Gold, Stocks and the Dollar: The Rise and Fall of a Correlation

Despite the fact that pundits and experts toss out explanations each afternoon about why the market just moved the way it did, it's impossible to really explain why stocks -- or any other investments -- go up or down on a given day. But since President Obama was sworn into office, a strong relationship between the dollar, stocks and gold has developed. When the dollar dropped, stocks and gold rose. The mathematics of that relationship were nearly perfect.

The simple explanation for this inverse correlation -- I'm not sure whether it was valid -- was that investors bought gold as a hedge against a declining dollar and stocks because a weaker dollar would boost American exports and corporate profits. But now, that correlation is approaching zero, and as gold ATMs are starting to dot the American landscape, the implications for gold bugs are ominous.

"Close to Zero"

First, let's briefly discuss a fundamental concept in statistics: correlation coefficients. These range from -1 (when A goes up, B always goes down -- a perfect inverse correlation) to 1 (when A goes up, B always goes up -- a perfect positive correlation). When there's no consistent relationship between the behaviors of A and B, the correlation coefficient is 0.

Between January 2009 and the end of 2010, stocks and gold rose when the dollar dropped. According to The Wall Street Journal, the correlation coefficient between stocks and the dollar was nearly -1 during that time. However, since the beginning of 2011, that connection has evaporated. "For much of the past month, that correlation has been close to zero, meaning the relationship between stocks and the dollar has been, practically speaking, almost nonexistent," explains the newspaper's Mark Gongloff.

Not only has the negative correlation between stocks and the dollar vanished, but so too has the positive correlation between gold and stocks, held for most of 2010's second half. Since New Year's Day, the relationship between gold and stocks has turned negative: Now, when stocks rise, gold falls, and vice versa, and gold's price is down 5% to $1,347 an ounce from its year-end 2010 price of $1,421 an ounce.

Is Gold an Illusory Hedge for the Dollar?

When an apparent correlation relationship dissipates, it's good to remember that there's a more subtle problem with the whole idea of analyzing correlation: the distinction between correlation and causation. Does a rising price for A cause the price of B to rise (or fall), or it just a coincidence? That's important in this case because gold bugs claim that gold is a hedge against so-called fiat currency -- meaning that people buy the precious metal because they think the dollar is essentially worthless (a view shared by U.S. Rep. Ron Paul (R-Texas).

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But now that the correlation between the values of gold and the dollar has gone from near -1 to near 0, that argument goes out the window. After all, if gold's price movements have nothing to do with the rise or fall of the dollar, gold becomes a terrible hedge against a weakening dollar.

Regrettably for investors in gold, this revelation is arriving on the scene at a time when gold ATM machines are popping up in places like Boca Raton, Fla., and Las Vegas. This feels reminiscent of how TV shows about rehabbing and flipping real estate became really popular just before the housing bubble burst. And it could mean that anyone buying gold from these machines is getting in at the top of a market about to tumble.

The Wall Street Journal article concludes that the changing relationship between the dollar, stocks and gold means investors are beginning to focus more on fundamentals. I think that conclusion is wrong. The reality is that unless big buyers and sellers have to tell regulators -- under penalty of perjury -- the real reasons for their trading decisions in real time, all other "explanations" are really just idle speculation.

That Popping Sound

It could be that gold and stocks are parting ways because investors are sensing a turn in the public mood against gold, ironically, just as Rep. Paul -- the new GOP chairman of the House committee that oversees the Federal Reserve -- is moving to push the Fed toward a gold standard.

Once investors stampede for the exits, the sound of that gold bubble popping will be loud and clear.