Swedroe: Don’t Be Distracted By Gold’s Glitter

March 17, 2017

In terms of gold’s value as an inflation hedge, the following example should help provide an answer. On Jan. 21, 1980, the price of gold reached a then-record high of $850. On March 19, 2002, gold was trading at $293, well below where it was 20 years earlier. Note that the inflation rate for the period 1980 through 2001 was 3.9%. Thus, gold’s loss in real purchasing power was about 85%. How can gold be an inflation hedge when, over the course of 22 years, it loses 85% in real terms?

As additional evidence of gold’s inflation hedging abilities, Goldman Sach’s “2013 Outlook” contained the following finding: During the post-World War II era, in 60% of episodes when inflation surprised to the upside, gold underperformed inflation. That said, gold has been a good hedge of inflation over the very long run (such as a century). Unfortunately, that’s a much longer investment horizon than that of most investors.

Thus, in two of the three cases, with the exception of the safe-haven hypothesis, there is not sufficient evidence to support investing in gold.

A Research Update

In August 2015, Erb and Harvey updated their 2012 study. They began by examining the argument that gold is an inflation hedge, or what they call a “golden constant.”

The authors explained: “One way to think about the golden constant perspective is as a collection of statements that assert that: 1) over a very long period of time, the purchasing power of gold remains largely the same; 2) in the long run, inflation is a fundamental driver of the price of gold; 3) deviations in the price of gold relative to inflation will be corrected; and 4) in the long run, the real return from owning gold is zero.”

Their study covered the period beginning in January 1975. The authors found that, over the period, the average real price of gold is 3.46 times the U.S. Consumer Price Index (CPI). I updated the data through January 2017. Doing so put the CPI level at 241.7. Multiplying gold’s average real price by the current CPI (3.46 x 241.7) delivers a price of approximately $836. This represents what the nominal price of gold should be today—if we assume the real price of gold is constant.

Of course, over time, prices have strayed far from the golden constant. And, as Erb and Harvey noted, the golden constant isn’t a fact, just a hypothesis. But if your reason for buying gold is that it is an inflation hedge, your expectation should be that gold will revert to its golden constant over time. Despite haven fallen from a peak of almost $1,900 in September 2011, with the price of gold at about $1,209 as I write this, it’s still about 45% above the golden constant of $836.

Returning to the 2015 update of Erb and Harvey’s paper, they asked: If the golden constant provides a guide to the value of gold, what typically happens when the price of gold is above or below its golden constant value? They found that the high real price of gold has been about 8.73 and the low real price of gold has been about 1.47.

Thus, while there is a tendency to revert to the golden constant, the price of gold can vary greatly from the golden constant and stay well above or below it for a long time. And as the authors observe, there is no way of knowing if the “future high and low real prices of gold may be more or less extreme than in the past.” As of March 2017, those are still the highest and lowest values. In addition, the current real price of gold is about 5.00, roughly 45% above its historical average of 3.46.


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