What You Are Told About Inflation Protection Is Wrong

by: David Cretcher

"It's not what you don't know that gets you into trouble. It is what you know for sure that just ain't so." Mark Twain

Investors often follow their beliefs, or they follow what they are told by media experts. By blindly believing without reviewing the evidence, they risk proving true Mr. Twain's observation. It will be what they think is true, but isn't, that will cause the trouble. In the case of investing, the trouble is a bad prediction based on a false belief. Unfortunately, in the world of investing, bad predictions make for bad investments.

By studying historical relationships and understanding what has happened in the past, investors can make better predictions about the behavior of investments and make better investment choices.

There are many false beliefs in the world of investing, but some of the worst come from the advice about how to protect your capital against inflation. Here are a few common beliefs that simply don't add up when you review the evidence.

Gold Will Protect a Portfolio Against Inflation

There is a lot of media folklore about how gold is a great hedge against inflation, maybe even the best protection for the investor. The hypothesis behind this is that gold is still some sort of money. Since it comes from the ground instead of from governments, it isn't at the mercy of government money printing operations. Since, according to the theory government money printing inevitably leads to inflation, gold will maintain a more constant real value and protect the investor against inflation.

It is true that in the very long-run gold does sort of track inflation in a very roundabout way. This can be seen in Exhibit 1 which graphs the price of gold against the CPI level. In this graph the price of gold has very roughly tracked inflation, between 1980 and 2013.

The problem, of course, is the path is wildly different. In the following graph, gold (red line) has no correlation to inflation (blue line) at all between 1980 and 2005. After 2005 it violently over-correlates to inflation. The path is so different that it is almost useless.

If the investor believes the hypothesis that gold is an inflation hedge and makes an investment in 1991 for instance. The prediction would be wrong - very wrong. In the next ten years, not only is gold not an inflation hedge, it inversely correlates to inflation.

The investor would unfortunately have received the opposite result from what he or she predicted. Inflation (blue line) would increase as their gold investment decreased (red line).

If investors had bought gold (red line) as an inflation hedge during our last bout of high inflation between 1974 and 1984, they would have again seen no correlation. This is during an inflationary period when they would have most needed the protection against inflation.

This hypothesis is false because two of the premises are wrong. First, gold is not money. At least, it is not money in the sense that you can take some gold bricks out of your basement vault and go to the local auto dealer and buy a new car. Inflation tracks the price of consumer goods and consumer goods are not purchased in gold. Gold is a metal.

The second problem is that money printing doesn't cause inflation. In short, excess spending causes inflation and excess money is not always spent.

So a hypothesis based on gold as money and inflation as a result of excess money printing will not yield reliable predictive power. Ultimately, short of blind luck, bad predictions yield bad investment decisions.

Stocks Are a Good Hedge Against Inflation

This is another hypothesis I hear from advisors and retirement planners. Investors need to own stocks to protect their portfolio against the effects of inflation. It's true investors, particularly retirement investors, do need to protect themselves from inflation. But, it is not true that stocks will necessarily do this for them.

Stocks do benefit from having dividends that roughly adjust for inflation. Corporate profits also more or less adjust with rising inflation, but it doesn't follow that the market will adjust with inflation. This is because the P/E ratio tends to be low during periods of high inflation. Inflation tends to raise the nominal interest rate which in turn raises the cost of capital and lowers the break-even of leveraged corporations..

The result is stocks, like gold, are very unreliable protection against inflation. As can be seen in the next graph from 1947 to 2008, stocks in the long-run do track inflation.

The concern for investors is stocks do not reliably track inflation in the short run. In particular, stocks don't track inflation when it is relatively high. The period from 1962 to 1982 was a period of relatively high inflation. This was a time when investors needed the most inflation protection and stocks failed to provide the hedge. Notice in the following graph during this period flat stocks performance (red line) failed to provide any protection against steadily rising inflation (blue line).

Likewise from 1999 until 2009 when inflation was relatively low, there was no unreliable correlation between stock prices (red line) and consumer price inflation (blue line).

Stocks like gold are not a reliable inflation hedge.

A Quick Cross-Check

If stocks are a good inflation hedge and gold is a good inflation hedge then it stands to reason that since inflation has been present in our economy in the range of recent history then gold should be somewhat correlated to the stock market.

In the below chart, the stock market (blue line) is poorly matched to the price of gold (gold line). Obviously, these two are not going to show a strong correlation, but if each were actually correlated to the rate of inflation we should see some stronger relationship.

TIPs Are A Good Inflation Hedge

For the investor, Treasury Protected Securities (NYSEARCA:TIP) do track inflation relatively well and provide the most reliable hedge against inflation, particularly relatively high inflation. TIPS are indexed to CPI so they are mathematically linked and must correlate to inflation. The below chart tracks the change in inflation (blue line) against the change in 30 year TIP prices (red line). It is not perfect but it is more or less reliable.

Investment Predictions and Decisions

Investors should base their investment predictions based on known historical correlations and behaviors. Both gold and stocks have shown to have historically weak correlations to inflation. Unless you are predicting a change in the relationship between the two investments based on new information, you should avoid using these investments in your portfolio for inflation protection.

In practice what we do know is the obvious. The stock market (NYSEARCA:VTI)(NYSEARCA:SPY) is correlated to the stock market. The price of gold (NYSEARCA:GLD) is correlated to the price of gold. The price of TIPs (NYSEARCA:TIPZ)(NASDAQ:VTIP) is indexed to the CPI.

The danger lies in believing that the price of stocks is positively related to the rate of inflation, or the price of gold is related to the rate of inflation, when the historical evidence shows they are not. The danger is "what you know for sure that just ain't so."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

Additional disclosure: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.

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