Gold Loses Its Value as Selloff Protection

You might find food could hold up better in a downturn.
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There's been a lot of ink spilled in the last few years (and I have contributed some of that ink) about how investors can use commodities to diversify their stock portfolios because there's a low correlation between the two asset classes.

The easiest and most obvious commodity to capture this effect is gold, but lately I have been starting to wonder if gold has a tighter correlation to stocks than it used to because it has become so popular. Author Nassim Teleb had a great comment on the Wealth Track program a few weeks ago when he said that diversification used to work when no one knew about diversification.

A lot of people know about gold -- maybe too many people -- and that may be why it has not offered much protection during the last three biggish stock market dips. During the selloff that started in May of 2006, the

S&P 500

dropped roughly 5% in a month. Gold, as measured by the

StreetTRACKs Gold Trust

(GLD) - Get Report

, fell 17% over the same period.

Again in the first quarter of this year, when the S&P 500 fell 5%, GLD dropped 7.5%.

Gold is holding up better than stocks in the current market panic, having lost only 4% since July 19, compared with not quite 10%, on a closing basis, for the S&P 500. But that's still not as low of a correlation as investors might expect.

This makes it reasonable to wonder whether gold no longer offers the diversification it once did against ordinary financial crises. After all, the more people there are who believe gold will rise when stocks fall, the more the price of gold is likely to be bid up ahead of a selloff in stocks.

That means when stocks do slide, there are fewer people left to buy the precious metal, and it does the opposite of what it's expected to do. (This is a simplified explanation, but it should provide the basis for understanding.)

One commodity that might offer better protection from a stock market decline is food. Unlike gold, agricultural commodities aren't widely used to diversify out of stocks, and demand is pretty inelastic.

For now, the easiest way for stock market participants to invest in this commodity is through the

PowerShares DB Agriculture Fund

(DBA) - Get Report

. DBA invests 25% each in corn, sugar, soybean and wheat futures. Because futures contracts are purchased on margin, most of the assets in the fund are actually in T-bills. So after paying the ETF's 0.75% management fee, there will be some yield paid out at the end of the year, in addition to any gain in the value of the futures contracts themselves.

(By comparison, GLD invests in gold bullion, rather than futures contracts.)

DBA has only been trading since Jan. 5. During the first quarter stock market dip, the ETF dropped 3.5%, holding up a little better than stocks and a lot better than gold. In the current selloff, DBA is actually up a little over 1% (as of Friday) since July 19. But I should note that at its recent low it was down 3.2%. In other words, during the past two major stock market dips it has endured much better than stocks and a little better than gold.

This three-month chart also captures the low and sometimes negative correlation between DBA and the S&P 500.

A Better Way to Hedge?
The Powershares DB Agriculture Fund has a low correlation with returns of the S&P 500

Click here for larger image.

Source:

So food, as represented by DBA, has a relatively low correlation with stocks during financial crises; but what about non-financial market disruptions, such as terrorist attacks? DBA did not exist in September 2001, but we can back-test to see how it might have performed. As you can see in the second chart, below, DBA offered some relief from the September 2001 selling but did not appreciate. The price of gold, however, did go up in the wake of those terror attacks.

What Might Have Been
Back-testing shows agricultural indices holding up better than stocks after the Sept. 11, 2001, terrorist attacks

Source:

If there is another terrorist attack, gold might well rise again, but the financial markets are a different place. There were no gold ETFs in 2001, and the yellow metal had not yet gained its status as almost a household investment. Now that there are more investors who

expect

gold to go up in a terror event, it may not be able to do so.

Further, these kinds of external events are so rare that it's reasonable to wonder if it even makes sense to hedge against them. And if you believe it does make sense to hedge against a so-called black swan, wouldn't you be better off using an inverse stock index fund, instead of gold?

Given that financial shocks occur more frequently than events such as terrorist attacks, and given that gold may not be as good of a hedge as it once was, something like DBA might be a better alternative.

At the time of publication, Nusbaum was long DBA and his clients hold both DBA and GLD, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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