Gold Isn't Tracking Inflation as Well as Oil and TIPS

Playing the Reflation Rally

Monetary and fiscal stimulus have ignited a reflation rally and a liquidity boom, and this explains most of the recent movements in stocks, bonds, commodities and precious metals. I believe that playing reflation correctly is the key to investment performance for the rest of 2009. Reflation is bullish for stocks, which will benefit from rising corporate earnings (in nominal terms) and reflation is generally bearish for bonds (due to maturity risk), though hi-yield will benefit as reflation reduces defaults and credit risk.

What's the Right Inflation Hedge?

I also believe that inflation relief won't last, so I have been bullish on oil, gold, and TIPS. Nevertheless, I've reconsidered my motives for owning gold, since its price doesn't track inflation; instead, it tracks fear of financial collapse. The chart below tracks Gold against the S&P 500 (IVV).

Gold Hasn't Been Tracking Inflation

Gold was negatively correlated with stocks from November through March, when investors feared the world was coming to an end. Gold was serving as a store of value, and it was not hurt by deflation fears. (If gold is an inflation hedge, it should have collapsed when deflation was all the rage.) In March, a reflation rally for stocks was ignited by positive economic surprises and huge amounts of monetary stimulus. Gold gave back its gains after March, and since then it has been positively correlated with stocks. It's odd that gold has held steady in spite of the obvious possiblity that reflation will morph into inflation: Why isn't gold rising faster? I believe that it's because gold is not acting as an inflation hedge; rather, it has become a hedge against financial catastrophe. That is a good reason to have a little gold in your portfolio, and not necessarily because of its inflation-hedging properties.

Oil Benefits from Reflation or Inflation

Over the last six months, oil has tracked U.S. equities, though it has fallen and risen more sharply. I believe that oil will be the key beneficiary of global reflation, and I owned it from March through early June. I sold my position earlier this month because I thought that oil prices had gotten ahead of economic reality. Since then, and I've been waiting for a pullback, or for improved fundamentals to buy. Oil has been holding up better than I expected, so I may have misjudged how much global liquidity is available. In any case, the monetary stimulus must convert into global demand relatively soon, or the excess inventories of oil will overwhelm the long-term bull case for energy.

TIPS Are Working

Treasury Inflation Protected Securities (TIPS) have been successfully tracking expectations of both deflation and inflation since late last year. (The underperformance of TIPS in 2008 was an anomoly caused by depression fears.) In 2009, TIPS are up about 5% compared to a 4% loss in Treasuries, according to this article today on Yahoo Finance, originally in the Wall Street Journal. Moreover, TIPS are still fundamentally attractive, since they assume only 1% inflation over 5 years and 2.5% inflation over 10 years. For tax reasons, TIPS are best in 401(k)s and IRAs, but I still think they are the best form of pure inflation insurance.

Rebalance After the Green Shoots Wither

I plan to rebalance my positions as economic optimism fades. I believe second-quarter earnings guidance will be disappointing, causing stocks and oil prices to retrace their gains, and inflation concerns to temporarily fade. This pullback should provide an opportunity to add to stocks, TIPS, and USO. The slump in fundamentals may also provide the opportunity to trim gold if depression fears boost the price. In the meantime, I still own a little gold, just in case my assumptions are all wrong and financial catashtrophe is lurking just around the corner.

Disclosure: Long GLD, IVV, TIP; waiting for a pullback on USO.

Comments

[Egg:]

Patience.

Gold has doubled in the last few years. The price of bananas has not....yet.

Jul 01 11:34 PM

[Roger Knights:]

I think you're right about inflation not being the main driver of gold's price, but rather systemic risk. (I've made comments to this effect here myself.)

In addition, there are two growing demand-drivers for gold. First, as a superior diversifier for portfolios. ("Bullion is a beta-blocker.") Second, net central bank buying. If China wants to establish the Yuan as an international currency, it will need to back it up with more gold. It's starting to do so, and other central banks have been ramping down their selling.

