Back to Basics: Examining the XAU

Why do gold prices and gold stocks move higher during periods of market volatility? When investors become anxious about the state of the financial markets, they often turn to gold because a global market for gold will always exist, regardless of the future direction of stocks and bonds. So when investors begin to sell stocks aggressively, they often move some of that money into gold, which leads to higher gold prices.

In turn, this flight to gold often encourages stock investors to buy shares of gold-mining companies. This helps drive up the components of the XAU. For example, last year, while the broader market as measured by the S&P 500 fell 24%, the XAU rose 43%, making it the year's top performer.

The XAU is frequently used as a hedge in uncertain times because it tends to move in the opposite direction of other market sectors, but it isn't a perfect hedge. The chart below shows the one-year performance of the XAU and the S&P 500.

At times, both indices fall together, which has been the case throughout much of this year. While the XAU has fallen 15.6%, the S&P 500 is down 5%. Therefore, investors who sought refuge in the gold and silver index have so far been disappointed this year.

The XAU isn't a perfect hedge for several reasons. As already noted, it's a capitalization-weighted index that favors four large companies. Therefore, it doesn't really reflect the happenings in the gold-mining sector as a whole.

In addition, gold is influenced by factors other than the stock market. For example, the U.S. dollar has an important (and inverse) relationship with the precious metal. Also, investors are more likely to drive up the price of gold during periods of inflation because gold has historically performed well when inflationary forces mount. Today, however, there is no inflation. In fact, many market watchers are more concerned about deflation.

Although talk about the XAU seems to increase in times of market volatility, many different forces influence gold prices. As a result, trading this index isn't an ideal way to protect your portfolio. Instead, consider using protective puts, collars or other low-risk strategies that are more certain to yield results if the stock market takes another trip south.