Gold Could Rip

| About: SPDR Gold (GLD)

Summary

Inflation isn't directly related to gold, but it drives gold investment.

There is a direct relationship between past change in inflation and future changes in gold.

Inflation is on the rebound - it's time to buy gold.

Over the last few weeks, I've written several recommendations suggesting that readers purchase gold (NYSEARCA:GLD). After studying a variety of economic indicators and statistical methods, I have arrived at the conclusion that gold truly could rally by up to 50% over the next 1-2 years. This belief is not based on mere opinion, but on the study of historic price movements following similar economic environments. In this article, I continue this thesis by showing a clear relationship between changes in inflation and the future price change of gold. If you're crunched for time, here's the punch line: it's time to buy gold.

Inflation

When you engage any gold bug in a conversation as to where the price of gold is headed, you are bound to hear "inflation" and "to the moon" within a few minutes. The belief that inflation drives the price of gold is very pervasive, and to the honest, I didn't belief in the relationship until I actually dug into the data for myself. You see, there actually is a fairly predictive relationship between past changes in inflation and the future change in the price of gold. But why should this be?

Inflation (as measured by the CPI), in and of itself, has absolutely nothing to do with gold as a commodity. The CPI measures the price changes experienced in a typical basket of goods which the average consumer purchases. The idea behind the CPI is to try to concisely summarize the effective inflation rate experienced by the average consumer. Gold, on the other hand, is a commodity with prices set by the confluence of supply and demand across a variety of exchanges. As you can see in the chart below, there is very little relationship between these two.

Click to enlarge

When you generate an investment thesis, you need to look beyond the numbers. It is not enough to say "x causes y" or "x and y are unrelated" - we need to test the data to see if there actually is an underlying, exploitable relationship.

Even though there is no direct, fundamental relationship between inflation and the price of gold, billions of dollars transact on commodity exchanges based on readings and expectations of inflation. As investors expect inflation to rise, they tend to park capital into gold as a perceived "hedge" against inflation. Now here's the interesting part. The very act of "hedgers" piling money into gold becomes a self-fulfilling prophecy, propelling gold prices higher as inflation increases. Don't believe me? Here's the data.

As you can see, there's a moderately strong relationship between inflation and gold. When inflation rises in a given six-month period, there's a greater than half chance that gold will rally over the next six months. When inflation rose in a given six-month period, gold averaged a 10% return over the next six months. If you were to lengthen your holding period, you would find that when inflation increases over a six-month period, gold rallies by an average of 24% over the next year. This can be exploited for profit.

Here's a chart of the current CPI and the six-month change in CPI. This shows the inflation rate over the last six months. Do you see the significance of the chart above? I've circled it. This chart tells us something very impactful - it tells us inflation is on the rebound. Or in economic talk, this tangibly means that the economic recovery has now entered into another upwards swing and the demand for goods and services has risen such that the average price of goods is on the mend. This is good for the economy and good for gold. Over the previous year, we have seen the rate of change in inflation flip negative for several months, culminating in the final sell-off of the collapse in gold. Right now, inflation is strengthening - this is very good news for gold. As previously demonstrated - when inflation rises, gold rises in the future due to "hedgers" acting on the expectation. If the future is anything even remotely similar to the past 48 years of market data, then gold could rally by 24% (or more) over the next two years. It's time to buy gold.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in NUGT over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.