Investment Articles

04/01/10 - It's not Gold, Jerry

By: Jeremy Carpenter, MBA

We’ve all heard it before.  If you turn on any financial news station you are inundated with experts or commercials saying, “Gold is the best hedge against inflation,” “You need gold in your portfolio now,” “Learn how to trade gold for yourself”.  In fact, it reminds me of a few other times in history when we’ve been berated with a constant sales pitch.  Each time that I can recall it has ultimately ended in a major bubble bursting.  Currency trading, oil, and internet stocks come to mind.  The last time this happened, before I worked with Investor Solutions, I was a market maker with E*trade Financial.  I was in a pit with several other traders watching CNBC.  They were running a feature on real estate, specifically Miami’s real estate.  I can remember a senior trader turned to me and said, “Well that’s the top of that market.  Only suckers will be buying there now.”  That was April 2006 and we now know that there wasn’t much price appreciation between April and the top of the market and less than a year later it crashed.  Not to mention, Miami is one of the hardest hit locations in the country.  Which brings me back to my point, besides being a potential bubble, gold is not an effective hedge against inflation.

The two things you should look for when choosing an effective hedge is either a vehicle with a 1 to 1 positive correlation with whatever you are hedging against or an asset class that consistently outperforms inflation.  As you take a closer look at the historical performance of gold, you see that neither is true.  Though many believe that an inevitable collapse of the markets will cause a flight to gold, there is no evidence that gold is anything more than a speculative asset.  It has no real value.  It is a luxury commodity with no coupon rate or growth prospects.  Warren Buffett famously remarked, “It gets dug out of the ground...then we melt it down, dig another hole, bury it again and pay people to stand around guarding it.  It has no utility.  Anyone watching from Mars would be scratching their head.”

One of our prerequisites for a good hedge is the asset’s correlation with whatever it’s trying to hedge against.  Looking at the correlation matrix below we see that gold isn’t very closely correlated with the Consumer Price Index (CPI or inflation index).  Asset classes that are closely related would be the S&P 500 and the Russell 2000 Value at .80.  Interestingly enough a basket of commodities like the S&P GSCI actually performs closer to the CPI than gold does.  The GSCI has a component of gold in it but it’s small at around 3%.  If you took the energy component entirely out of the GSCI gold would still be only 10%.  Additionally, we’ll see later that the GSCI has a better historical return than gold.  Taking these two things into consideration, why wouldn’t one buy a diversified basket of commodities rather than just gold itself?

Sources: Zephyr Associates, Inc. S&P GSCI Commodity Index Gold Performance: London Fix - http://www.kitco.com/charts/historicalgold.html

The second requirement we looked at was constant outperformance of an asset versus what you’re hedging against.  The 30 year historical return graph below shows the Consumer Price Index, or inflation index, as the green line.  As you can see gold, which is the gold line, has several periods of underperformance versus the CPI.  The majority of the performance is either in-line or worse than inflation.  This is not the mark of the kind of consistency we are looking for.  You can see with the brown line how the basket of commodities has dramatically outperformed gold.  More importantly the graph shows that short-term, high quality bonds (the tan line) have constantly increased in value and consistently beaten inflation.  The black and the light blue lines show the performance of the overall market, domestic and international respectively.  They have produced consistent outperformance over the entire 30 year period not to mention that an international portfolio hedges against another problem, currency risk.  Finally, the dark blue line represents the Russell 2000 Value index.  This shows how Investor Solutions’ philosophy of a small and value tilt can favorably add to your portfolio’s performance.

I mentioned buying a basket of commodities instead of just gold to hedge against inflation, but my suggestion is to go beyond that.  The historical returns chart shows that short-term, high credit quality bonds steadily increase over time far outpacing inflation even during the worst inflationary times.  TIPs are talked about as a great hedge for inflation.  My only reservation is that they haven’t been around long enough to get a good picture of how they perform in relation.  Equities, even after this rough 10 year patch, still have an impressive run over 30 years.  These factors indicate that the best way to hedge against inflation is still with a diversified portfolio of global equity and short-term high quality fixed income.  As you get closer to retirement or drawing down your portfolio you need to reduce your risk to bear markets as short-term events have a greater impact.  These are the best ways to avert inflationary pressures.

 

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