Gold for Deflation?

[buddtholomew]

According to William Bernstein in Deep Risk, gold tends to outperform in periods of deflation. He doesn't provide the rationale says the rise is a result of a pursuit for real return. This is consistent with what I have read before -  negative real interest rates can drive gold higher. Is this synonymous with deflation?

[barrett]

The short answer is no, they are not the same.

We have had negative real interest rates here in the US for a while because:

Real Interest Rate = Nominal Interest Rate - Inflation

Real rates are incredibly low while there is still some inflation so, using the above formula, you get a negative number.

Deflation is where prices are going down. My understanding is that it doesn't happen very often but that it is very bad when it does (Japan is the prominent recent example).

Where are those backtesting results for the Japanese PP?

[D1984]

If anything, negative real rates are nearly the opposite of deflation; in a system that has any kind of paper currency at all, the zero lower bound will be an issue (rates can't go much below zero for any length of time since people would just choose to hold physical currency instead) and this means that during a time of deflation nominal interest rates (even if at 0%) will be positive during a time of deflation since even earning zero percent is a real return if prices are declining.

Negative real rates happen when inflation is higher than interest rates themselves. This means that even if you earn (for example) 2% but inflation is at 4%, you have lost money in real terms even as you've gained it in nominal terms. Sharply negative real rates (or the expectation of them) are generally good for gold. Sharply positive real rates (like we had for most of the 1980s and 90s), on the other hand, are typically pure poison for gold so one wonders why Bernstein would state that deflation is good for gold (the 1930s don't count since the US government artificiality raised the gold price from $20 to $35...that wasn't the market reacting to deflation) unless he meant that central bank actions to combat said deflation, and not the deflation itself, might be what was good for gold.

[barrett]

Here is the Japan data I was referring to (along with PPs for Iceland, The Eurozone and The UK):

http://europeanpermanentportfolio.blogs ... folio.html

The real inflation/deflation numbers in the right hand column when cross referenced with how gold performed doesn't seem to support Bernstein's claim. Of course this is only one example.

[murphy_p_t]

au went to$35 from $20 during the deflationary 1930s

[barrett]

Murphy, Are you pulling our legs? The USG fixed the price of gold in the 1930s (and well before that). First it confiscated gold from US citizens when the price was set at $20, and then they raised the price to $35. Major a-hole move on their part.

What I wonder about is gold's reaction to inflation in the 1970s. Prior to 1972, the price was still fixed so we don't know what the actual market price would have been. It was then unpegged from the dollar and the price (during a time of inflation) shot up until it was briefly over $800 per ounce. When interest rates started falling the gold price "settled down" (I think I am correctly paraphrasing Harry Browne here). It stayed in a range - more or less - from about $250 to $400 until 1999. So do we figure that the price at which people are comfortable holding gold - absent serious inflation or negative real rates - is actually in that range?

Harry Browne said in one of his podcasts (around 2004) that the USD was the world's #1 reserve currency but that when the USD was threatened, people would turn to their #2 choice which was gold. To my mind, with that statement he went beyond saying that gold only does well during serious inflation or negative real rates. I believe he foresaw that there could be other circumstances where gold would do great, say, for example, when major economies all start printing money like a bunch of mofos.

Still waking up. Any typos are mine and mine alone.

[buddtholomew]

Bernstein considers TIPS, value stocks and diversifying internationally as better inflation hedges than gold.

[barrett]

He may be right about TIPS but they have only been around since 1997 so we don't really know. I bought some around 2001, held them to maturity and did well with them. Seems like they are only designed to give limited inflation protection, plus they are USG instruments so they can change the rules anytime they want to (or, at the very least, you have to accept their numbers for the CPI).

From what I know, Bernstein's recommends 75% in stocks and 25% in bonds. Value stocks can get pounded when stocks in general get pounded which is why I would be leery of those as an inflation hedge. International stocks are subject to exchange rate fluctuations which means that they could outperform or underperform for more than one reason.

Budd, Do you recommend Deep Risk?

[buddtholomew]

Not at all. The parallels to the permanent portfolio are too recognizable to ignore yet the delivery lacks clarity and actually introduces more confusion. He dismisses the PP on the grounds that it does not protect the investor from deep risk (long-term risk >20 years) as it is not equity centric, has too much in fixed income and cash investments as well as gold. In his view, gold is a deflation hedge and equities have demonstrated their ability to respond to inflation and provide a positive real return.

His four horseman include inflation and deflation (HBPP), confiscation (HBPP advocates offshore investments as well) and devastation (basically ignored as nothing will save you from this outcome besides equities as they have the chance to recover.). Equities in large portions are a given. So you see, the concepts are not novel by any stretch of the imagination. He only substitutes equity investments for gold (PME) and the rest stays pretty much the same. The one difference is his recommendation to not concern yourself with deflation as Japan is an outlier...

So invest in stocks (International, Value, PME), some gold and TIPS if you are looking to hedge inflation, deflation, confiscation or devastation. The only caveat is your horizon should be >20 years. Not very actionable for an investor who has to mitigate shallow risk (short-term) events as they have the potential to derail your portfolio.

One POV that I agree with is the arbitrary 25% allocated to each economic outcome. This has been discussed on this forum but I am not sure any conclusion was reached.

[dualstow]

Bernstein considers TIPS, value stocks and diversifying internationally as better inflation hedges than gold.

But Dr Bernstein doesn't hate the permanent portfolio strategy.

