Gold's Not the Best Investment in Inflationary Times

| About: SPDR Gold (GLD)

Previously we talked about why it’s important to own “things” (i.e. commodities, stocks, homes) for the long run, especially since the government is willing to dramatically increase the supply of money (making existing money worth less, and assets worth more). Basically the government is potentially going to create a lot of inflation at some point down the line. So the question that is always asked is, if we are heading into an inflationary environment shouldn’t we buy gold?

There are two reasons people buy gold - as an investment or for jewellery (there is a small percentage used for industrial applications as well, but for our purposes let’s ignore that). I have to imagine that jewellery sales are declining, or at least gold jewellery sales, as silver is currently a more attractive option (it’s in style and 1/80th the price). So anyone investing in gold today is making a bet that either a) the economies of the world get materially better (and jewellery demand picks up as people start spending more on luxuries) or b) because there are inflation concerns (money will be worth less, therefore gold is worth more).

If you’re investing in gold because you think the economy will get better and jewellery demand will increase (even at gold’s current high price, relative to everything else) then, simply put, you’re crazy. If the economy recovers (and with it jewellery demand), and that is the bet you are willing to take, then there are thousands of better investments than gold.

Since I don’t really think anyone is that crazy, then the only rational reason people are investing in gold today is the safe haven trade. That is, gold is viewed as a safe haven against inflation. I’m going to lump the collapse of capitalism into “inflation”, meaning the extreme gold bugs who see the US dollar becoming effectively worthless (not worth less) and the world ending, are effectively making an inflation trade. An extreme one, but an inflation trade none the less. As an aside, why do gold bugs put US dollar price targets on gold? The ones that think the US dollar is going to collapse and gold will go to $5,000/oz are effectively saying that they would trade their gold for US dollars at some price. If the US dollar is worthless, it's worthless - why trade your gold for something that is worthless?

Ignoring the extreme case, the argument, going forward, is effectively that the Fed has created such an enormous supply of US dollars that when people get around to spending them the inflation will be massive. So if you want to protect against inflation you buy gold, since it is perceived to have significant value and that value relative to dollars will be more significant in the future. Of course that logic is somewhat circular.

Imagine we lived in Perfect and there were 1,000 citizens each with $1,000 dollars. The price of gold is $850/oz in Perfect and the price of a basket of other goods is $850 and their main index trades at 850. The government of Perfect decides that the citizens need more cash so they give everyone $1,000 more. In Perfect the price of gold would go up to $1,700/oz, the basket to $1,700, and the index to 1,700. You can still only change 1 ounce of gold for 1 basket of goods or 1 unit of the index. You are only better off having purchased gold as an investment if your alternative was only to leave it in cash. That is, if you are faced with the choice of money in the bank or investing in gold, then the choice is clear in an inflationary environment… invest in gold. In Perfect the price of gold would increase at the rate of inflation.

The last year, however, has taught us that we do not live in Perfect. We live in Far From Perfect, the land where perception is reality. The perception, as it relates to gold, is that we are entering an inflationary period that is going to send the price of gold skyrocketing. So the price of gold has held in relatively well (compared to any other ‘asset’ class) and that is the current reality. The true reality is that inflation CANNOT exist without increased economic activity. That is, you can increase the money supply all you want, but if people don’t spend it then there won’t be inflation. Inflation occurs when people get into bidding wars for goods and services. If we have increased economic activity then, as I said before, there are thousands of better investments than gold.

I’m not saying gold won’t increase in price in 2009. I’m just saying everything else will probably increase more.

From the team at Magna Partners, we wish you a happy, healthy, and prosperous New Year!

Stock position: None.