Gold as the Mythical Inflationary Hedge (Commentary)

I saw an article on Bloomberg recently by Michael R. Sesit that was such a revelation to me I had to share it. For centuries, eons maybe, gold has been thought of as a “store of value” and an “inflation hedge.”

Heralded by kings and scholars through the ages the mystique of gold lives on today.

As investments go, it might be nothing more than a shiny paperweight.

But there is also a mystique to gold that lives, lurks and even resurges from time to time in financial lore.

The million-dollar question of course is, are we heading toward a recession? Market participants seem equally divided on this issue and we will not opine. However, a couple of interesting inputs to watch are the price of oil and the price of gold.

Year to date through November, oil is up 45.31 percent to $88.71 and gold is up 22.61 percent to $782.20.

Neither of these could currently be considered indicative of a recession.

The deciding factor will be housing and consumer spending going forward, something to watch closely.

Let’s dispense with the myth of gold once and for all and leave the mystique to kings and jewelers.

As I write this, gold is $790.00 an ounce. It reached its record high of $850 an ounce, less than its price now, in January 1980.

If the price of gold since this high had kept pace with inflation, its current price would be an astonishing $2,268 per ounce.

In reality, the price of gold is only about one-third of what it should be if it were just to have tracked inflation.

To truly be an inflation hedge it should even be higher than $2,268.

Adjusted for inflation, gold is priced about the same as it was in 1975.

The decoupling of gold and inflation occurred most recently in the mid-1980s and it hasn’t been the same since.

According to Goldman Sachs, the correlation between the price of gold and U.S. inflation expectations is a paltry 36 percent. Even worse, the correlation between gold and actual U.S. consumer price inflation is only 23 percent.

The correlation between gold and core inflation (excluding food and energy) barely registers, coming in at 7 percent. Inflation’s actual effect on gold is transmitted through the exchange rate of the dollar, moving very much in tandem with a basket of currencies about 91 percent of the time.

Remember, dollar weakness is often associated with inflation.

Year to date, gold is up about 22 percent and reached a 27-year high of $837.50 on November 11, 2007.

Prompting this rise, in our view, has been the tremendous amount of global liquidity, decreased mine production, jewelry demand from China and India, and yes, the weak dollar.

Keep in mind too, that gold earns no income and is hard and expensive to store in large quantities and it has no direct link to economic growth or weakness as do commodities like oil or wheat.

The thesis of the Bloomberg article is not that gold is a bad investment, but rather it should be “invested in for the right reasons” according to James Gutman of Goldman.

It may be a good investment, after all it’s up 22 percent this year.

But any lingering belief that it’s an effective inflation hedge should be thrown out the window.

Given the current geopolitical climate, it doesn’t even appear to be a hedge for that.

Investors who have held gold since 1975 have seen no increase in purchasing power.

When your investments grow at a faster rate than inflation, your purchasing power, and thus your standard of living, grows as well.

We’ll stick with stocks for that.

(Glenn E. Atkins, CFA, is executive vice president and fixed income portfolio manager at Garrison Asset Management Co., a registered investment adviser in Fayetteville. He may be reached at [email protected].)