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Six Things Most People Don't Know About Gold (Part 1)

|Includes:SPDR Gold Trust ETF (GLD)

Gold has become a bigger and bigger story over the last several years as it's steadily surged toward new peaks above $1,200 per ounce.  This has dovetailed in perfect synchronicity with increasing fears about long-term inflation, concern about the strength of our national currency, and uncertainty about our collective economic future.  

We wrote a lot about that earlier, about how all those factors tie into what we see as coming decade of hardship.  With this series, we look at what role gold will play.

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Now's as good a time as any to drill down and separate myth from reality.  As usual, what we have to say may not be what you've heard elsewhere.  We like to take a contrarian perspective on the world, though certainly not just for the sake of being contrarian.  Fundamental correctness is absolutely paramount to any contrarian viewpoint.  We are firm believers that when it comes to macro investing, the best way to make real money over the long run is with a stance that is both contrarian and fundamentally correct.  Being contrarian is easy (though not as easy as you might think), but being correct is hard.  There is a lot of money to made from situations where most of world has it wrong and you have it right.

Gold is probably the one thing we get asked about the most.  When we meet people out in the world that find out that we trade commodities, they almost invariably ask us what we think about gold.  Most people that you talk to tend to have an opinion about it.  Unlike stocks and especially bonds, investor sophistication has little to do with an individual's opinion of gold.  Quite simply, everybody wants it.  They have for millennia.  What's more is that they understand it innately.  The want is almost primal.

Gold has been demanded and desired by basically every civilization in history.  It’s been used as a store of wealth throughout the ages.  At various times in various economies in history it’s been used as a medium of exchange, either directly, or indirectly as a hard asset backing a paper currency.

Understanding all this historical and psychological context is important before we get down to the nitty gritty.  When we begin looking at gold, and more importantly, begin using gold as a tool, it's important to keep all the noise at bay.

So here we go, the first of the six things most people don't know about gold:

1) It’s not the inflation hedge you think it is.

In the past gold hasn’t actually correlated very well with inflation.  Gold went pretty much straight down from the frenzy peak in 1980 until about 2001.  That was a period of unquestionably positive, albeit modest, inflation.  If you bought gold in the 80’s to hedge against future inflation, you lost money on both sides – not exactly the kind of result one is looking for in a hedged trade.  Even if you waited years after the bubble before buying, it still declined while inflation rose.

Over the long, long run gold has worked as an inflation hedge.  But a lot of things have gone up in value over the last century and have thus have correlated positively with inflation.  In the 20th century, just about everything that was denominated in dollars went up in value as the value of the dollars denominating them went down.  So over the long, long run, it’s not really much better a hedge against inflation than equities or real estate or other physical assets (except during bouts of hyperinflation).

You might also be curious if gold can predict future inflation.

The below chart looks a little confusing at first but it really isn’t so bad.  All it does is run back through history, stopping at each month to look back at the previous 12 month change in the price of gold and chart it against thenext 12 month change in the inflation rate (as measured by the CPI).

So each dot represents one month and it measures the prior year’s change in the gold price versus the coming year’s change in inflation.  I also did it for a 6-month interval as well.

Make sense?  We now can ask:

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The answer is… sort of.

It’s pretty clear to see that the slope of the regression lines are both positive which means that there is indeed a positive correlation between past movements in gold and future movements in inflation.

But during normal times i.e. annual inflation between zero and 5%, movement in gold does a very poor job predicting the rate of inflation.  Perhaps because normal times are boring.  Nobody cares about inflation in the low single digits.  That is what the Fed is actively shooting for, after all.  Central bankers around the world sleep soundly and have happy dreams if inflation is positive and low.

What investors want to know is if there’s a way to forecast hyperinflation.  And here you can see that when gold has really gone wild, increasing by 100% or more in 6 months, it has usually meant that high single-digit or double-digit inflation has followed in the next 6 months.  It does a little better job as a predictor here, but keep in mind that just about all of those data points towards the top right corner in that chart were from the late 70’s and early 80’s.  The gold market was held in the grips of a speculative frenzy and the country had already been experiencing double-digit inflation for years.  So none of those data points would have been particularly useful in practice.

The take-home point here is that one should be careful when looking at the gold market and using its movement to divine the future.  Yet again, we bump up against the ubiquitous conclusion that past performance is not indicative of future results.

Gold’s up over 30% in the last 12 months which is a gigantic move, but nobody in their right mind expects significant inflation in the coming year.  Even without that economic forecast, very little should be excluded from our expectations of the change in coming the inflation rate. 

Pretty much any outcome is in play.

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Stay tuned for Part 2 early next week.  The entire series originally ran last Fall on our newsletter, TheDraconian.com



Disclosure: Long GLD
Stocks: GLD