

Even if we desire to stay in the stock market for years, we still might want to come up with a good plan to hedge our risk, and this is what we will be offering you in this article. Just about all investors think that hedging involves either diluting their positions or waiting until things get very bad, but neither are efficient at all and both are actually a terrible way to do this. We won’t be looking to encourage either.

When investors hear or even think about timing their positions, they think of this as an attempt to try to beat the market, don’t really have the skills or the inclination to want to mess around with these things, and choose instead to stand pat or to have money in things like bonds or gold. If they stand pat, they will expose themselves to quite a bit of damage before they finally decide to act, and if they hold standing hedges, they will be protected more, but not enough, and will both dilute their returns and not manage the risk that well either.

If the market pulls back by 30% for instance, this still probably won’t scare them and they will probably insist on taking an even bigger hit, perhaps anything that the world can throw at them. If you put half your money in something else, you’ll be stuck with much lower returns with the half that are out of stocks, and take half the hit of bear markets, which is still too much.

There is no other good solution other than looking to time things with the conditions, dressing to the weather we could say, but investors just don’t know how to do this very well and have little interest in learning how, even though they have so much at stake. They fear that they will mess up and end up with a lesser return than the market for their efforts, and that may indeed be true.

To seek to manage this reasonably, we need to first account for the limitations that investors are under. They are not traders, they have no interest in becoming traders, and therefore whatever we recommend here is going to have to be simple enough for them to execute. We can’t rely on teaching them any sort of technical skills, like someone looking to predict the weather would rely on, although anyone can look outside and see what the weather is like, and this needs to be our approach if we want to help these investors.

They will have to understand though that hedging often comes with a price, and while the right skills can have us beating the market without a lot of effort with market timing, that’s not what we are shooting for and it is even fine to see your return drop a little in bull markets, although it can’t drop too much either or we’re going to make the same mistakes that the blanket hedgers do.

If a more properly hedged investor was comparing results with someone who does not hedge, their returns might be a little less during the good times, but when things go downhill, this is where they will shine. That’s true of hedging in general, but since we’re looking to do this efficiently, we want to be in for the great majority of the good times and be out for the great majority of the bad times, using hedging more efficiently than it is normally used, much more efficiently in fact.

This will require that we actually look to move with the conditions, meaning that half-hearted approaches won’t cut it. You are either in stocks or out of them. There is no in-between. If the skies are clear, we are in. When they cloud over enough to have us worrying, we are out.

To put this another way, when the expectation with stocks is ahead, we’re in stocks. If the expectations for stocks deteriorates to the point where the expectation turns negative, and we find something that has a positive expectation, we’re in that instead, and if we cannot find such an opportunity, we ride out the storm in cash.

Since we want to keep this as simple as possible while still striving for effectiveness, we will want to select both a stock ETF and an alternative asset ETF. Ideally, we will choose the Nasdaq because it goes up more than the other major indexes, and going up is the assignment of our stock ETF. While the Nasdaq is also more volatile, our hedging will protect us against that. We don’t want to even be in stocks when it is raining, so when it does come, we’d be out of whatever we pick, and while we’re in, it’s just better to be in a faster car.

Our rainy-day plan will be to go with SPDR Gold Shares, as bonds are too tame for such a plan, even though they have been pretty hot as of late. This isn’t the norm at all and we don’t want to be settling for nominal returns when we could be shooting for better.

We Should Prefer to Invest with our Eyes Open

Stocks and gold often move in different directions, and while the correlation isn’t that strong normally, it gets better when the decline in stocks is event-driven, like our current situation with this virus. There are various reasons why people sell off stocks, but the only one we’re interested in is ones that are fear-driven, whether that be fear of a trade impasse, a recession, the Fed raising rates, a slew of bad earnings calls, a notable decline, or any number of things.

Since we’re not worried about being too fine with the timing of our stock ETF exits, we can be pretty liberal with using this move and could even want to pull the trigger on this right now. Once whatever it was that inspired us to get out passes, whether that’s one day or a year, we are ready to get back in, and this approach could have been used a number of times in 2019 as an example and have us achieving our objectives, which are purely defensive.

