Gold: A study that seeks to link the metal with inflation protection

By Jon Nadler
In one of our recent posts we noted that a very timely paper titled "The Golden Dilemma" was published earlier this year by commodities expert Claude Erb and by Duke University Professor Campbell Harvey. The research document addresses certain "age-old" questions that continue to dog the minds of the average gold investor. Namely, "Do I seek inflation protection by paying a high real gold price that almost guarantees a decline in future purchasing power?" and "Do I avoid gold and run the risk of a decline in future purchasing power if inflation surges?"

The authors set out to try to better understand the treatment that gold ought to receive when it comes to portfolio allocations. They examined a host of "popular stories" that are commonly employed to make a pro-gold argument. You know the themes: inflation hedging, currency hedging, and disaster protection. By delving into the facts-and-figures-based reality in gold over a long timeframe, the authors manage to debunk such "conventional wisdom" line by line, in devastating fashion.

First of all, they assert, it is not plausible to expect that the real rate of return in the long-run for gold could be13% per annum, as it has been from 12/1999 to 3/2012 (more like 15.4% actually, minus a 2.5% annualized rate of inflation). Second, the authors caution, "given the most recent value for the CPI index, this version of the "gold as an inflation hedge" argument suggests that the price of gold should currently be around $780 an ounce."

They also remind the reader that the only other time that the real price of gold was as high as it is currently, was back in 1980 and that periods when such real prices are above average are followed by extended periods of time when they are to experience returns below average.

As regards gold and long-term inflation, the team notes in one of their graphic exhibits that There has been substantial variation in trailing ten year annualized gold returns: from as low as -6% per annum to as high as +20% per annum. Over the same time period the low and high inflation returns were +2.3% per annum and +7.3% per annum. The exhibit suggests that gold is not a very effective long-term inflation hedge when the long-term is defined as 10 years."

The Erb/Harvey study starts with the commonly held truism that "gold is a currency hedge." In other words, note the authors, if the US dollar loses 10% against the yen, for example, then the price of gold should offset that loss by rising an equivalent 10%. That argument, unfortunately, only holds water if in fact one of the two countries involved in such a calculation/hedging can consistently boast of an inflation rate of...zero percent.

What has, in fact, taken place is that, since 1975, the US dollar price of gold has risen and the US dollar has depreciated against the yen. On the other hand, the price of gold in yen also rose and the Japanese yenappreciated against the dollar.

Last week, the World Gold Council (EGC) issued its report on the gold price performance in the second quarter of 2012, in which it noted that gold prices declined in most currencies with the exception of the euro, the Swiss franc and the Indian rupee.

For any particular currency pair, if gold is able to hedge one country's currency, it certainly is not able to hedge the other's currency. As regards gold as a hedge against "domestic" currency "debasement" the authors find that, from a macro-perspective, the mantra of "currency down –gold up" also does not hold true. The authors conclude, there seems to be little connection between currency returns and gold returns.




Recently, the Erb/Harvey team followed up on their June study with a fresh look at the real price of gold and how it currently translates in various currencies. They state that "The "real" price of gold in the US is historically high, relative to its history as an actively tradable asset. " In other words, in USD terms, we have just as high a real gold price as we had in 1980 and not since.

The authors then ask: "But what about the real price of gold in other countries?" The answer is a bit of a shocker: "It turns out that, in our impressionistic sample of 23 countries, the real price of gold is high everywhere. The real price of gold is high in "troubled" countries as well as in "safe" countries. If the real price of gold is a barometer of perceived troubles then there is trouble everywhere." There is however, alternatively, the possibility that gold is just expensive, everywhere."

The Erb and Harvey team finds that "in the United States, since 1975, when the real price of gold was above its historical average, [subsequent] future real returns turned out to be below average." They note that historically, the "real" price of gold, the inflation-adjusted price of gold, has been "predictive of future inflation-adjusted gold returns." Therefore, they deem it to be reasonable to ask if the real price of gold can be thought of as something like the "PE ratio" of the gold market.

The writers advise that "Investors in gold should determine for themselves if gold is like most other assets, where valuation matters, or if the price of gold is free of any valuation concerns. Just as the nominal and real yields of bonds differ from one country to another, and just as stock market price-earnings ratios differ from one country to another, it is certainly possible that estimates of the real price of gold may differ from country to country."

The team's latest research moves away from a strictly US dollar-focused take on the real price of gold and it analyzes how the real price of gold has behaved in 23 countries. Based on their findings, they try to answer such questions as:

– Is the real price of gold historically high in some countries and historically low in others?

– Across countries, what does the historical price of gold look like when adjusted for inflation

– Across countries, does the inflation adjusted price of gold have a trend?

The image below shows the real price of gold from the standpoint of a U.S. investor. Starting in January 1975, when gold futures contracts commenced trading on the COMEX, the "spot" price of gold is divided by the level of the U.S. Consumer Price Index (base year 1982-84=100).

As noted by Messrs. Erb and Harvey in back in June, the real price of gold has fluctuated significantly: “The real price of gold in the U.S. today is almost as high as its level in 1980. This is simply an observation. Exhibit 1 is a simple at-a-glance way to assess if real gold prices are historically high or low within a country.” After studying 22 additional countries and the real price of gold in each one of them, the team notes that “the real price of gold is historically high in all 23 countries.” This includes certain nations that do not immediately come to logically-minded…minds.

At any rate, the authors posit that “the nominal gold price and inflation adjusted gold price charts for the various countries seem to echo the experience of the US. Nominal prices have risen over time and inflation adjusted prices seem to be trendless, though volatile. It is important to recognize that even though the estimated value of all the gold that is thought to exist in the world is about $10 trillion, very little of that gold trades in any year.”