[Observer]

Hi All

I bet Deep Risk does'nt go into behavioral dynamics of investors? or does it? who would wait for 20 years to prove to themselves whether Equities are a good hedge for inflation ? (especially when there is Japan as an example)

It seems to me that  Equity markets are always positively correlated across the globe with differing levels of volatility/standard deviation, and that diversifying across different international equity markets will not provide TRUE diversification, but it will only give volatility diversification.

https://www.vanguard.co.uk/documents/ad ... d-bond.pdf

Listening to one of Harry Brownes podcasts , he did mention that there was no real sophistication behind splitting the four asset classes equally 25%, and the reason he did this was to avoid any behavioural bias to to market time across different asset classes. I think he really addressed the behavioral side to investing more than any other observer, and that is one of his legacies

Mitul

[buddtholomew]

Bernstein considers TIPS, value stocks and diversifying internationally as better inflation hedges than gold.

But Dr Bernstein doesn't hate the permanent portfolio strategy.

He may not hate the PP strategy, but I wouldn't say he is an advocate of it either. How can you promote the PP and at the same time challenge the allocation to gold, treasuries and cash as well as the reduced amount to equities.

What makes the PP the PP? Is it the 4x25 quadrant with equal weightings to each asset or the assets themselves? In other words is a 50/40/10/0 (stock, bonds, gold, cash) allocation considered investing in the permanent portfolio?

[Reub]

Hi All

I bet Deep Risk does'nt go into behavioral dynamics of investors? or does it? who would wait for 20 years to prove to themselves whether Equities are a good hedge for inflation ? (especially when there is Japan as an example)

It seems to me that  Equity markets are always positively correlated across the globe with differing levels of volatility/standard deviation, and that diversifying across different international equity markets will not provide TRUE diversification, but it will only give volatility diversification.

https://www.vanguard.co.uk/documents/ad ... d-bond.pdf

Listening to one of Harry Brownes podcasts , he did mention that there was no real sophistication behind splitting the four asset classes equally 25%, and the reason he did this was to avoid any behavioural bias to to market time across different asset classes. I think he really addressed the behavioral side to investing more than any other observer, and that is one of his legacies

Mitul

[Observer]

Interesting comments Bud

I would say that what makes the PP a PP is the Optimal identification of assets that will ALWAYS be held, so that these assets can take advantage of ALL economic environments as and when they arise. Harry Browne identified stock, bonds, gold, cash as Optimal (i suppose) because they were the most responsive to changes in economic perceptions. What makes these assets permanent (i suppose) is he couldn't think of any other assets that should be held better than the ones he has mentioned. What i would be interested to hear about would be, how would we know whether these assets are no longer effective for their designated purposes - when or how would we know this?

I would say that investing in a 50/40/10/0 (stock, bonds, gold, cash) allocation would be an allocation to the permanent portfolio if (for whatever reason) ONLY those 4 asset classes would be held. However, i feel any deviation from equal weighting would go against the spirit for which the permanent portfolio was designed, ie to eliminate forming a bias. Also, because there are 4 main economic environments, there is an equal weighting to 4 economic environments, if there were 5 main economic environments , i would imagine there would be a 20/20/20/20/20 split

hope the above was'nt too boring

[barrett]

What i would be interested to hear about would be, how would we know whether these assets are no longer effective for their designated purposes - when or how would we know this?

Observer,

Yeah, that is what people are wondering for the most part when they start threads like "Is the PP Broken?" We don't really know, but the fact that there is a specific intention behind holding each of the four assets, I think appeals to a lot of PPers.

Thanks for editing your original post, Budd. The Bernstein rationale still seems a bit flimsy because "pursuit of real return" doesn't seem gold specific. For example, 30-year bonds - even those with a 3% coupon - would look mighty attractive during a deflationary period.

And are we really not supposed to concern ourselves with Japan? I would be very surprised if The Fed is not concerned with a Japan-style deflation. They don't have a lot of tools left (ZIRP and printing don't seem to be able to really goose the US economy). Sure feels kinda similar to me.

[dualstow]

{ Bernstein }may not hate the PP strategy, but I wouldn't say he is an advocate of it either. How can you promote the PP and at the same time challenge the allocation to gold, treasuries and cash as well as the reduced amount to equities.

I don't think he would recommend any of those assets in isolation, but that's ok. Neither would Harry Browne.

[Libertarian666]

I have corresponded with Bill Bernstein about his neglect of solutions to serious risks that he actually identifies. His response, paraphrasing, is that the only way Americans can really geographically diversify to hedge against risks to the dollar and to the US economy is to buy physical gold overseas, and gold is "too complicated".

I don't understand what is so complicated about gold, but that's his objection.

[buddtholomew]

I have corresponded with Bill Bernstein about his neglect of solutions to serious risks that he actually identifies. His response, paraphrasing, is that the only way Americans can really geographically diversify to hedge against risks to the dollar and to the US economy is to buy physical gold overseas, and gold is "too complicated".

I don't understand what is so complicated about gold, but that's his objection.

His loyal fan base ascribes to the BH investing philosophy and the community's perspective on investing in precious metals. PM equities are an exception as they generate dividends, etc.

[dualstow]

(Bernstein's) response, paraphrasing, is that the only way Americans can really geographically diversify to hedge against risks to the dollar and to the US economy is to buy physical gold overseas
...

Buy physical gold overseas or just hold it there?
Isn't just buying physical gold good enough?

[Libertarian666]

(Bernstein's) response, paraphrasing, is that the only way Americans can really geographically diversify to hedge against risks to the dollar and to the US economy is to buy physical gold overseas
...

Buy physical gold overseas or just hold it there?
Isn't just buying physical gold good enough?

Not if the US makes it illegal to own gold... again.