Why Gold Hasn't Been a Hedge Against Inflation

As I toured around the world to talk about the merits of gold during the last several years, the same question was posed to me over and over again:

"John, oil is $80, $100, $150 a barrel, why hasn't gold lived up to its reputation as a hedge against inflation?"

Oil's triumph over gold from 2001 - mid 2008

While gold investors fared well as gold went from $250/oz in 2001 to $1,000/oz in early 2008, oil investors reaped stupendous profits as oil prices topped $145/barrel in July 2008, up from $22/barrel in 2002.

Ten year charts of gold and oil:

People have attributed oil's superior rise, and the relative underperformance of gold to:

1. Peak oil theory.
2. Emerging market needing oil, not gold.
3. Oil is consumed and gone, while there is lots of gold.
4. Jewelry market favoring platinum, not gold anymore.
5. Central banks having lots of gold to sell.

And my answers have always been:

1. Oil production has been rising yearly from 60 million barrels a day in 1980 to now over 80 million barrels a day.
2. Gold is about preservation of global wealth, which is ever increasing.
3. Gold is money, which is to be saved, not consumed.
4. Jewelry demand represents a tiny fraction of gold's trading or gold's total volume, most of it in bullion form.
5. True, but central banks today have also inordinately large amounts of US dollars (over $8 trillion), yet to be diversified.

So why was gold lagging until recently? My single most plausible answer was:

"People are buying the growth story. Speculators like oil, not gold at the moment."

Financial deleveraging and gold's resurgence in 2008

The fortunes of gold and oil have reversed 180 degrees since July, when we witnessed the most spectacular fall in oil's history in the last 100 years. The oil price plunged over $110, or 75% from $147 to $37 a barrel. You can't possibly explain away such dramatic correction by fundamentals. So what if super tankers are storing oil and world oil inventory now can sustain 59 days instead of 54 days of global consumption? Would you see the price of milk go down 75% because people are cutting back consumption?

In my view, the freefall of oil price has more to do with the collapse of Lehman Brothers, US banking, and US hedge fund industry. Many of those outfits were leveraged up to 30 times, bankrupt, and had to close out entire lines of positions (including oil) in a hurry at any cost.

We can also see the rapid and all-out deleveraging through the reversal of yen carry trade. The yen has gone up 24% since August not because Japan all of a sudden became a star investment destination.

12 month yen chart:

Where is gold headed?

Adjusted for inflation/CPI/money supply growth, various analysts have pegged a fair gold price of between $700/oz and $1,200/oz. Gold authority James Turk will show you how gold has exchanged more or less the same units of oil through hundreds of years.

20 year chart of gold to oil ratio:

The lower and upper horizontal bands in the chart above show an oz of gold has exchanged between 22 and 10 barrels of oil since 1989. The ratio dipped to as low as 7 and right now it trades at 20. One shouldn't buck against the trend and I expect the ratio to exceed 20 to reach perhaps 30 or more.

You can play with two of the three variables (oil, gold, and ratio) and come up with the third. For example, at ratio of 30 and oil price of $50/barrel, the formula produces a gold price of $1,500/oz. I honestly have no idea what future lies ahead, except

• Oil is oversold and cheap
• Gold is not expensive by historic means
• The gold-to-oil ratio will keep rising until it comes down.

Fundamentally gold is attractive as an investment of last resort. It's no good to leave money at the banks earning zero interest, or buy real estate that is faltering, or invest in the equity market during recession.

While gold's blow-off phase is yet to come, I would like to offer a word of caution. Given how quickly things can change, it might soon be a good idea to hedge gold positions by going long oil.

Enjoy the ride and happy holidays from all of us at Mau Capital.

Comments

[User 282223:]

If oil is over sold, then is must be over bought: Selling requires buying.

Gold is about right in history.

There is no correct "oil to gold price."

2008 Dec 21 05:13 PM

[Alex Filonov:]

Every article about gold supply and demand which doesn't mention India, is a bunk. How can you explain price of gold if you forget about country which consumes at least 30% of it?

