Gold Gold Gold! As the greediest species on the planet, we can’t get enough of it. And the US is no exception. Ever since the California Gold Rush in 1848, Americans have had an unnatural obsession with gold, and have creeped in some illogical economic advice into the average investor’s mind.
I’m talking about using gold as an inflation hedge. Here’s how the logic goes: despite the fact that gold is only slightly more useful than the green in your wallet, there is a limited supply of it, but an unlimited supply of potential money (all the Fed has to do is update an electronic balance). This means that if inflation increases prices so high that money is unusable, gold will come in and replace it. After all, all paper money was backed by gold only 50 years. So as inflation numbers increase, gold should increase in step right?
Perhaps not, take a look at this chart comparing monthly gold prices with the monthly CPI numbers.
Despite all the gold-inflation link talk during QE1 and QE2, the correlation between these two series from 1970 to 2012 is about 43%, which means that there’s hardly a connection to be seen. Now why could this be? Warren Buffet explained this in an article from Forbes. Since I’m not trying to outdo the Oracle, I think I’ll let his words speak for themselves:
Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce — gold’s price as I write this — its value would be about $9.6 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers — whether jewelry and industrial users, frightened individuals, or speculators — must continually absorb this additional supply to merely maintain an equilibrium at present prices.
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops — and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil (XOM) will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.
Gold does not produce productive value as real money can in our current economy. So while we may see some short term connection during another quantitative easing run, don’t expect an investment in Gold to outperform something like TIPS when inflation starts to go bonkers.