Gold and Inflation

[Tiburon]

I have a question for you Permanent Portfolio experts out there.

First, let me say that I agree wholeheartedly with the basic concepts of the PP. My broad asset allocation is 1/3 Equities, 1/3 Fixed Income and 1/3 Hard assets (raw timber land, commercial real estate, and gold). The gold represents about 2% of my total portfolio.

With gold's significant drop (-29% this year - with this being the first yearly decline since 2000 and the biggest since 1981), I have been giving it more thought.

Here is my question.
The PP theory says gold should do well when inflation is high but the run up since 2002 seems to have very little to do with inflation and much more to do with the global increase in all commodity prices – steel, oil, etc. etc. based on the global (read Chinese) surge in consumption.

Inflation was essentially the same in the 2000s or even lower than it was in the 80s and 90s but gold was flat until 2002 and then more than tripled in price.

http://www.usinflationcalculator.com/in ... ion-rates/

http://www.kitco.com/scripts/hist_chart ... graphs.plx

Without this unusual run up, the PP returns would look significantly worse.

What am I missing?
Modify message

[Libertarian666]

Actually I think gold responds to negative real interest rates, which we have had since 2000 or so.

[Pointedstick]

Actually I think gold responds to negative real interest rates, which we have had since 2000 or so.

That, and serious inflation. Gold seems to be lackluster when inflation is positive, but fairly low like we've been seeing for the last couple of years. However, should we be getting yearly price increases of 10% or more, gold will probably do very, very well.

[dualstow]

The PP theory says gold should do well when inflation is high

In one of the radio shows archived on Craig's Crawlingroad website, Harry Browne stated that gold's rise won't necessarily match up chronologically with inflation's rise. It may precede it, it may follow it, or it may overlap it.

[Tiburon]

Actually I think gold responds to negative real interest rates, which we have had since 2000 or so.

That, and serious inflation. Gold seems to be lackluster when inflation is positive, but fairly low like we've been seeing for the last couple of years. However, should we be getting yearly price increases of 10% or more, gold will probably do very, very well.

So again, why did gold triple in price from 2002 to 2013? Negative real interest rates?

My concern is that the PP theory really doesn't explain gold's behavior and without this 10 year aberration, the PP performance looks significantly worse and a 25% Gold allocation appears to be an unnecessary drag on a portfolio over the long run - like it was before 2002.

My guess is that without this huge Gold spike the PP book would not have achieved nearly as much traction.
And understand, I basically agree with the concepts. I am not a hater! I am just trying to point out what appears to be an obvious problem.

[Pointedstick]

Maybe not so much negative real interest rates but falling real interest rates. The closer they get to negative, the higher gold seems to go.

[murphy_p_t]

nice chart, PS.

My interpretation of this is that the "theory" is more like a story to help people into the PP. My instinct is that these things are just too unpredictable. For example, the "theory" is that we have rising stocks in "prosperity" climate. Does the 30% rise we experienced in stocks last year correspond with general increasing prosperity in the USA? If it does, I don't see it.

[Pointedstick]

nice chart, PS.

My interpretation of this is that the "theory" is more like a story to help people into the PP. My instinct is that these things are just too unpredictable. For example, the "theory" is that we have rising stocks in "prosperity" climate. Does the 30% rise we experienced in stocks last year correspond with general increasing prosperity in the USA? If it does, I don't see it.

Nobody ever knows why any assets do anything, really. In the past few years, we've had stocks rising without real prosperity, gold rising without real inflation, bonds rising without deflation… it goes on and on. Nobody can predict what the macro asset classes are going to do even though historically they often follow a general pattern.

[modeljc]

Maybe not so much negative real interest rates but falling real interest rates. The closer they get to negative, the higher gold seems to go.

PS nice chart!  Is there a way to get it up to date through 2013?

[Benko]

Nobody ever knows why any assets do anything, really. In the past few years, we've had stocks rising without real prosperity, gold rising without real inflation, bonds rising without deflation… it goes on and on. Nobody can predict what the macro asset classes are going to do even though historically they often follow a general pattern.

PS,

I realize this is likely an unanswerable question, but if you had to speculate, do you think that is because things really are different now then previously (for whatever reason), or that it's always been different and this time period is no more different than other time periods?

[Libertarian666]

Nobody ever knows why any assets do anything, really. In the past few years, we've had stocks rising without real prosperity, gold rising without real inflation, bonds rising without deflation… it goes on and on. Nobody can predict what the macro asset classes are going to do even though historically they often follow a general pattern.

PS,

I realize this is likely an unanswerable question, but if you had to speculate, do you think that is because things really are different now then previously (for whatever reason), or that it's always been different and this time period is no more different than other time periods?

As a wise man once said, "Things are more like they are now than they have ever been before."

[Tiburon]

Again, why didn't Harry Browne or Craig Rowland mention all these explanations?
Is gold now supposed to be a hedge against falling real interest rates?

[HB Reader]

Again, why didn't Harry Browne or Craig Rowland mention all these explanations?
Is gold now supposed to be a hedge against falling real interest rates?

Tiburon –

I've followed the PP strategy for many years and have pondered the same questions you've raised about the relationship between gold, inflation, and real interest rates.

The relationship clearly isn't simple like the mechanistic inverse relationship between long-term interest rates and bond prices.  Or even the more complicated but still fairly direct relationship between prosperity and rising stock prices (whereby the stock market reflects overall conditions in the economy, but market moves may vary because of the constantly shifting consensus by investors about current or future monetary policy, rising or slowing productivity in the economy, etc.).

