The Inflation Hedge Trade: Not Just A Precious Metals Vs. Paper Question

by: Retired Aviator

Gold bulls say things like:

  • Gold has skyrocketed only when measured in fiat currency - actually it’s only retaining its value, not increasing in value.
  • You see how precious metals have soared along with the ballooning deficits and National Debt? It’s all about money printing.

We hear such claims more frequently and ever louder these days, but they are not really true. They are also quite dangerous arguments in seducing new buying of precious metals (PMs) at current prices. Gold clearly has not merely “retained its value”—it has in fact exploded in terms of its purchasing power, as it has rocketed from $300/oz a decade ago to as high as $1900/oz this year. Congratulations to those who got in much lower [I bought gold at $300/oz and silver at $4.50/oz, but alas I sold much of it too soon].

But that is the problem—even gold bugs admit that gold is not supposed to explode in terms of its purchasing power. It is supposed to more or less track price inflation and thus have relatively steady purchasing power. In other words, as go consumer prices, so should go gold. (Not 'as goes deficit spending, so should go gold.')

As a personal anecdote, I recall a decade ago buying an ounce of gold for $300. At the same time I purchased a new Trek bicycle, also for around $300. So gold and the bicycle were trading at parity. In other words, the respective markets were viewing the bike’s value as equal to 1 ounce of gold: 1 Bike = 1 oz. of gold [using dollars as the medium of exchange].

Fast forward to today—gold is valued at $1600/oz while today’s comparable model of Trek bike still only costs around $375. Do you see the glaring problem? Those fearful that the price of the bike would skyrocket have flocked to precious metals, ironically bidding them up and inflating them by many times what the actual $75 hike in the bike’s price over the same period would suggest that precious metals should have risen. It’s the same story whether you look at bicycles, ice cream, home insurance, tires, or what have you—sure, all these things have gone up in the last ten years, but nowhere near as much as gold. Another way to look at this is to compare what you could get with your money in the two time periods: In 2002, with $300 in hand you could either buy 1 ounce of gold or 1 Trek bike. Today, it takes $1600 in hand to buy your ounce of gold, but for that amount you can presently have a whopping 4.3 bikes. (Let’s call it 5 bikes if you shop around.)

So the question is: If you’re worried about runaway inflation, why not just dump your paper dollars to buy something like bicycles instead of gold? Answer: the bikes are a much, much safer choice of inflation hedge. After all, the crowd that is crowing about runaway inflation or hyperinflation to come is suggesting that a bike won’t cost $375 several years from now, but perhaps $3750 or $37,500 or even $375,000. Buy a bike now at $375 to stash away and later sell it for one of those figures and you’ll probably beat the pants off of gold in your quest for preserving your wealth. Think of it this way: If you dump your paper dollars for some physical asset today in order to preserve purchasing power, and one day you will sell that asset for cash in order to buy groceries, what does it matter what that asset is? It doesn’t. Once you’ve exited the trade round trip it will have made no difference whether you had held gold, bikes, bricks or bassoons. All that will matter is the price you received compared to the price you paid, and how that percentage gain compares with inflation in general. So the best way to do the physical-asset-in-your-possession inflation hedge trade is not to automatically buy precious metals at the current spot price, but to buy something that looks quite underpriced today and will surely appeal to buyers in the future. Certain antiques or collectibles might fit the bill as physical possessions where a lot of value can conveniently pack into a small space.

Stocks: A Much Better Inflation Hedge than Precious Metals Today

I believe the best inflation hedge today is not physical possessions at all, but stocks. The stock market, broadly represented by the S&P 500, ETF ticker (NYSEARCA:SPY), is trading at a historically quite low P/E ratio of 13, compared to over 30 during the stock market bubble of 1999-2000. And the "E" denominator—earnings—is rather depressed from the current economic malaise and so has plenty of room to grow in the future. Stocks are cheap, and with them you get business growth, growing income and a much better inflation hedge than gold purchased today at $1600/oz. Yes, stocks are an excellent inflation hedge because if toilet paper is going to cost $500 a pack, that's surely going to be reflected in the exploding revenues, dividends, and share price of Charmin-maker Procter & Gamble (NYSE:PG).

In truth, if runaway consumer prices, e.g. hyperinflation, were forthcoming, the question now before investors is not between holding fiat paper money vs. precious metals, as the gold bugs would have you believe. Cash versus gold & silver are only three out of many possible choices. The question is actually between holding fiat money (or bonds, which are promises of future fiat money), vs. most any other durable asset. Yes, if a tempest of runaway inflation were coming (though I’m sure it is not—see my other writings), long term you’ll surely be better off by stowing away a diversified ETF of stocks—or even a bunch of bicycles—than gold at today's inflated price. You’ll get so much more punch for your fiat dollar that way.

