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It has finally become well known that gold is great to own in times of serious uncertainty. Investors ranging from multi-billion dollar hedge funds to blue collar retirees have been pouring money into the this metal, mostly through gold ETFs such as GLD and SGOL.

If you ask these investors why they want to own gold, you will get a variety of answers. Some might say that they’re hedging against inflation. Others will say that they don’t trust the government and think the Federal Reserve will keep printing money to pay off our debt. There is the fear that the powers that be will debase the dollar vs. other currencies in a desperate attempt to juice exports and, theoretically, economic growth. And still others believe we will have to go back to a gold standard in order to hit the reset button on our impossibly overwhelmed national finances.

All of the reasons cited above have some merit to them. But it’s important to take a look at what has happened historically during large movements in gold prices. Let’s start with the ultimate meltdown: The Great Depression. Gold prices were not reliably published on a daily basis during this time period, but we do have the stock price of the largest gold miner in the U.S. at the time, Homestake Mining. In September of 1929, the Dow Jones Industrial Average (DJIA) hit its peak of 381. Homestake Mining’s stock was at 80. By December 1935, the DJIA was at 41, an 89% decline, while Homestake Mining was at an eye-popping 495, a 518% increase. Add to this the fact that Homestake actually increased its dividend payout, giving its shareholders a total of $128 per share over this time period.

There are a couple of things to keep in mind when looking at an analysis such as this. First, we are looking at a gold mining company, not gold itself. Gold miners are leveraged plays on the price of gold due to their swings in profits as the price of gold gyrates. Secondly, after passage of the Gold Reserve Act, President Roosevelt devalued the dollar against gold in early 1934 from $20.67 an ounce to $35 an ounce. This was a boon to those who held gold, especially miners, and nothing short of theft from those holding dollars.

Even with the two caveats mentioned, the astronomic rise of Homestake Mining during this time period cannot be ignored. What makes it all the more interesting is that the inflation rate, as measured by the CPI at the time, actually fell by 21% from 1929 to 1935. This goes against the theory that gold is a good hedge against inflation. If this were true, gold and gold mining stocks should have done poorly during this time period.

Let’s now look at a time period when gold was a good hedge against inflation. From 1970 through 1975 gold started a meteoric rise, increasing by 375%. During this time period, as the chart below shows, the CPI also began to climb, peaking at a year-over-year rate of 12%. Gold also had a similar bull run in the early 80s when the CPI index hit a peak of nearly 15% y-o-y.

After the 1980 bull market in gold, we see something interesting happen. From its peak in 1983 through April 2003, gold fell by 51% while the CPI increased by over 118%. During this time period, gold was a terrible hedge against inflation.

Why did gold do so well against the backdrop of serious inflation in the 70s and early 80s, but so poorly afterward? The reason is that the inflation rate, while positive, was relatively stable and low. It is tempting to make the following generalizations about what has happened historically to gold under times of economic stress and under times of relative stability.

Severe

Deflation

Severe

Inflation

Stable/Moderate

Inflation

Gold Price Way Up Way Up Down or Little Change

But this does not do justice to the real explanation about what was happening during these time periods and what is happening today. During the Great Depression, the credit system collapsed and the government was becoming involved in many more facets of our economy. There was widespread and justifiable fear that the only way out for the government was to print money. The world had already seen what Weimar Germany did to try and get out from under its massive debt and economic problems. They turned to the printing press. Now they were afraid that their own government would resort to the printing presses in order to break out of the deflationary spiral the U.S. was in.

We are in a similar situation today. Even though inflation as measured by the CPI is nearly 0%, the price of gold has gone up 133% since the housing market started its collapse in 2006. We are still undergoing a massive deleveraging as the largest credit bubble in history unwinds. We have a Fed chairman who has told us that he wants inflation and will do whatever it takes to get it. The Fed is monetizing federal debt by openly buying U.S. treasuries in the bond market. Even though CPI inflation remains tame, there are plenty of people who sense trouble.

There are those, like myself, who see the beginnings of the end of our fiat currency regime. Then there are those who simply know that something is inherently wrong with printing money and buying debt. Either way, there are enough investors out there speaking with their wallets and they are buying gold. There are skeptics who are pointing out that gold is at its all time high. Yes, but that is in nominal terms. If we deflate the price of gold by the CPI, even though it admittedly has a host of problems as a price index, we do see that today’s price is at least 30% lower than the peak achieved in 1980. Given the changes made over the years to the CPI by the government to help bias it downward, it is likely that the difference is greater than that.

One lesson to take away from this analysis is that gold is not a good hedge against inflation in the short run if inflation is relatively low and stable and there is no economic turmoil. Over the long run, yes gold will keep up with inflation and will protect your wealth. But the real upward swings happen when people begin to fear the collapse of the currency. The dollar is based on nothing but faith and in the end it is worth only the paper it is printed on. Gold has historically been the ultimate shelter for wealth as people flee fiat paper currencies. Based on history and the size of the deleveraging that has yet to occur, this bull run in gold is far from over.

Disclosure: Author holds positions in GLD and GDX

Source: What Is Gold a Hedge Against?