The study remarks that “The fact that gold is a large market with relatively little liquidity was alluded to by investor Ray Dalio (2012) who recently remarked that “…the capacity of moving money into gold in a large number is extremely limited….the players in the world…that move that money….really don’t view gold as an effective alternative…..but it could be a barometer…and it is an alternative for smaller amounts of money.”

Thus, the authors ask, “Gold may be a barometer, but a barometer of what? Is the high real price of gold a barometer of the ability of investors to “see though” inaccurate official inflation reports? Or is the high real price of gold a barometer of irrational pessimism?

You might be a believer in imminent hyperinflation or a non-believer in allegedly distorted, “shadowy” government statistics, or maybe you just see a “safe vs. unsafe” global list of countries. Many hard money newsletter scribes and individual gold investors are most likely to quickly classify the U.S. as a “troubled” country and, say, Switzerland as a “safe” country.

From a U.S. perspective, the Erb/Harvey team asserts, “it is possible to assert that the real price of gold is high because the US is a “troubled” country with many perceived financial problems. And as a result, even if the real price of gold is high, gold may seem to offer investors in the U.S. a way to possibly deal with a “troubled” and possibly inflationary future.”

Well, then, take look at the image below. It shows that the real price of gold in Switzerland.

In fact, the authors note, “the progression over time of the real price of gold in Switzerland looks much like the progression over time of the real price of gold in the U.S. If a high real gold price in the U.S. makes sense to some because of the problems the U.S. faces, is it really possible that the real price of gold is high in Switzerland because of the many troubling financial problems facing Switzerland? Switzerland is supposed to be free of many of the financial ills that plague the U.S. In fact it is possible to ask which is preferable: a cache of gold or a cache of Swiss francs in a Swiss account?”

They then conclude that “the real price of gold is high in the United States. The real price of gold is high in at least 22 other countries. If the real price of gold is a useful long-run valuation metric, then it is most likely useful in thinking about long-horizon rather than short-term real gold returns. A casual, visual inspection of all of the 23 real gold price charts suggests that, in the past, the real price of gold mean-reverted over a roughly decade long time span. A high real price of gold suggests the possibility of a long-term real return headwind, not a portent of an imminent crash.”

Messrs. Erb & Harvey remind us that “there is no shortage of examples of expensive asset markets becoming even more expensive,” and, as such, they do not exclude the possibility that the nominal and real prices of gold could continue to rise to levels not seen before. However, they also leave us with a few words of wisdom to ponder. American philosopher and essayist George Santayana once suggested that historical curiosity might have some value by warning that “Those who cannot remember the past are condemned to repeat it”. If that were not enough, American journalist H.L. Mencken was once supposedly quoted as saying that “For every complex problem there is an answer that is clear, simple and wrong”.

“Valuation is a complex problem. If valuation matters for gold, then remembering the past is a way to attempt to avoid future missteps,” the Erb & Harvey team advises.

What, then, is a would-be gold buyer to do? Remember our starting point and the two most important questions to pose to oneself: “Do I seek inflation protection by paying a high real gold price that almost guarantees a decline in future purchasing power?” and “Do I avoid gold and run the risk of a decline in future purchasing power if inflation surges?”

Well, we might have an answer for such pivotal queries. Recently, Money Morning Australia’s John Stepek posted an interesting article. What is interesting about it is not the fact that it extols the historical virtues of the yellow metal- the MM publication has always reflected the heavily pro-gold views of Agora Publishing. “What’s So Important About Gold?” tries to teach a few lessons about gold ownership. It also tries to (correctly) repositiongold as a form of insurance.

Here is a most valuable excerpt from Stepek’s – let’s call it: “Gold Ownership 101”- posting:

“I like gold. But after 11 years of constant increases, I believe we’re nearer to the end of the gold bull market than to the start. This is the stage where more and more people are going to start piling in for the wrong reason. They’ll buy gold because it’s going up, not because it’s a sensible investment. That means that this is also the stage where – even though there are likely higher peaks ahead of us – some people are going to start getting badly burnt in the inevitable panic sell-offs.

“So it’s important to get your rationale for buying gold right. It’s not 2001 anymore. You can’t just buy it and sit on it, safe in the knowledge that chances are, it will never ever be that cheap again, and that you’ll always be able to sell at a profit. [And] If you’re hoping to ‘ride the bubble’ when it comes, put that thought out of your head right now. That way, financial disaster lies. Timing a bull or bear market is painful. No one can know when the final peak or trough will come.”

So what do you do? Well, another way to think of gold is as an insurance policy. You don’t put your entire portfolio in gold. It’s something that you hold to insure the rest of your portfolio against financial disaster. The possibility of such a disaster seems quite high just now, which is why the insurance policy (gold) is more expensive than it once was. So we’d suggest that you invest 5-10% of your portfolio in some form of physical gold (gold stocks are separate – they’re driven by more than just the gold price, and they’re certainly not insurance).

“And when you check your portfolio every six months or so, you rebalance accordingly – if gold’s share of your portfolio is creeping higher, sell some and invest in something else. If it’s dipping, then top it up. That way, you’ll profit from the inevitable ‘bubble’ phase. But you won’t be left over-exposed when prices go down, as they one day will. And when the gold bull-run is over, you’ll be pleased. Because when the gold price re-enters a bear market, it’ll be because the wider economy is finally turning around. And you’ll be able to buy cheap insurance again for the next crisis.”

No one could not have said it better, Stepek. The $64K question however, is: who will heed your advice? Hint: not those who do not believe in mean-reversion, natural market cycles, and/or history repeating itself.

Until next time, stay informed…

(Author is the Senior Analyst at Kitco Metals Inc.)