Time To Hedge

Elmwood Data's picture

 

Since the summer of 2010, the way gold was viewed and used by the overall market has changed.   For much of the period from Jan 1, 2008 until June 30, 2010 for example, gold (GC) has had an inconsistent relationship, in correlation terms, relative to the S&P 500 (SPY).  There were times during this period when it moved in the opposite direction, but much of this time it moved in the same direction as the market.  This can be seen in the first chart shown.

Toward the end of  2010, however, the relationship of gold relative to the stock market has changed somewhat. Gold started to become a more active instrument for investors looking to hedge themselves against downside risk in the market.   This isn’t unprecedented by any means, rather the use of gold as a hedging tool simply seemed to escalate during this time versus the past couple of years.   Gold consequently moved to consistently be more negatively correlated with the market over the past 12 months.  This can be seen in the following chart.

Where does this leave us?   It means that at least in the current environment the VIX volatility index should not be viewed as a stand alone measure.   It makes intuitive sense to us to combine both gold and the VIX into one series to properly reflect both investors who wish to hedge with gold, and those who wish to accomplish it through the VIX. We’ve put this into ratio form (GC/$VIX) in the following chart.   The first takeaway here, is that if you’re looking to hedge, the VIX may be your best bet at this point in time as a rising ratio as shown on the chart implies the VIX is cheap relative to gold.  

Last, since the absoutute level of both Gold and the VIX are well known to the market, we prefer to view this as a slow MACD (24,52,18).  A MACD gives you a much better visual of the accelearations and decelerations of a data series.  So created a weighted series using 50% Gold and 50% VIX, and then converted this into a slow MACD.  See chart below. As you can see, some of these spikes up and down have turned out to be very prescient bottoms and tops in the market.   Our read right now, is that the MACD (blue line) has just crossed above the MACD AVG (red line), and in the past that has been the prelude to a market correction.   Once we see the MACD really spike above the MACD AVG, that would be the point to remove hedges and become more short-term constructive on the market again. 


This purpose of this model is not just to try and time the market, rather to identify entry and exit points of our hedges. Judging by the above, it’s a good time to hedge, and the instrument of choice should be the VIX.