Thinking About Gold

We've been thinking a lot about inflation risk lately. As was discussed in our recent quarterly commentary, we grind our teeth at night worrying about the potential for an uncontrollable rise in the money supply, interest rates or both. In the past year or so, the Fed has added more money to the reserve accounts of its member banks than was the entire global supply of currency before August 2008. We took 100+ years to put $900 billion into circulation. We took merely a few months to add an equal amount to banks' reserve accounts. The banks are now free to withdraw that money and start lending it out; the usual multipliers will kick in and and what starts out as, "Good news! Banks are lending again!" turns into, "Yikes! A gallon of gas costs six bucks!" That worries us, and we think it should worry you. (As soon as you start reading stories about how banks are lending madly again, go fill up your tank.)

Our job at Creekside isn't to fix such problems. Those who recently rifled through Timothy Geithner's phone records learned that he hasn't been calling me for advice. Our job is to accept the world as it is and make investment decisions for our clients that, we hope, keeps them moving forward toward their financial goals.

That leads us to consider all the available asset classes and ask what might be the effect on that asset class if high inflation does, in fact, come to pass. While some assets, such as stocks and real estate, keep up with inflation in the fullness of time, that time horizon can be unacceptably long. We think about asset classes that can offer the possibility of keeping up with inflation in real-time. As you might imagine, we field a lot of questions about gold as.

It is true that gold will generally rise in periods of accelerating inflation. The problem is that its rise and fall is far out of scale to the nature of the problem -- and the reversal of the problem. The price index grew by 36% between fall 1976 and spring 1980. Gold rose by 740%. While you might think that proves that gold covers inflation, it should in fact give you pause. Gold prices wildly overshot inflation. When a price overshoots its proper place, it inevitably falls back to earth. Sure enough, gold had lost more than 60% of its value by summer 1982. Between spring 1980 and summer 1982, the price index rose by 22% and gold fell by 63%. Some inflation hedge!

If you were fortunate enough to have gotten in early -- say by early 1978, then you ended up with decent inflation protection by the summer of '82. Gold did cover inflation over that period, from where it started to where it bottomed out.

In our view, the extreme volatility of gold is in large part due to the fact that so little of the world's gold is available for investment applications. Jewelry, dental and industrial uses consume some 90 percent of the world's annual gold production of about 2,200 tons. The total annual production of gold would make a pile that would fit in your living room -- and only a small fraction of it ends up in coins or bullion. The world's entire historical accumulation of gold in all forms would make a cube that would fit on the infield of a Little League baseball diamond.

Given the somewhat small market for actual gold, it is surprising (to me, anyway) that the annual futures market trading activity in just the Chicago exchange exceeds $3.4 trillion dollars! That trading volume is about 40 times the world's actual yearly production of gold -- and Chicago is just one of many worldwide exchanges. (Coincidentally, that figure equals the approximate market value of all gold that exists in the entire world.)

The result of this very large amount of money chasing around this very tiny amount of gold is that a surge in demand for gold can easily send its price soaring past all measures of reasonableness. We expect that will happen if inflation accelerates. We also expect that the price will collapse once the inflationary fears abate -- as happened in the early 1980's. We are quite reluctant to buy into an asset class whose profit potential is utterly dependent on getting the starting and ending dates right.

We can grant for the moment the goldbug's assertion that, volatility aside, gold will keep up with inflation. True enough, perhaps. But -- how much of your portfolio are you going to invest in gold? Some gold proponents say 2-3%; others 5%. The more aggressive folks say 10%. Now, let's imagine that the consumer price index rises twofold over the next five years -- bordering on hyperinflation. If gold matches inflation (and it has never done more than that over a full economic cycle), a 5% position in gold will have added 5% to your portfolio value (since the gold doubled in price). That's about 1% a year contributed toward your inflation protection, during a time when inflation was raging at nearly 20% per year.

Not such a great hedge, eh? The only way gold is going to cover your loss of purchasing power over an entire bust-boom cycle is if you put everything into gold. And then you hope and pray you bought early enough, and will sell out at the right moment.

We agree with the premise that, in the face of runaway inflation, we are well-advised to own "real" assets instead of paper ones. However, we think that gold is not that asset. While gold is a physical commodity, its market price is as often as not fueled by the same irrational human emotions and "animal spirits" as are the prices of paper assets (eg, stocks or currency). We prefer physical assets that have a role in the production chain instead -- industrial metals, oil, gas and other natural resources. With a far larger base of annual production and consumption, we are more confident that the prices of these assets will stay more closely linked to the real world than will the highly emotional price of gold.
While we worry about a spike of inflation over the next couple of years, we think there are better ways to position our portfolios than making a meaningful commitment to gold. We have our bonds concentrated in short maturities (less than three years); we have our stock positions tilted toward energy and natural resources companies; we have overweight positions in foreign-denominated stocks and bonds. We are in the midst of a closer look at inflation-indexed bonds, or "TIPS," and will publish our conclusions soon.

We have taken a serious and sober look at gold, and we can only conclude that the risks far outweigh the potential benefits. We believe there are less volatile and equally effective ways of mitigating the effects of inflation on our clients' portfolios.