Jul 02 12:03 AM

[Roger Knights:]

PS: Gold's sensitivity to indications of systemic risk implies that it should jump somewhat when the news hits world headlines that California has defaulted. Every state that follows it will be another shoe that drops and boosts gold. State and municipal bonds will become less attractive, and gold more attractive, to conservative investors.

(If the US backs up the bonds of the states and cities, then Treasuries will become less attractive relative to gold.)

Jul 02 12:14 AM

[TradingHelp...:]

There is no reason why gold should have a higher correlation to inflation than other commodities.

It is unique, a safe haven in times of chaos. It sits in the gap between risk-free assets and traditional risky assets like equities, high yield bonds, property, etc (that are increasingly highly correlated).

Everyone needs some gold. The question is what percentage of one's portfolio should it represent? 5%, 10%?

The correlations support my theory: seekingalpha.com/artic...

Jul 02 03:39 AM

[watchthedow...:]

At this stage gold will track stocks until inflation is actually seen....gold is trading at its 40-yr median of 1/9.25 of DJIA.......in the 1973/74 period, gold behaved the same way until actual inflation was seen......historical correlations can break down temporarily, and my best estimate is that gold will not be a great safety net against a drop in stocks until inflation shows itself, or until gold gets too cheap and generates real long-term buying interest (not just the hyperinflation tomorrow crowd)

Jul 02 07:20 AM

[paultheprofit:]

Tips...EH' ..???...you really trust the Gov. to give out PROPER and FAIR number's....

REALLY....

How 'bout this...look how much R.E. values have gone/going down...and see what GOV. tells you it went down when you get the tax bill.

30/40% actual to the gov. telling it only went down 8-10%...

roflmao at ANYBODY who suggests investing in TIPS...j/geez

Jul 02 07:32 AM

[GMiki1:]

Why expect gold to work the way it doesn't? It works a little differently. But it does work. Moreover, we do have inflation. Try paying last year's prices for something you need. At any rate, hyperinflation starts suddenly, those who've experienced it say. Get your gold now while you can still buy it at a reasonable price. What percent? Twenty percent of your holdings or higher.

Jul 02 10:59 AM

[billyboy54:]

Harry Schultz, one of the oldest, most widely known, and most venerable of financial newsletter writers, advised his newsletter recipients last year to hold AT LEAST 30% of their portfolios in gold and gold stocks.

I followed his advice, but hold more than that........I've done well, while all my retired friends who let others handle their money, have lost 30-50% of their life savings.

This is why I hold gold and gold stocks.

Jul 02 02:39 PM

[Robert Mart...:]

Roger Knights: Excellent points about China and about gold as a portfolio diversifier. We could also add in "gold as hedge against dollar collapse."
I am amazed at how many dollar bulls rely on the USD as a global reserve currency. That is true, but it's backward looking. China's gold purchases and trade surplus bode ill for greenbacks.
Thanks for your comments. Well put.

On Jul 02 12:03 AM Roger Knights wrote:

> I think you're right about inflation not being the main driver of
> gold's price, but rather systemic risk. (I've made comments to this
> effect here myself.)
>
> In addition, there are two growing demand-drivers for gold. First,
> as a superior diversifier for portfolios. ("Bullion is a beta-blocker.")
> Second, net central bank buying. If China wants to establish the
> Yuan as an international currency, it will need to back it up with
> more gold. It's starting to do so, and other central banks have been
> ramping down their selling.

Jul 03 12:33 PM

[Robert Mart...:]

BillyBoy54: Thank you for your comment.
I congratulate you on your investment success, since you avoided the collapse in capital markets last year. Looking ahead, however, do you believe that gold will successfully hedge your investment portfolio against inflation? Gold's price action recently suggests that it will track fear, not inflation.
Thanks again,
Rob


On Jul 02 02:39 PM billyboy54 wrote:

> Harry Schultz, one of the oldest, most widely known, and most venerable
> of financial newsletter writers, advised his newsletter recipients
> last year to hold AT LEAST 30% of their portfolios in gold and gold
> stocks.
>
> I followed his advice, but hold more than that........I've done well,
> while all my retired friends who let others handle their money, have
> lost 30-50% of their life savings.
>
> This is why I hold gold and gold stocks.