Which ETFs or CEFs to Buy as an Inflation Hedge?

I like (NYSEARCA:DIA), the ETF of the 30 Dow Jones Industrial Average large-cap stocks, as a way of owning a diversified piece of the U.S. economy. It's a bit cheaper on a P/E basis than (SPY) and yielded 2.6% vs. 1.96% for SPY over the past year. Both of these ETFs also have highly liquid options markets—a plus for those who are savvy at writing options against their position to generate extra income. DIA also pays its dividends monthly—a benefit because in the event that your shares are called away, it's painful if you don't get to collect months of dividends that have accrued. That can happen with SPY.

Another great way to own a diversified stock portfolio is through closed end funds (CEFs). CEF's shares trade in the market freely at any price, which can be considerably above or below the sum of the holdings' current prices (known as NAV). The best values currently can be found among those funds that happen to be trading at 10-15% discounts to NAV for no good reason. Some Eaton Vance CEFs presently fit the bill, including some that currently deliver impressive dividend yields in the 10% range. The high yields are obtained largely by the fund manager utilizing options writing strategies. (Unlike option buying, covered option writing does not add risk but in fact reduces it). The Eaton Vance funds I own are (NYSE:ETB), (NYSE:EOS), (NYSE:ETV), and (NYSE:ETW). I should mention that these funds' options writing strategies mean that they are positioned very well for volatile, range-bound markets such as we had in 2011, but they underperform in strong bull markets such as during 2009 and 2010. They still make money, but not quite as much. The options strategy also adds another valuable benefit—in the event of a sinking bear market the sold options expire worthless and so the premiums received become cash profits that mitigate the fallen stock values.

All this means that in my view the ~10% yields on these funds are very likely sustainable (and may even be increased at some point in the future). The dividends were slashed last year, which probably explains the sell off of these funds to the current hefty discount levels. But even if the dividends are only maintained at this reduced level—or even cut a bit further—it's still a great yield. I believe any fears that may be driving the discounts are overblown. Doug Albo, who specializes in CEFs as a profession and follows many of them closely, notes that these particular Eaton Vance funds' NAV performance is quite good and he recommends them. A CEF's favorable long term NAV performance relative to the relevant benchmark is the mark of an effective fund manager, while a CEF's market price is simply subject to market whims and beyond the manager's control. Especially with the low trading volume typical of many CEF's shares, it's not so unusual for the share prices to get out of whack with both the NAV and the fundamentals of the management quality. I like to buy a decent fund when it's discounted and sell when the market wants to pay a premium for it, collecting the high yield along the way.

But What of Gold and Silver?

Finally, if you're a risk taker, now may be a good time to short still-overpriced gold by shorting (NYSEARCA:GLD) or (NYSEARCA:IAU). If you're even more of a risk taker you could buy the bearish leveraged gold fund (NYSEARCA:GLL) or short an ETF of gold mining stocks (NYSEARCA:GDX) or (NYSEARCA:GDXJ). But gold could very well catch another tailwind and go as high as well above $2000/oz, so keep your bet small and don't use margin! Gold is hot and highly charged with emotion these days, so anything can happen to the price of gold. Central bank and institutional buying in my view is a big wild card because when a very large buy order comes on the market the price can move up powerfully—and for a sustained period of time. This can be highly reassuring to gold bugs, who then, ironically, can be even more apt to buy at the higher price. In the end, though, the gold trade all comes down to consumer prices—I am quite sure that prices will not be skyrocketing, for reasons I've been writing about for some time now. Sooner or later when this reality sets in, it will be clear that the flight from fiat paper money into gold was unnecessary and then look out below for the price of gold.

Silver (NYSEARCA:SLV) is trickier to figure out and does not seem so overvalued to me as gold. Personally, if it retreats back below $20/oz I will be trading it in that range for quick profits, but if it remains near the current $30/oz range or goes back above $40/oz, I don't see a margin of safety in owning it and so I would not recommend any position in silver at these levels.

Remember, you don't have to own precious metals if you fear inflation—many other assets provide an inflation hedge. Real estate, anyone?

Disclosure: I am long DIA, ETB, ETW, ETV, EOS.

Additional disclosure: I also have a small short position in GLD which I will increase if gold tops $2000/oz. I have no positions in any other securities mentioned. I have no relationship with Eaton Vance.

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