Gold: Risks To The Downside Ahead?

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Includes: GLD
by: Philip Baker

Summary

The gold price has held up this year against the overall downturn in commodity prices.

Our outlook for a rising US dollar and weaker commodity prices cause us to be bearish on the gold price over the next month.

Using the model underlying our analysis to trade gold could create an alternative investment offering valuable diversification to a US stock portfolio.

At around $1200 currently, gold is 70% above the low end, and 37% below the high end, of its six year trading range of between $705 and $1901.

Amongst a general downturn in commodity prices this year, gold has held up reasonably well -

Source: fairvalueonline

As shown below, the volatility of the gold price has been stable this year, as a result of which the rising DJ UBS commodity index volatility has overtaken gold's volatility. This is against a background of outperformance by gold of the commodity index.

Source: fairvalueonline

We have developed a fair value of gold based on a multiple regression analysis of its price on 22 driver variables including interest rates, stock indices, other commodities and exchange rates. The database is six years of daily prices.

The elasticity of the gold fair value to groups of driver variables is shown in the graph below.

Source: fairvalueonline

As can be seen, gold is negatively correlated to the US dollar (as is also the commodity index).

We have also developed a prediction model based on the lead given by the change in the Baltic Dry Index (BDI) of raw material shipping freight rates. This index is widely seen as a leading indicator of world economic growth, with increases viewed as bullish and conversely.

Based on the BDI lead, it is possible to develop price predictions for a range of commodities, interest rates, stock indices and currencies. These can be combined with the fair value model elasticities shown above to give a predicted movement in the gold price over the next month. We also backtest the prediction models to assess their value in a trading environment (taking a long position when the predicted price change is positive and a short position when negative).

The predicted price changes for the next month, and the annualized return/volatility ratio over the last six years from trading the predictions, are shown in the following table -

Predicted price change

Backtest return/volatility

1 month

1 month

US dollar

1.9%

103.5%

VIX

3.8%

40.2%

Interest rates

-3.9%

85.6%

S&P 500

1.4%

86.6%

Oil

-8.1%

60.3%

Other Commodities

-3.2%

136.1%

Total

188.2%

The return/volatility from trading all the predictions combined (of 188%) compares with that applying to the S&P 500 over the same period, of 102.2%. We consider this to be reasonably robust given the period commences in mid-2009, around the start of the latest bull market in US stocks.

Our predicted movement in the gold price for the next month is shown in the table below. The contribution of each driver variable to the overall decrease is also shown.

Impact of predicted price changes on

gold

1 month

US dollar

-4.3%

VIX

0.2%

Interest rates

0.9%

S&P 500

-0.3%

Oil

-0.2%

Other Commodities

-1.2%

Total

-4.9%

As can be seen from the above two tables, our positive view on the US dollar drives a negative view on gold over the next month, exacerbating the effect of our bearish view on commodities.

We also used the BDI model to directly forecast the gold price movement for the next month. A change of +1.7% resulted, at variance with the signal given above. The six year backtest return/volatility ratio from trading this model was 89%.

We showed above gold's negative correlation to both the US dollar and the S&P 500. Unsurprisingly, significant diversification benefits could be realized from allocating a component of a US stock portfolio tracking the S&P 500 to gold traded using the BDI leading indicator as outlined in this article. For a 5% allocation, the ratio would have improved from 102.2% to 108.5% for the last six years.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.