2008 Dec 21 05:15 PM

[NOWHEREMAN:]

When gold revved up above $900, Indian buying slowed. This was before the Rupee tank against the dollar. Indian Weddings traditionally require large amounts of Gold, they could no longer afford the associated cost. I would imagine, that although Gold has fallen since then so has the Rupee.

Demand destruction of a different sort. IMO

2008 Dec 21 05:51 PM

[silverwood:]

Just like everyone was bullish on the price of oil earlier this year, now the pendulum has moved the other way. As the hedge funds delelvered, the smart guys got short oil and are still short oil. Shortly some event will occur and the shorts will run for the hills and oil will shoot back up, you can count on it!

2008 Dec 21 06:23 PM

[slickvguy:]

"The gold-to-oil ratio will keep rising until it comes down."

Brilliant.

2008 Dec 21 06:52 PM

[Anthony Dad...:]

Gold is no longer the standard.

2008 Dec 21 07:08 PM

[sbenard:]

My gold bug buddies are going to want to send you to the guillotine, John!

2008 Dec 21 08:11 PM

[Vladimir Se...:]

John,
you said that eventually it might make sense to hedge long gold positions by going long oil.
Excuse me for stating the obvious, but this is very difficult to do with oil. Gold is easy. I buy bullion and store it in a vault. Oil on the other hand is expensive to store. If you think oil is "cheap" now look at the contango! It's not going to be cheap at all if you wanted to hedge a longer term position (even if it is just a few months long).

2008 Dec 21 08:52 PM

[bthomas:]

It is still early for long oil. As the global conditions worsen, the economies most dependent on oil export are 'over a barrel'. Despite promises and pledges to reduce production their nationalized oil economies cannot afford it. As an inflationary hedge stick with aurum. As conditions improve (months away) oil will slowly rise as the shorts are squeezed. Fed policy helps gold as well. Ben's helicopter is really an inflation machine.

2008 Dec 21 08:57 PM

[Alan von Al...:]

I'm not persuaded that speculators (i-banks and hedge funds) were responsible for driving commodity futures prices up or down. The CTFC conducted an investigation last spring without finding much of anything except volatility and momentum trades. PBR ran from $30 to $70, for instance, on widespread misunderstanding of new reserves.

www.bloomberg.com/apps...

It seems reasonable to me that oil and base metals fell sharply in reaction to the broader credit market collapse and global demand destruction. China abruptly halted commodity imports.

It's important to keep in mind the microeconomic principle of marginal utility. The last particle of capital invested is the marginal rate. The spot price of the last barrel of supply ripples through the whole downstream business, and likewise a marginal drop in demand in Peoria broadcasts an amplified sell signal to the markets in Chicago and Singapore.

At the moment, oil production is very slightly in surplus to demand. What this has to do with gold, I dunno. Gold production is unable to supply current demand, and however depressed we are in terms of speculative investment, gold seems to have established firm support at $800. If the dollar drops, demand for gold will rise. No connection to oil.

2008 Dec 21 09:01 PM

[steveballmer:]

I have a few tons buried on the south forty! Dang!

2008 Dec 21 09:23 PM

[Greg Pinelli:]

People really pay you to talk about gold?? Tha's astounding. Gold's not a hedge against inflation? Have you EVER looked at a chart? Gold is one of the very few investment to be up during the past 4 years..It is not only a hedge against inflation..it's one of the few that exist.
So lets talk a few facts Mr. Lee..
1. Since July 2008..Gold has gone from $980 to $840 and change (Sunday Asian Market)..a decrease of 14%..most..if NOT ALL due to panic deleveraging..Ever heard of that? I thought not.
2. Oil (WTIC) has gone from $145 to $42 and change....a decrease of 71%!

THESE STATS ARE FROM inflationdata.com....C... inflation since Jan 2006 to Nov 2008 is 12.17%...GOLD'S GAIN IN THAT SAME TIME FRAME IS +64.71%..

2008 Dec 21 09:54 PM

[Bill M:]

100 years a go, 1 ounce of gold would buy a nice suit, today an ounce of gold will do the same. How is this not a hedge against inflation?

