Academic journal article Quarterly Journal of Finance and Accounting

Gold and the Value-Growth Differential in Stock Returns

Academic journal article Quarterly Journal of Finance and Accounting

Gold and the Value-Growth Differential in Stock Returns

Article excerpt

Introduction

Gold is in demand as an investment, as jewelry and as an industrial commodity. The demand for gold as an industrial commodity is relatively stable over time. However, the demand for gold as jewelry and as an investment changes substantially across time. For example, in 1998 the demand for jewelry gold was 80% of the total demand for gold, and the demand as an investment was only 7% of the total demand for gold. But, at the end of 2009, the former was 45% and the latter was 40%. (1)

As an investment, gold is similar to growth stocks in that it does not pay any cash dividend, but as jewelry it provides consumption dividend. We expect, therefore, that when the demand for gold as investment is high, the return on gold is similar to the return on other growth investments. On the other hand, when demand for gold as jewelry is high, the return on gold is less similar to growth investments. Consequently, as the relative portion of the jewelry demand for gold changes, its correlation with the value-growth factor in stock returns should change as well.

Rising stock prices can cause the demand for gold as jewelry and as an investment to increase simultaneously (that is, increases in investor wealth may cause the demand for both components to increase). However, even if the changes in the demand for gold as investment and as jewelry are in the same direction, the incremental change for the two components could be different. Accordingly, if an investor adds gold to a stock portfolio as an investment asset, its effect on the portfolio's returns along the value-growth axis could be separate from its effect along the market axis. It is also likely that combining gold with stock portfolios could have different effects on the Sharpe ratio depending on the tilt of the portfolio along the value-growth axis.

Another property of gold is its tendency to move against the value of the dollar (Pukthuanthong and Roll 2011). Big firms are likely to have larger multinational exposure than small firms and are thus more likely to be affected by changes in the value of the dollar. Consequently, gold may be sensitive to some of the same forces that influence the small-big differential in stock returns. Adding gold to stock portfolios could therefore cause style drift along the small-big axis. Also, the impact on the Sharpe ratio could be different when combining gold with small stocks versus combining gold with large stocks.

In this paper, we regress the excess return on gold (relative to the return on a 30-day T-bill) against the augmented Fama-French factors as in Carhart (1997). This approach helps assess gold's sensitivity to the market factor (Rm-Rf), the small-big factor (SMB), the value-growth factor (HML) and the momentum factor (UMD). When used together, these factors capture much of the common variation in stock returns compared to using only the market factor. Our approach provides an assessment of gold's sensitivity to these pervasive influences on stock returns. (2)

Our findings indicate that gold is a hedge against value stocks during periods of falling inflation, expansive monetary policy, recessions and a falling dollar. However, gold is a hedge against growth stocks during equity bull markets, periods of rising inflation and periods of restrictive monetary policy. Gold's loading on the market factor also changes sign across business/economic regimes, but these sign changes are unrelated to the sign changes in its loading on HML. Gold's loadings on SMB and UMD are either zero or positive depending on the business/economic regime. Thus, the empirical evidence indicates that combining gold with stock portfolios can change the portfolios' sensitivities to the augmented Fama-French factors. Further, our findings indicate that adding gold to stock portfolios improves their Sharpe ratios irrespective of their style (market, value, growth, small, big, momentum winners and losers) during most business economic regimes, but it reduces their Sharpe ratios during periods of rising dollar value and recessions. …

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