The past week included a number of unusual events. North Korea continued its sabre rattling. The US Federal Reserve released its closely-watched meeting minutes nearly a full day early to a variety of Wall Street banks, providing a field day for conspiracy theorists, before “correcting” the error the following morning by releasing the notes more widely. And gold suffered one of its worst weekly declines ever, falling over 5% in US dollar terms, putting it, as many commentators noted, in “bear market” territory as it has now fallen over 20% from its peak of over $1900 per ounce.
The asset class summary for the week shows the impact of this fall (and that of the price of oil) on commodities, which fell nearly 4% for the week. Canadian and Emerging Markets stocks were likewise dragged down, whereas US and developed market stocks delivered small gains, helped, perhaps, by the dovish Fed minutes.
Figure 1. Weekly Returns for Selected Asset Classes
Data source: Yahoo! Finance
Market Compass does not allocate directly to gold or gold stocks, although there is some exposure to each embedded in the broader indices that the models track. There are several reasons for this: historically, gold and gold stocks have historically behaved quite differently from broader aggregates of commodities and stocks, probably at least in part because of the supposed “safe haven” qualities of precious metals and related assets. In practice, gold and gold stocks do not deliver particularly strong results under trend-following approaches like the one that is at the core of Market Compass, so including it in the models does not offer much benefit. Holding gold as “disaster insurance” or as an inflation hedge may be psychologically comforting, but the empirical evidence for its effectiveness in these roles is mixed at best.
However, the recent sell-off was pronounced enough that Market Compass dug into the question of whether there might be some mean reversion potential in gold or gold equities. In other words, when they sell off this much, do the metal or the stocks offer some potential to bounce back?
To put last week’s declines into perspective, here is the price action of GLD, the most popular gold bullion ETF, and GDX, the MarketVectors Gold Miners ETF:
Figure 2. GLD Price and 13-Week Rate of Change
The blue line shows the ETF’s price, and the red columns the trailing quarterly (13-week) change in percentage terms. As we can see, the ETF has fallen as rapidly as 10% per quarter in recent weeks, a rate that it has exceeded on two other occasions since it began its retreat from over $180 per share. The only time when its decline was more abrupt was during the crisis period in 2008-9 (again suggesting limited effectiveness of holding gold in the face of distressed markets).
Figure 3. GDX Price and 13-Week Rate of Change
GDX, the gold miners ETF, shows even more striking declines, backing up the view of those who see gold stocks as a leverage play on the gold price. The correlation is far from perfect, however – gold equities lagged the metal in its climb to $1900, and have underperformed it in its decline. The amount of red under the 0% line is considerably greater in this chart than in GLD’s.
Looking at the pattern of what happens after declines of these magnitudes, we took a simple look at whether there is typically a reliable bounce from declines of this depth. This decline in both gold and gold stocks has been extreme – the move in both represented a decline of 2 standard deviations of weekly returns. Since the inception of the GLD ETF, there have been only 9 other occasions where both metal and miners have declined by 2 standard deviations, all in 2008. The return distribution for the following 4 weeks looks like the attached:
Figure 4. 4-Week Returns Following 2 Standard Deviation Declines in both GLD and GDX
History – based on very few occurrences – suggests that there may be an interesting gamble here for the brave. Roughly half of the occurrences lead to a positive outcome, with the average gain significantly outweighing the average decline. Looking out over 13 weeks, the results appear even more skewed to the upside:
Figure 5. 13-Week Returns Following 2 Standard Deviation Declines in both GLD and GDX
It is important to note, however, that this illustration not only represents a very small sample, but also shows results from only a single year – and ultimately, from a single crisis. The time periods in the above chart overlap, so these are not statistically independent events. So a reasonable way to interpret these charts is to say that “in 2008, gold and gold stocks got hammered, and then bounced.” Whether the same thing will happen again is impossible to conclude definitively on the basis of one violent decline.
More fundamentally, aggressive dip buying is not part of the Market Compass approach, so the models will not take a trade on the basis of this kind of analysis. Should a market decline like the one in precious metals reverse itself into an uptrend, there could be a trade for a Market Compass-type approach – ie, once trend-following and mean-reversion line up. But for now, the models remain focused on asset classes that tend to behave a bit better on average, and most of which are, for now at least, in reasonably solid uptrends.
The models made a few changes this week. The US model reduced its stock market exposure slightly up as US large caps lost a bit of momentum. The Canadian model saw a shift of several percent from US equities to International, reflecting the continued surge of Japanese markets. Both models hold significant levels of cash (20% in the Canadian model, 25% in the US version), with the largest contributor still being the 0 weight to commodities, which certainly seemed the right positioning this week!
The model outputs are available as always at:
Have a good week!