In my previous post, I have presented some thoughts on the next stock market correction. I have concluded that according to the "rhymes of the history," there is a good chance the next correction will be relatively mild. The situation would be different if the economy was hit by some unexpected negative shock, though. In this post, I would like to elaborate on this topic by trying to answer a simple question: When the market turn comes, where should the investors turn?
For long-term investors a mild correction should actually not be a reason to make significant changes in their stock portfolios. As Warren Buffett once stated, it is best to buy the stocks in sound companies and then behave as if the market closed for several years. Usual alternatives to "doing nothing" are cash, government bonds, and gold (or precious metals in general).
Government bond yields are rising, but they are still on exceptionally low levels. This means investors cannot expect exceptionally high returns from these assets even during a flight to safety. Moreover, we are in a very special situation now since government bonds may be a source of safety as well as a source of instability. I personally do not believe, there is a bubble on the government bond markets across the world - the low yields are mostly a reflection of fundamental economic situation. Nevertheless, we live in a world of self-fulfilling prophecies and these markets could theoretically become a source of instability. We would then face an unprecedented dilemma: What happens if the usual source of the safety becomes the source of danger?
All the above seems to favor gold and precious metals in general. There is a widespread conviction that gold is a risk-free investment. That is obviously not true, short-term and long-term volatility of the gold price is rather high (both in real and nominal terms). Nevertheless, gold could still have some value as far at hedging is concerned. Looking at ten-year correlations (data from JPMorgan Guide To The Markets), we see the correlation between gold and US equities is 0.33. Three-year correlation is at 0.17. This sounds good, but correlations are very tricky concept to rely on. Reason is simple: While in good times there may be low correlations and theoretically a big potential for diversification, in bad times the correlations usually move sharply higher. It is like having a car with exceptionally good brakes, but the brakes would only be functioning on a long straight road.
What are the rhymes of history telling us about the stock market and gold? If we look at long-term trends, we can see there was clearly a negative relationship - strong stock market was usually accompanied by declining gold price and vice versa. We can perceive it as waves of trust and distrust in financial assets in general. More importantly, we can see that gold is far from being a safe bet at the beginning of recessions. Actually, after 1930, there is just one clear exception: year 2001.
Therefore, it seems that the next correction will be a challenge as far as safe havens are concerned. Government bonds could be in a state of schizophrenia and history does not suggest gold is a good bet or hedge. But there is an important "detail", which is obvious from the structural change that took place on the gold market after 2000: The market became dominated by fears of reckless monetary easing and subsequent high inflation.
Therefore, there is actually some chance gold will react positively when the next correction comes. The reason will not be the correction (or possible recession) itself. It would be a renewed inflation fear coming from another aggressive monetary policy easing. We could argue the markets have learned in recent years that aggressive monetary easing does not automatically mean hyperinflation. On the other hand, we would quite likely move deeper into the monetary unknowns in case of another recession. And these unknowns are good for gold, at least at the beginning. I would not advice to make large bets on this type of gold rally, though. I am convinced that unless the central bankers become slaves of the politics, the inflation fears can (paradoxically) live only during periods of significant deflation threat. This means the gold rally would (again) stand on shaky legs.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.