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Why Gold Does Well When Other Investments Don't

May 27, 2011 12:44 PM ET
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I came across another anti-gold column this week. The author doesn't spring to mind, but the gist was easy to recall.
It was the tired old argument that "gold is not an investment" because you can't value it like a traditional investment. Because gold does not have cash flow, or offer some form of intrinsic asset comparison, it has to be a "speculation." (With speculation implied as a dirty word.)
This line of thinking seems silly to me. Who is to determine what counts as a speculation and what doesn't?
Buying a growth stock at 50 times earnings sure smells like a speculation, even if there are tangible cash flows and assets to measure. One could say the same for the entire S&P 500 at certain valuations, which means even plain-vanilla index funds have "speculative" qualities at times.
At the same time, buying gold as a crisis hedge -- with total exposure in the 5% to 10% portfolio range -- seems a lot more like common sense, or a form of insurance, than a seat-of-the-pants speculative play.
Traditional investors don't like gold because they don't know how to value it and they don't like to think about it. So they pooh-pooh gold and misunderstand its value in times of crisis.
In one sense, gold is a hedge against government folly. The more foolish the monetary policy, the better gold does.
That is partly why gold is more relevant than ever now -- because free markets are witnessing one of the most intense periods of government intervention in all of financial history.
If you really think Bernanke and his Europe/China counterparts have gotten it right, you don't want to own gold. In fact you probably want to be short.
But if you suspect they haven't gotten it right -- or may have even screwed up royally -- then gold makes natural sense as a hedge against that risk.
Gold also has a unique investment property. Along with its characteristics as a precious metal, gold can do well in periods of inflation OR deflation.
When market conditions are inflationary, gold rises along with other commodities. This is why gold has been doing well for nearly 10 years now -- conditions have been inflation-prone since the early 2000s.
But gold is unique because it can also shine in times of deflation -- when general prices, including commodity prices, are falling. Why does that happen? Because of gold's role as a "neutral currency."
In times of deflation, the central banks of the world tend to panic and pump out more liquidity. It doesn't do much good -- the "pushing on a string" effect -- but gold outperforms anyway as the one form of currency not being actively debased.
The environment where gold does poorly, as we hinted at earlier, is in periods of sustained moderation, where economic growth is decent and inflation is mild or even falling.
That explains why gold was a terrible investment for nearly 20 years, from 1982 to 2002. Having peaked in the late 1970s, Western inflation and interest rates then declined continuously for the next 20 years, even as leverage grew.
(Don't forget, you can sign up for Taipan Daily to receive all of my and fellow editor Joseph McBrennan's investment commentary.)
So if we look to the lessons of history, there are a few questions we can ask in respect to gold's attractiveness:
  • Is the present-day period of crisis and uncertainty coming to an end?
  • Have the major problems of the day been resolved, or otherwise addressed powerfully?
  • Can we reasonably expect inflation to fall... and general economic growth to rise?
I don't have to tell you, the answer to all three is "NO."
If anything, the level of uncertainty is rising, not falling. Potential for new crisis has gone up, not down, due to the extra layers of leverage baked into the systemic crisis cake. In the 1970s it took a bold leader, Paul Volcker, to "break the back of inflation" with firm and decisive action; today there is no such sheriff in sight.
And finally, any meaningful drop in inflation threatens deflationary bust, thanks to "extend and pretend" and stimulus gone wild.
In sum, there are plenty of historical reasons why gold remains a good "speculation" -- if not a wise hedge against inflation and deflation. When uncertainty peaks and pro-growth, low-inflation conditions return, we'll know.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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