In our common parlance, the term “inflation”? is usually invoked to describe monetary deterioration through consumer prices rising at an alarming rate, especially as seen through statistics like the CPI.  But I think inflation is a much more complex monetary phenomenon than that.  If you think it through, monetary destruction can also be manifested through long periods of negative real interest rates, although on the surface the deterioration may not seem as obvious as rising consumer prices.  Negative real interest rates mean you aren’t receiving a sufficient interest return on your money to compensate for the fall in the purchasing power of the money.

I think the best explanation for the gold/inflation connection is contained in Chapter 25 of HB’s 1987 “Why the Best Laid Investment Plans Usually Go Wrong.”?  Read the entire chapter carefully, particularly the discussions: “The US Dollar is #1”?, “Gold is #2”?,”?Crises”?, and “Deflation”?.  I think it gives a reasonably good explanation of the complex and volatile interplay between the dollar, gold and the push and pull of inflationary and deflationary forces.  While HB didn’t discuss changing real interest rates in that chapter, I think his explanations and inferences can logically be applied to how the US dollar and gold relationship might be impacted when such a variable is injected into the equation  In his newsletter (which I read from 1980 to 1995) he did occasionally speculate that there could be factors other than consumer price inflation (like a banking crisis or the confusion/fear accompanying the start of a deflation) that might cast doubt on the safety of the US dollar.
 
It is actually quite difficult to come up with a precise definition of inflation everyone will accept – probably because some people are referring to the actual “money supply”? (itself notoriously difficult to define) while others are simply referring to “prices”? (also notoriously difficult to measure) in the economy.  I think most people do agree it involves, in one way or another, the on-going process whereby our government and central bank creates money and credit to try to stimulate the economy and/or prevent the wide-spread liquidation of enterprises in the economy that may or may not be economically sustainable in the absence of the money and credit creation.

Some fear the money and credit creation process will lead to dangerously rising prices (e.g., the US CPI in the 1970s, German price inflation in the early 1920s), or unsustainable bubbles in certain asset classes (e.g., the US housing market before 2008, the US stock market in the 1920s), or other malinvestments.  Others believe the process can be managed in a manner whereby excessive price rises and other negative effects can be minimized and the overall process can lead to beneficial results for the economy as a whole.

Given these differing points of view, it is hardly surprising that reactions to “inflation”?, interest rates, and the exchange rate of the US dollar (the supply and demand for which is highly variable) versus gold (the supply of which is largely fixed, but the demand for which is highly variable) are so volatile and don’t fit into neat little time lag and relationship boxes.

As HB explained in 1987, the key point is that in periods of perceived crisis (whether political, economic or monetary) people’s demand to hold “money”? in some form versus other assets increases.  This often manifests itself in increased demand for the US dollar, but if something (like expected high US price inflation, or a banking crisis in the US where most dollars are held) casts doubt on the safety of the US dollar, some of this demand for “money”? shifts to gold.

I realize the logic here may seem a little tortured, but based on my investment experiences over many years I think it is valid.

[Pointedstick]

Excellent post, HB Reader!

[clarara]

Interesting discussion. I also read that gold isn't the best thing to invest in under inflation conditions. Here is another chart which demonstrates it - you might be better off investing in real estate: http://www.statista.com/statistics/2727 ... inflation/

[dragoncar]

Interesting discussion. I also read that gold isn't the best thing to invest in under inflation conditions. Here is another chart which demonstrates it - you might be better off investing in real estate: http://www.statista.com/statistics/2727 ... inflation/

That's a survey...

[barrett]

Maybe I should start another thread but I think this ties in with the gold vs. inflation topic here... I read James Rickards' book Currency Wars a while back (It's actually what pushed me to explore the PP). He talked a fair bit about how when a major economy (the US, in this case) starts printing a lot of money, other economies are forced to do so as well in order to prop up the value of the goods and services they are trying to sell (We will simultaneously devalue so that everything is not cheaper in US$ terms). Does anyone on here have the figures for what China and The Eurozone have been doing while the US was printing 85 billion a month (now 75 billion, allegedly, though there seems to be some indication that the FED has not actually started to taper... just announced its plans to do so). While he only offers one hypothetical scenario about what might happen this time around, Rickards often says in that book that currency wars "never end well." He speculates that whatever happens people are going to be in a situation where they will want to be holding some gold. But, back to my question about the Chinese and Euros, or any other major economy for that matter. Have they been matching us step for step in printing money? Thanks.

[brownehead]

The PP theory says gold should do well when inflation is high but the run up since 2002 seems to have very little to do with inflation and much more to do with the global increase in all commodity prices – steel, oil, etc. etc. based on the global (read Chinese) surge in consumption.

Inflation was essentially the same in the 2000s or even lower than it was in the 80s and 90s but gold was flat until 2002 and then more than tripled in price.

http://www.usinflationcalculator.com/in ... ion-rates/

http://www.kitco.com/scripts/hist_chart ... graphs.plx

Without this unusual run up, the PP returns would look significantly worse.

What am I missing?

I view this in a simpler way: gold not only reacts to inflation, but to expected higher inflation. And both rising commodity prices and extraordinary economic stimulus causes expectation of higher inflation, then gold rises.

[jason]

Interesting discussion. I also read that gold isn't the best thing to invest in under inflation conditions. Here is another chart which demonstrates it - you might be better off investing in real estate: http://www.statista.com/statistics/2727 ... inflation/

That's a survey...

I'm pretty sure that HB talked about real estate and commodities other than gold, and while they may be good inflation hedges, only gold can be counted on in a serious economic crisis/collapse.  As we saw in 2008, when the economy crashed, real estate crashed, too.  This is the reason why silver, for example, is not part of the PP.  Silver is a pretty good hedge against inflation, but it's an industrial metal, so in a bad economy, the industrial demand for silver is likely to drop, decreasing the price.  Over the past several thousand years of history, when the SHTF, people have consistently turned to gold (not silver, not copper, not diamonds, and not real estate).