Gold is a precious metal considered as a commodity and a monetary asset. It acts like a source of wealth, a unit of value and medium of exchange. Also, gold is a mean of investment which is highly liquid and a valuable metal used to make jewelry. Traditionally, gold has been an indicator of future inflation, acted as a hedge against inflation, an important asset in portfolio allocation and has shown its role in crises, because gold creates a hedge to diversify the increasing risk in the market during the crises. Central banks and international financial institutions retain a large amount of gold for diversification, and economic security.
Despite the importance of gold for currency hedging and trading, volatility of gold price may lead to negative consequences in financial markets, because an increase in the gold price volatility lead to an unsafe investment condition, while lower gold price volatility lead to safe investment condition. Thus, it is essential to learn about gold price volatility, for derivative valuation, hedging decisions, financial markets and the overall economy. An increase in gold volatility is an alert for investors and producers of the gold industry and exposes them to risk. So, understanding the gold price volatility enhances our understanding of financial markets and enables us to have a better view of the whole economy.
Significance of Gold in Stock Market:
The stock market is influenced by several interconnected factors such as economic, political, and social developments and there is a complex connection among these factors. The stock price is affected by macroeconomic variables, including gold price, crude oil price, gold and oil price volatilities, the inflation rate, and the exchange rate. The aim of this paper is to investigate the long-run relationship among oil price, gold price, oil price volatility index, gold price volatility index, and S&P price index by applying bounds test.
Theoretically there is an inverse relationship between the stock market and gold prices.There have been circumstances where the stock markets rise and gold prices fall. Gold prices may also rise in sympathy with the fall in stock prices. The reason lies in the perception of the market by investors. Investors who foresee a bearish market, usually take positions in gold futures to safe guard their investments. In the United States sometime in the 1970’s, the economy stagnant causing gold futures to become a more attractive option for investors.
The role of Short run and Long run relation with stock market:
There can be both short-run and long-run relationships between financial time series. Short-run relationship between the stock market indices and gold price. In addition, there are two different theories on the relationship between gold demand and income. The classical theory argues that there exists a positive relationship between gold price and real income, while Keynesian theory argues that more demand means more economic backwardness hence low income, which indicates an inverse relationship.
The relationship between stock valuations and the gold price is another widely discussed correlation. The standard view is that these two markets are negatively linked: when the stocks go up, the yellow metal dives, and vice versa. Some studies found that there is no long run relationship between stock market of India and gold markets.
Is there a stable gold-stock relationship?
The relationship between stock valuations and the gold price is another widely discussed correlation. The standard view is that these two markets are negatively linked: when the stocks go up, the yellow metal dives, and vice versa. There is empirical evidence that confirms this common opinion, at least partially. The chart below shows the gold price and S&P 500 Index. As you can see, from 1987 to 2000 there was negative correlation between these two markets. Then, the dot-com bubble started bursting in 2000, while the bull market in gold began not earlier than in 2001. The stocks and gold have also been moving in opposite directions since 2011; however the 2000s can be regarded generally as a period of co-movement. Therefore, this chart clearly indicates that the gold-stock relationship changed over time, depending on external conditions, especially the macroeconomic factors.
Why do we often see a negative correlation between the stocks and the shiny metal?
Well, this is connected with risk aversion. When traders go into defensive mode, they may prefer gold to relatively risky stocks. The saying goes that gold is a safe-haven, so it is naturally negatively correlated (or at least uncorrelated) to stocks during serious financial turmoil, like in 2008.
The second reason is that the opportunity costs and the resulting investment flows change over time. The risk appetite is the one factor affecting the relative attractiveness of stocks in comparison to gold, but not the only one. Others include the pace of economic growth, the real interest rates, the U.S. dollar exchange rate, the momentum in both markets and so on.
Typically, when the economy experiences a slowdown with falling stock market returns, investors may shift their funds from stocks and invest them in the gold market until the economy rebounds. This scenario is likely to happen when the real interest rates are low, which is often the case during periods of a weak economy (due to low demand of cautious consumers and businesses, the monetary loosening implemented by the central banks to revive the growth, or the high inflation).
The best example may be the 1970s, when the economy was in stagnation, and the stock market remained flat. The expansionary monetary policy caused high inflation and weak U.S. dollar. All of these factors combined with low real interest rates (largely due to high inflation) made gold much more attractive than stocks. Conversely, the next two decades were a period of stabilized economy and controlled inflation.
The Volcker's interest rate hikes and reduced inflation led to higher real interest rates, which made gold less appealing. Additionally, the subsequent belief in economic prospects under the Clinton's New Economy (resulting partially from genuine wealth creation fueled by technological progress, deregulation and globalization) combined with Greenspan's monetary easing fueling the NYSE stock market bubble.
Gold is considered a safe investment. It is supposed to act as a safety net when markets are in decline since the price of gold doesn't typically move with market prices. Because of this, it can be considered a risky investment as well, as history has shown that the price of gold does not always go up, particularly when markets are soaring. Investors typically turn to gold when there is fear in the market and they expect prices of stocks to go down.
Furthermore, gold is not an income-generating asset. Unlike stocks and bonds, the return on gold is based entirely on price appreciation. Moreover, an investment in gold carries unique costs. As it is a physical asset, it requires storage and insurance costs. Taking into consideration these factors, gold works best as part of a diversified portfolio, particularly when it is acting as a hedge against a falling stock market. Let's take a look at how gold has held up over the long-term.