Deflation Fighter?

Gold’s average annual return (using average monthly price) from 1980 through 1986 as it followed the inflation rate down is a negative 10%; from 1980 to 2005 it is a negative 2%.  Meanwhile, gold didn’t hit its average monthly high again until over twenty five years later when it began its recent bull run in 2006.  Since 2006, gold has averaged a return of over 17% per year.  However, inflation has hardly been out of control during this time and, in fact, the prevailing fears currently facing the markets are those of deflation.  So how is it that a commodity that has a history of being used as protection against inflation is suddenly a haven in a deflationary environment?

Yosemite Sam’s Investment Choice

Gold is also a reflection of the overall faith (or lack thereof) in the economic and political system. Issues such as the European debt crisis, the Gulf oil spill, persistent joblessness, a housing crash hangover, etc. have created a sense that the problems we face are too big and might lead to widespread economic collapse.  Currencies will tumble in value in a collapse scenario, so the hedge with gold is that you will have protected your ability to trade for goods and services through the relative stability of its value.  That, in effect, is the bet that is being made by those who are pushing gold up into stratospheric territory.  The gold bet in 1980 didn’t break even for another twenty five years (even longer when adjusted for inflation), it will be interesting to see how well today’s gold bet plays out.

(1) Countries that went away from the gold standard sooner fared much better during the Great Depression than those that held longer (like the U.S.)

(2) Average inflation, under the gold standard, is determined by the pace at which gold is mined

http://www.j-bradford-delong.net/Politics/whynotthegoldstandard.html

photo credit: tao_zhyn

The uncertainty in the economic environment as a result of the government’s growing deficit has provided the perfect storm for gold’s move to the top of the list for investors. With the risk of heavy inflation and a weaker dollar, people’s fears have driven them toward the implied security that gold can hold during these conditions.  To make matters worse, the exaggerated rise in gold since 2003, only compounds investors “being left out” reflex.  It’s very difficult to see and hear how an asset class is rising and not want to be a part of it.

In our evaluation of assets, we lean toward long-term trends.  If you look at a chart of gold prices since 1975 (like the one below), you notice that the price of gold had a similar run in the late seventies hitting a record of $750 an ounce or so in 1980.  Moving forward to 1999 the price was closer to the $300 an ounce range.  Taking a look at the chart, if you invested in gold in 1980, you would have had to wait 27 years just to earn your money back.  This example emphasizes the importance of understanding where you are in a market cycle, before investing in a specific asset class.

photo credit: ethan bloch

The speculative nature of investing in gold is eerily similar to the speculation that we observed with oil in 2007-2008.  With both of these asset classes, there have been multiple reports in the news of how high the prices might rise, which is one of our clearest warning signs for an overheated investment.  One of the latest price targets being promoted for gold was that it could rise to $5000 an ounce.

It’s important to remember that gold itself is not a cash-generating asset.  It may be tangible, but if you are holding gold it can actually cost you money in the transportation and storage of it.  In this article, Vitaliy Katsenelson does a nice job describing the concept of gold as an investment.