Hedge Your Bets: Use The Gold/VIX Ratio

Includes: SPY
by: Elmwood Data

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 (futures symbol-GC) has had an inconsistent relationship, in correlation terms, relative to the S&P 500 (NYSEARCA: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 is not 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 have 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.

To put this all together, we have created another ratio which shows the S&P 500 and compares it to the ratio of the S&P to the gold/VIX ratio. This is expressed as: SPY/(GC/$VIX). Judging by this relationship, when this ratio goes above 2.6 it has generally been a good time to take off your hedges, and when it has dipped down to 1.4 it has been a good time to put on your hedges. This ratio currently sits at 1.45, which is precariously close to previous points where the market suffered corrections.

This purpose of this model is not to try and time the market, rather it is 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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment professional as to the suitability of such investments for his or her specific situation.