History has taught us that certain assets perform better during inflation, while other assets thrive in a deflationary environment. There is a common perception that hard assets and commodities do well during inflation and poorly in deflation, whereas and bonds and cash have contrary performance. However, it is a misperception to lump gold into the hard assets category since it performs equally well during deflation.
Gold is a monetary metal with unique characteristics that preserves its purchasing power both during high inflation and high deflation. This is because gold offers protection both against depreciating currencies as well as deflationary busts, bank-runs, insolvency and other deflationary scenarios since it does not have any counterparties.
You will see that gold outperformed vertically all other asset classes both during times of great deflation, between 1929 and 1940, as well as during times of great inflation, during 1968 to 1980.
The chart shows the performance of four different assets; equities, bonds, real estate and gold, during the Great Depression. Government bonds did reasonably well, but gold was the clear winner. Real estate and equities got crushed.
The next chart shows the performance of the same assets during the highly inflationary times of the late 1960s and 1970s. This time real estate did reasonably well, but yet again, gold was the clear winner. Equities were flat and bonds were negative, but if you factor in the high inflation rate to these returns, they also got crushed.
Stocks and bonds have done well during times of low or moderate inflation. The chart shows the performance of these assets during 1982 to 2000, a time of low to moderate inflation. Stocks and bonds were the best performers while real estate and gold did poorly.
Today, the world is in a struggle between two giant forces of inflation and deflation. On one hand we find ourselves in a great deleveraging process. Economic growth is slow or negative, companies are going bankrupt and countries are on the verge of default. This is highly deflationary! However, on the other side of this equation, governments and central banks worldwide are trying to re-liquefy the system through money printing, quantitative easing, bailouts, and other schemes, and this is highly inflationary.
We are currently at a standstill, and it is not yet certain which of these two forces will prevail in the end. Some parts of the economy, like real estate and derivatives, are deflating, while other parts of the economy, such as up commodities and food prices, are inflating. If deflation prevails, bonds will do well, and if inflation prevails, hard assets should do well -- but in either case, gold will be the clear winner.
In this environment of uncertainly, I recommend retail investors to allocate at least 25% of their portfolio into gold (NYSEARCA:GLD), and another 10% to senior gold mining stocks, such as Barrick Gold Corporation (NYSE:ABX), Goldcorp (NYSE:GG), Newmont Mining (NYSE:NEM), and Yamana Gold (NYSE:AUY).
Disclosure: I am long GLD, AUY.