When Inflation Attacks, Gold is Not the Defensive Weapon of Choice

August 19, 2008 by  
Filed under Investing, Retirement Planning

Inflation is Attacking (But You Knew That Already)

A proper financial plan and retirement plan needs to include an inflation protection strategy.  The news on the inflation front is not good.  (You probably didn’t need me to tell you that.) 

For the 12 month period ending in June 2008, the wholesale inflation rate increased to 9.2%, the fastest rate of increase since 1981.  Consumer prices rose by 0.8% in July, twice the rate that was forecast.  This run-up in consumer prices capped a 12 month CPI inflation rate of 5.6%, the largest 12 month gain since 1991.  During the same period, average weekly earnings fell by 3.1%, after adjustment for inflation.  This represented the largest year-over-year decline in employee earnings since 1990.

The real world effects of this data have left consumers struggling against higher food and energy prices.  At the same time, investors have been scratching their collective heads to find an asset category – a weapon if you will- to effectively confront the attack of the inflation monster.  Mr. ToughMoneyLove is here to recommend against choosing gold as that weapon.

Gold Pundits Say “Yes” But the Data Say “No”

The personal finance/investing press is full of pundits touting the benefits of gold as an inflation hedge.  Indeed, the cries of the gold lovers seem to echo off each other.  The hard truth is that the long and short term data do not support these pronouncements.  Let’s look at the short term data first.

On August 17, 2008, shortly after the release of the awful wholesale and consumer inflation numbers I referenced above, what did gold – the great “inflation hedge” –  do?   It fell 4.2 percent to $772.98 an ounce.  That is a drop of $100/ounce since August 1 and $260 per ounce (-26%) from gold’s peak price in March, 2008!  Logically, an asset category that is supposed to function as an inflation hedge should show some sort of correlated positive movement in response to negative news on the inflation front.  But we are seeing what appears to be negatively correlated behavior, in which the inflation news is bad and the gold price news is worse.  Is this a temporary glitch?  Well, the gold speculators think not, as December gold futures closed last week at $792/ounce.  Oops.  That is some hard truth right there folks.  How can any reasonable observer conclude from such behavior that gold is acting as an inflation hedge?

Perhaps Mr. ToughMoneyLove is being too hasty and the gold-loving financial planners are right.  Let’s turn to the long term data and see.   According to a study conducted by Dr. Jeremy Siegel, a finance professor at the Wharton School:

$1 invested in T-Bills in 1802, with interest reinvested, would have grown to $5,061 by 2006.

That same dollar invested in bonds would be worth $18,235 in 2006.

$1 invested in common stocks in 1802 (with dividends reinvested) would be worth more than $12.7 million.

Finally, that same $1 invested in gold in 1802 would have been worth – wait for it – ready – OK, now- a whopping $32.84 at the end of 2006!!!

I don’t know about you, but Mr. ToughMoneyLove is not impressed with that un-glittery gold outcome.  Granted, there have been inflationary periods where there has been some correlation with gold prices, but consider the following:

Gold prices increased from $105 in 1976 to $850 in January, 1980.  Consumer prices increased by about 28%.

Gold fell from $850 in 1980 to $256 in 2001.  During that same period, consumer prices more than doubled.

Gold prices increased from $256 in 2001 to $1,011 in March, 2008. During this period, consumer prices increased by about 20%.

This data tells us that gold prices are all over the map, with no apparent correlation to what is happening with inflation.

So what is it about gold that is attractive to some investors in inflationary times?  I believe it is the doom and gloom phenomenon.  Bad news brings interest in gold, but that bad news may or may not be accompanied by inflation.  There is no cause and effect that gives us confidence that we can fight inflationary pressures and losses with gold purchases.  We must not forget that gold is a commodity of sorts but not like oil, wheat, or pork bellies.  Gold is not consumed like these other commodities.  Consumers can simply choose not to use it and not purchase it.  This makes gold pricing patterns highly unpredictable and not closely associated with any particular economic condition except bad news.  (Well, maybe a falling dollar but that is a discussion for another time).

So What is the Inflation Weapon of Choice?

Now maybe you are thinking that smarty-pants Mr. ToughMoneyLove is just a data-mongering skeptic with no inflation-fighting ideas of his own.  (Gosh, that’s a harsh assessment of a blogging baby boomer.)   So, to combat those thoughts, I will tell you what I did last year when the Fed started dropping interest rates faster than we could say “what the ….?”  I tripled our position in our inflation-protected securities fund.  (VIPSX to be exact.)  Just a simple, logical strategy that has done well for us, as VIPSX is up 12.6% in the last year.  I’m no genius, but where else would inflation-fearing, logical investors go with their money in scary economic times, with stagflation on the agenda?

As always, Mr. ToughMoneyLove is ready to be persuaded that his logic is all wrong or that there are better inflation fighting weapons available to us.  So show me some tough love.  Fire when ready.

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6 Responses to “When Inflation Attacks, Gold is Not the Defensive Weapon of Choice”
  1. goldenrail says:

    Thank you for this post Mr. ToughMoneyLove. I saw an advertisement about investing in gold playing on a Vanderbilt informational TV on campus yesterday and was wondering if it was really a sound investment strategy. Now my questions have been answered, and I’m more concerned about where I saw the ad.

  2. Andy says:

    Great analysis and I like your approach to mitigate inflation concerns. I am not a big gold fan myself….

  3. Andy – Thanks for your comment. My brother has been a gold addict for years. I think he has done OK but at my age the volatility and lack of correlation with anything except bad world news is too much for me to handle.

  4. MasterPo says:

    I would own some physical gold for diversity sake and some other intangable reasons. But as a long term inverstment – definately not.


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