On Monday, the rationale for owning gold collapsed along with its price. The yellow metal plummeted more than 10%, settling above $1,350 an ounce at the close before bouncing back a bit Tuesday. That was its lowest level since February 2011, crashing through every support level in sight and pushing gold deep into bear market territory. It's down 28% from its peak above $1,900 in August 2011.
But gold's price could be headed much, much lower, said Campbell Harvey, a professor at the Fuqua School of Business at Duke University. Harvey has looked at gold prices over the centuries, and concludes that it's still trading at lofty multiples of inflation. At more normal multiples, he told me, it would be changing hands below $800 an ounce. If it gets there, many investors who loaded up on gold coins, bullion, shares of gold mining companies, and gold ETFs will get a rude awakening.
In a recent paper, Harvey and colleague Claude R. Erb, whom Mark Hulbert interviewed earlier this week, systematically demolished most of the reasons people have owned gold in recent years. You can download their paper, "The Golden Dilemma," for free here. There's no evidence, they say, that gold has been either an effective currency hedge or a "safe haven." And it’s not even a very good hedge against inflation, except in some very extreme circumstances. Indeed, I would argue that gold bugs' capitulation on the prospects for hyperinflation is behind the current price collapse.
But let's start with its value as a currency hedge. "There seems to be little connection between currency returns and gold returns," Harvey and Erb wrote. "In fact, the change in the real price of gold seems to be largely independent of the change in currency values."
Nor is it the kind of "safe haven" in chaotic times investors wish for, peasant lore and urban legends notwithstanding. Harvey and Erb tell about the "Hoxne Hoard," the largest collection of Roman gold and silver coins ever discovered in England. Archeologists dated the collection to the fifth century, "a time of great social stress and political turmoil in England," when the Romans were abandoning the island. But when the treasure was unearthed in 1992, it was untouched, suggesting that the wealthy family that hoarded it got little use out of it. "Indeed, the Hoxne Hoard is an example of an 'unsafe haven,'" Harvey and Erb conclude.
Gold is also, well, pretty heavy, making it difficult to schlepp around when society has broken down and you have to move quickly. Not to mention that we haven't gotten to that state in the modern world -- and all the money printing by all the central banks won't get us there, either. Which brings us to inflation, the traditional reason people own gold. But tracing prices back to ancient Rome, Harvey and Erb show it's not a good inflation hedge at all, except maybe over extremely long periods.
"Gold may very well be a long-run inflation hedge," they wrote. "However, the long run may be longer than an investor's investment time horizon or lifespan." Or, as Keynes said, we'll all be dead. "Gold is too volatile to be an inflation hedge" over shorter periods, Harvey told me, even in rare periods of hyperinflation.
They looked at Brazil, which suffered annual inflation of 259% in the 20 years between 1980 and 2000. "If you bought gold over that period, the real price of gold fell by 70%," Harvey told me. "If you held the Brazilian real [or cruzeiros], you lost everything. If you held U.S. dollars, you were flat."
So, the best hedge over that period was the much-maligned U.S. dollar. Of course, that was a different era for the dollar, but his point is that in a recent period bordering on hyperinflation, gold lost much of its value, too. Over the past week, investors have thrown in the towel on hyperinflation fears. China's report of sub-8% GDP growth has intensified a general plunge in commodity prices. It came on top of reports of slowing growth in the U.S. and persistent weakness in Europe.
Disinflation and even deflation appear to be the bigger risk now, so fears that central bank money printing will result in a new inflationary surge look more and more remote. That's one reason Harvey thinks gold will return to a more normal multiple. At $1,900 an ounce, the yellow metal changed hands at around eight times the Consumer Price Index, adjusted for inflation, since 1975. Now at around $1,400, it's still about six times CPI.
But at the historical average of 3.2 times CPI, gold would trade below $750 an ounce, about where it was at the depth of the 2008-09 financial crisis. Whether it falls that low or not, Harvey advises investors to buy gold only as part of a diversified portfolio of commodities comprising no more than 5% to 10% of their portfolios.
The Dow Jones-UBS Commodity Index Total Return ETF (DJP) and the PowerShares DB Commodity Index Tracking ETF (DBC) are broadly diversified commodity funds with modest precious metal holdings. I don't own much gold, either, but I may lighten up some more on reflex rallies of the kind we saw Tuesday. Because as Warren Buffett wrote in Berkshire Hathaway's 2011 annual report: "What motivates most gold purchasers is their belief that the ranks of the fearful will grow ... As 'bandwagon' investors join any party, they create their own truth -- for a while."
The party is over and the bandwagon is hurtling in the other direction, creating a new truth -- but this time it looks like an awful one for gold investors.