Jul 03 12:36 PM

[Robert Mart...:]

Gmiki1:
Thank you for your comment. I agree that a little bit of gold belongs in most portfolios, but I could not put 20% in mine. I would want to own some silver, palladium, and platinum, since these precious metals should benefit from rising global growth fueled by the reflation rally.
Nevertheless, there are many investors like yourself who believe that the CPI data from the U.S. government are fabrications, halucinations, misinformation, or a combination of the three. In this case, gold should work better than TIPS, which are explicitly linked to the CPI.


On Jul 02 10:59 AM GMiki1 wrote:

> Why expect gold to work the way it doesn't? It works a little differently.
> But it does work. Moreover, we do have inflation. Try paying last
> year's prices for something you need. At any rate, hyperinflation
> starts suddenly, those who've experienced it say. Get your gold now
> while you can still buy it at a reasonable price. What percent? Twenty
> percent of your holdings or higher.

Jul 03 12:40 PM

[Robert Mart...:]

paultheprofit:
Thank you for your comments.
You say that housing fell much more than the government numbers suggest, so I guess you are saying that the CPI overstates inflation. If so, that would be bullish for TIPS.

I have noticed that the CPI is universally reviled in the blogosphere, and it is now an urban myth that the BLS cannot be trusted. Critics attack the weightings in the CPI and the methodology. It sounds like you are attacking the use of owner equivalent rent to track housing prices.

In my article "Why Marc Faber Is Wrong About the CPI", I defend the methodology of the BLS. The CPI may not be perfect, but I haven't seen a better alternative.

Bottom line: TIPS have worked as an investment this year, and as an inflation hedge.

On Jul 02 07:32 AM paultheprofit wrote:

> Tips...EH' ..???...you really trust the Gov. to give out PROPER and
> FAIR number's....
>
> REALLY....
>
> How 'bout this...look how much R.E. values have gone/going down...and
> see what GOV. tells you it went down when you get the tax bill.<br/>
>
> 30/40% actual to the gov. telling it only went down 8-10%...
>
> roflmao at ANYBODY who suggests investing in TIPS...j/geez

Jul 03 01:08 PM

[Robert Mart...:]

Watchthedownside:
Well said!
I was unaware of the historic price action of gold vs. stocks in the '73-'74 recession. You've laid out a good indicator for gold, so I may be short-sighted in my analysis.
Thanks again,
Rob

On Jul 02 07:20 AM watchthedownside wrote:

> At this stage gold will track stocks until inflation is actually
> seen....gold is trading at its 40-yr median of 1/9.25 of DJIA.......in
> the 1973/74 period, gold behaved the same way until actual inflation
> was seen......historical correlations can break down temporarily,
> and my best estimate is that gold will not be a great safety net
> against a drop in stocks until inflation shows itself, or until gold
> gets too cheap and generates real long-term buying interest (not
> just the hyperinflation tomorrow crowd)

Jul 03 01:12 PM

[Robert Mart...:]

Roger:
Thanks for your comments about California. If the Treasury bails out CA, we will be one step closer to dollar collapse.
Rob


On Jul 02 12:14 AM Roger Knights wrote:

> PS: Gold's sensitivity to indications of systemic risk implies that
> it should jump somewhat when the news hits world headlines that California
> has defaulted. Every state that follows it will be another shoe that
> drops and boosts gold. State and municipal bonds will become less
> attractive, and gold more attractive, to conservative investors.
>
>
> (If the US backs up the bonds of the states and cities, then Treasuries
> will become less attractive relative to gold.)

Jul 03 01:13 PM