Gold as an Inflation Hedge

by: Living4Dividends

Investing in Gold is the latest rage. The Gold craze has only been fanned by recent moves into Gold by the hedge-fund legends David Einhorn, John Paulson and others.

Gold as a Diversifying Asset Class.

Historically, Gold has had zero correlation to the stock market. No one has shown a ironclad inverse correlation between the price of gold and the price of stock indexes. That is Gold does not always rise when stocks fall. Even if such a correlation could be "proved" through data-mining, it wouldn't mean much, because correlations change over time. At one time bonds used to be inversely correlated to stocks and when stocks went up, bonds fell. That relationship changed over time.

Question: "Is Gold a Diversifying Asset Class?" The answer is: Yes, but there are other classes that diversify just as well.

Question: "Is Gold about to rally?" We could very well be on the verge of a global Gold rally. Gold could go to $500 or it could go to $2000. I have no crystal ball. No one does.

Is Gold a Good Inflation Hedge?

From 1801 to 2003, one dollar's ($1) worth of Gold has appreciated and is now worth $1.39 in inflation adjusted terms. Cash has done alot worse: $1 in Cash is now worth $0.07 in inflation-adjusted terms. Because Gold has beaten cash mightily doesn't make Gold a superb investment. Stocks, Bonds, Real Estate and even interest-paying Bills have clearly beaten Gold and cash over the same time period.

One could say "yes, but those were during times of low inflation, when the currency was backed by Gold. What about these modern times when the Dollar is a fiat currency, backed by nothing?"

In 1934, the U.S. went off the gold standard to limit private citizens' access to gold. It took decades for the Dollar to be fully delinked from Gold. 1934 is a great starting point because it marks a period of successive devaluations of the US Dollar vis-a-vis the price of Gold.

Taking 1934 as the starting point, Stocks, Bonds, and Real Estate have clearly beaten Gold over the period. Treasury Bills are a wash.

Question: "Is Gold a Good Inflation Hedge?" The answer is: yes, but their are FAR BETTER inflation hedges, that pay you interest. Gold does not pay interest, in fact it costs money to insure and store. The same goes true for other Precious Metals (PMEs) – these are less preferred investments because they are stores of value, not income-generating investments.

Earlier, I mentioned David Einhorn and John Paulson, two very successful Hedge Fund managers who are currently bullish on Gold. Here is what the most successful investor of all time, Warren Buffet, has said about Gold:

"It gets dug out of the ground in Africa or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it."

To be fair, over the past decade, Gold has outperformed the stock of the vaunted Berkshire Hathaway, Warren's holding company, as fellow Seeking Alpha author Mark O'Byrne writes in his article:; Over the longer term, Warren Buffet has mightily beaten Gold.

Gold as a Store of Value

During the Roman Empire a consumer could purchase a complete suit of high end clothes for one ounce of gold. The suit of clothes consisted of a bespoke (tailor made) toga, high end sandals and accessories. At the height of the Great Depression a consumer could purchase a complete suit of clothes for one ounce of clothes ( bespoke suit, shoes & accessories ). Today, a consumer can still purchase a new tailor made suit, a belt and pair of shoes for that same one ounce of gold. Gold has been excellent store of value for the very long term (Measured over millenia).

Gold does keep up with inflation. Because Gold is better than cash and bills doesn't mean you should go out and buy Gold. There are far better alternatives to Gold, like TIPS, which are alot less volatile.

Nothing excites the investing community more than the talk of Gold. I am sure that this post will get hammered by the Gold Bugs. I am not an expert in PMEs, I know enough to know that there are better choices for my own portfolio.

Gold does have it's uses at the right place and the right time: Gold was useful for the Jews during Nazi-occupied Germany. The Jews knew or suspected that their property rights (to Real Estate & Stocks) would not be honored. The German Mark was unstable as well. In times of war or a total collapse in governmental institutions, Gold has served it's purpose as a portable store of value. Gold is a choice for those who feel that war, country wide financial collapse and/or armageddon is just around the corner. When armageddon comes, you will have more things to worry about than how much Gold you have.

I am curious as to why investors buy slips of paper that represent stores of gold (e.g. the GLD ETF). If the financial system collapses, these slips of paper would not be redeemable into the actual metal. These investors would be better served holding the physical metal.

For the conservative, prudent investor who is optimistic about the future, and wants to grow his capital, Gold and other PMEs are a lousy place to put your money.

Inflation Fighters, Superior To Gold/PMEs:

  1. Inflation-Protected Bonds (WIP, TIP)
  2. U.S. Equities, Foreign Equities and REITS.

Because Gold has not been shown to significantly increase in value in inflation-adjusted terms in neither the past two millenia, past two centuries, or past fifty years, Gold is a store of value, not an income-producing investment. To add to Gold's poor choice as an asset class: it is very volatile. Over the past 40 years, Gold's volatility has exceeded those of stocks. I prefer to be an investor, not a speculator and that's why Gold (or other PMEs like Silver) are not in my portfolio.

DISCLOSURE: Long VNQ, U.S. Equities, Non-U.S. Equities, Emerging Markets Equities, US TIPS and WIP. Except for the gold chain around his neck, Author is neither long or short Gold or other PMEs. You should perform your own due diligence and consult with an investment advisor before investing.