This is not about thinking about down the road either, as we want and need to be acting in the present, and this point is very important. They can paint all the bleak pictures of the future they want, and while that may put us more on our guard, we need to see the sky actually darken enough before we should ever pull the trigger. This is true regardless with investing but is not one that many investors and those advising them understand very well.

We hear that the market is worried about this viral outbreak. We see the market waiver like it did last Friday. We can’t act until the market opens on Monday, but we keep a close eye on things and if it looks like this is still going on, we may want to step aside for now. We look to gold and see it’s doing well and is going up while stocks go down, and we have now found a suitable home for our money right now.

We want to be thinking ahead a little about what sort of damage that our concerns may cause, and in this case, this could take us down a fair bit, enough that getting out looks like a better move than not. The key to understanding the reasoning behind this is that the threshold we need to make sense of this is actually very low, and we could even exit at the first sign of any trouble and get back in when it is over and be moving in and out of the stock market anytime we get even a little pullback.

That would certainly be overdoing it though for an investor and this would seek to turn them into more of a trader than we have in mind with this plan, but you could have your plan being even this sensitive and achieve its objectives. What we are after instead is whatever threshold that the investor becomes concerned with, moves against them that in concert with the general mood of the market indicate we are likely enough to be at enough risk to want to protect against.

We need to not hesitate to act on both sides of this, as if we wait too long to get out, we will be prone to suffer bigger losses, and if we are slow to get back in, we will miss out on too much of the move the other way. Both of these represent risk, even though we might not think of the missing out part as risk. It is though, and all we need to do is think of the people that go out and watch things later move up a lot without them to get this.

You can invest long-term like this, wanting to be in stocks for 40 years for instance, but only when it isn’t raining. It the sun is shining on stocks, there’s nothing better to have our money in, and we want it all in then. When it rains, this is the worst place to be, so we want it all out.

The biggest reason that the popular view involves a hands-off approach to investing is that the people who are recommending this have no idea how one might do anything different well, and are afraid to do anyway. When you combine ignorance and fear, that leads to a pretty powerful deterrent.

Our plan doesn’t need to be even this complicated, as we could just go with in stocks or out, and even just use our level of fear as a guide, as long as we use what is actually happening as a guide as well. We’re scared of the coronavirus knocking down the market, and we’re afraid that some people will use this as a springboard to doing what they were close to doing anyway, getting out, as well as the threat of people who would otherwise enter here being put off by the news.

Later, we feel better, the market looks better, and we’re back in again. Maybe the move didn’t really materialize and we may have been a little better off doing nothing this time, but next time could be quite different and that’s what we’re out to guard against.

While other investors may lose sleep over their investments when things start to move the wrong way, we’ll be resting comfortably, and even may be going to bed a little excited if we are making money on joining those who drove stocks down and used their money to put gold up.

Gold continues to look good and while it can’t keep up to the Nasdaq, gold is up 7% since last October 1. The Nasdaq is up 18% over this time, which shows why you want to have your money in stocks when they are running up. Bonds are now exactly where they were back then, and bonds just don’t have enough potential over cash to be worth bothering with in this plan.

People may feel that bonds suit their tastes more than gold because gold is riskier, but we need to keep in mind that when risk does go up like it can with gold, we certainly do not want to be in it and this will be hedged against by our plan in the same manner that it hedges our stocks.

The reason why we may want to go to cash instead of bonds when stocks and gold aren’t performing is that when both of these assets are headed down, there is a greater risk with bonds because this happens more during the real bad stuff. This also tends to hit us more by surprise. During the selloff of 2008, for instance, both stocks and gold went down, and bonds took a big hit as well. Cash was the only safe haven.

We invest to take advantage of positive expectations, and while our expectations over the long-term may be positive, often times this is not the case in the short-term. We should never embrace periods where we’re significantly more likely to lose than not, and it’s not so difficult to figure out when it is a good time to step aside, when we see these negative expectations manifest. Two eyes and a brain are the only tools required.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.