Its not a good investment as in the past 100 years gold has returned 2-4% while the stockmarket is up 10-12%

2008 Dec 21 10:57 PM

[NOWHEREMAN:]

The stock market indexes are constantly manipulated. Of the original Dow 30, I believe only GE is left. The So Called returns include replacing the dead, the ones with low prices, as well as the acquired with higher priced substitutes. Comparing the return on Gold whose price was artificially restrained for 60+ of the last 100 years is not tantamount to comparing apples to apples.

There are thousands of stocks no longer in existence. People usually invest in stocks not Indexes. Indexes do not pay a dividend so the inclusion of dividends into the average annual return process is manipulation of people into thinking that they are better off in stocks than say, Treasuries or even Gold over a lenghty period of time.

IMO

2008 Dec 22 01:28 AM

[ewr:]

Some interesting points, accompanied by very suspect English. I, along with, presumably, many other investors, are very wary of the value of commentary that can not take the trouble to express itself correcty. Does this carry over into the care with which the comments have been researched ?

2008 Dec 22 01:30 AM

[DONE_SONZ:]

Currencies are dead.Gold is king.

2008 Dec 22 05:47 AM

[ATWshop:]

We are attempting to explain human behavior? After years of watching and reading... the conclusion regarding Gold price movements is quite simple. When times get tough...people buy gold because they are lemmings.
The Gold Loonies come out from under the rocks when times get tough and start telling everyone the same old story about how Gold is an inflation hedge and you have to buy it in case the financial world comes to an end.... baloney! Of course all the uneducated lemmings buy into this conspiracy of the world coming to an end and buy Gold, only to sell it a year or two later at a loss.
Don't worry, the next time things get tough... the Gold Loonies will be there with the same old story to take more Lemmings over the next gold cliff.
How about using Campbell Soup as an inflation and Doomsday hedge? This makes more sense to me... if you are right, you can trade a case of Soup for some sucker's home... if you are wrong, you can always eat the soup, which was purchased at a much lower price years before!!! Pretty hard to loose with this investment.

2008 Dec 22 07:22 AM

[NOWHEREMAN:]

Canned food is far too shortlived to be a good inflation hedge. Freeze dried or MRE is the way to go. IMO

2008 Dec 22 10:20 AM

[Chris B:]

"As I toured around the world to talk about the merits of gold during the last several years..."

Perhaps you should try spam email or faxes to get people to gold.

Folks, use some critical thinking. If you really believed the theories about a complete worldwide economic meltdown, and you felt that gold ownership would be the only way to preserve your wealth when it happened, would you be flying all over the globe and posting all over the internet trying to get more people to buy it? Wouldn't driving up the price be counterproductive to your goal of exchanging all your fiat currency for as much metal as you can get? Do you really think these guys are sharing their doomsday insights because they really care about you anonymous internet surfers and truly want EVERYONE to buy gold so EVERYONE can get rich?

Critical thinking, folks. It's how you avoid the pump-and-dump scams, the Bernie Madoffs, the pyramid schemes, and the various marketing hypes of the world. In investing, nobody cares about you and nobody has charitable intentions. Remember that.

2008 Dec 22 10:42 AM

[GMiki1:]

I sold a few ounces of gold last week having bought a bunch at $401 a little more than four years ago. Great hedge. I haven't done as well in energy, though I believe it will be great going forward and might well outperform gold at some point.

2008 Dec 22 01:00 PM

[NOWHEREMAN:]

Gmiki: Good idea to take some money off the table. Gold could take a really serious plunge next year if GLD unravels.

Better safe than sorry and its always better to play with the House's money anyway. IMHO

2008 Dec 22 03:04 PM

[frank90291:]

big macs (MCD) has done better than GLD for the last 3 years but that is it....... GLD has done 18%/yr average since it's creation in November of 2004 so what's the problem with that......... use a 300 dSMA and SET YOUR "STOPS" then get a life. Do it in your self directed IRA to avoid tax hassles.

2008 Dec 22 06:48 PM

[FB5000:]

Gold is a strong inflation hedge. Oil less so; it is not easy to store and it is a proxy for industrial activity - so it lags inflation does not lead it. further it is confounded by the actions of OPEC.

Gold will stagnate for a little while and tthen pick up as inflation come back probably in 2010. Oil is anyone's guess.

Take Care

2008 Dec 22 09:45 PM