by: David Goldman
June 20, 2010
The dog that isn’t barking in capital markets is the volatility of the gold price. Despite gold’s move up to a new record, gold’s historical volatility is around 18%, compared to over 30% for the S&P 500. If gold and stock prices both embody systemic risk, why should their volatility diverge so much?
GLD Implied and Historical Volatility
SPX Implied and Historical Volatility 
The last refuge of an ignoramus in financial analysis is “market segmentation,” that is, different people doing different things for different reasons. In this case, the odious “market segmentation” argument makes sense.
Equity prices, according to the (vastly oversimplified) dividend discount model, depend on the expected revenue stream and the discount rate. When both the discount rate and the revenue stream are low, stock prices can be quite high–but very small changes in either can send stock prices flying in either direction. Treasury yields range from 0% at the 3-month maturity to 3.2% at the 10-year maturity. If the market expects the yield curve to shift up by one percent, for example, that’s a 25% increase in the discount rate and a corresponding 25% drop in stock prices, according to the simplified model. Dividend discount analysis ignores risk factors (the shape of the expected distribution of outcomes as well as its mean play a role), as well as possible changes in the investment opportunity set, and so forth — but the point is that the combination of a low discount rate and low profits creates the potential for enormous volatility.
With the 10-year yield at slightly over 3% and the earnings yield on the S&P 500 at over 6%, it’s understandable why institutional investors who require some yield would buy stocks. Even if the miserable US employment situation persists and the housing market remains in the dumps, America’s stripped-down, cash-rich corporate sector should continue to churn out some profits. Unless another shoe drops in the sovereign crisis or the miserable US economy turns sharply downward, equity prices should chop sideways.
Gold is a different matter. Central banks and other investors who do NOT require current yield (although they like it, because it finances first-class airfares and junkets for their employees) but need to preserve value have a quandary. The US is financing its deficit on the balance sheet of the global banking system (that’s why the Treasury’s TIC data keep showing huge purchases of Treasuries out of London and the Caribbean), as well as the US banking system.
Because high unemployment and collapsed home prices foster deflation, the continued debasement of the US currency through balance-sheet leverage makes it unattractive as a reserve asset. But what alternatives are available? The euro is in danger, and Japan’s government is warning that its national debt at 227% of GDP threatens an eventual sovereign crisis for the yen. There’s talk of Russia buying Canadian loonies and Aussie dollars, but those are tiny markets.
So the central banks appear to be accumulating gold, slowly and steadily, buying on declines, and nudging the price up as gradually as they can in order to reduce their average cost. That might be why we observe so little volatility in the gold price. The prospective buyers, namely the central banks, are so much larger than the gold market that they avoid actions which might cause price spikes.
I’ve been an advocate of gold investing since this blog began; I own gold mining stocks, GLD, as well as some longer-dated gold futures. It’s a relatively small part of my portfolio, but insurance against serious trouble.
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