Why Gold Isn’t A Perfect Inflation Hedging Tool

It’s no news that inflation is one of the biggest retirement risks. There is a school of though that allocating a portion your self-directed IRA to precious metals – like gold or its stocks – could help hedge against inflation. In fact, with buzzes going around that inflation is around the corner, gold IRA rollover is becoming increasingly popular. But, in reality, gold isn’t the ultimate inflation-hedging tool it’s being made to be. Here is why.

Inflation isn’t what dictates the price of gold

The idea of using gold or its derivatives to hedge against inflation is rooted in the fact that the price of the commodity gold often move counter to the value of the US dollar. Therefore, if inflation, which reduces the dollar value, sets in, it’s expected that the price of gold would rise.

However, just like any other thing in any market, the law of demand and supply is what dictates the price of gold. According to the data provided by Statista regarding the global demand for gold, there are three categories of demand for gold. They are demand for gold: for the jewelry market, for the technology world and for investment purpose.

The demand from the jewelry market has consistently accounted for about one-third of the total demand for gold. Thus, logically, it is expected that this category of demand should have more influence on the price of gold. But, instead, it’s the demand for gold investment that has more influence on the price of gold.

Now, since demand for gold investment usually increases during inflationary periods, gold usually performs well. The bad thing is that most people have been led to believe that inflation dictates the price of gold. History has flawed this logic repeatedly. The chart below from CPM Group (found on Kitco.com) explains this better.

investment_demand_vs_gold_price_1966_2012

As seen in the chart above, since 1969, there has been a percentage increase in the price of gold whenever its investment demand increases. A look at the performance of gold in US inflationary periods shows a bit of correlation, but it doesn’t give a definite conclusion that gold performs well during inflation.

inflation_rate_US_1916_2012

In the last hundred years, the United States has seen two major inflationary periods. The first was in the 1940s, while the second occurred in the 1970s. At the start of 1940, inflation rate in the US was near zero percent (source). In 1947, inflation rate rose above the 14% mark and then the cycle ended at around 1950. To justify the case that gold performs during inflation, the price of gold also rose to a decade-high annual closing price of $43 in 1947.

However, the 1970s inflationary cycle shows some divergence from the positive gold-inflation logic. While gold seemed to perform well during this cycle, the periods when gold rose were more directly related to periods of increased investment demands than when inflation was at its peak. In 1975 and 1976, the demand for gold investment plunged and as a result, the annual closing price of gold fell during the two years. One thing that even flaws the positive gold-inflation logic is that inflation rate was at a five-year peak of around 11% during the period between 1975 and 1976, when price of gold plunged.

This tells us that the act of investing in gold during inflation has been around for a long time. However, inflation isn’t what makes gold perform; an increased demand for gold investment is what does. And as shown over last decade, when inflation rate has been relatively flat, increased demand for gold investment has been the main driver of the gold price surge. Therefore, if the demand for gold investment doesn’t rise during an inflationary period, there is no guarantee that gold would be perfect for hedging inflation.

Gold stocks also perform similar to gold investment demands

A look at the collective performance of gold stocks also shows a correlation with gold investment demands. Let’s consider the NYSE ARCA GOLD BUGS INDEX (NYSE: ^HUI). We’re considering this index because it gives a broader view of miners’ performance. Moreover, the mining industry is used to mergers, making it daunting to discuss performances of some individual companies accurately. For clarity sake, the HUI index takes into record the performances of big miners like Goldcorp (NYSE: GG), Barrick Gold (NYSE: ABX) and Newmont Mining (NYSE: NEM).

There isn’t information available for a hundred years, but we can make sense out of the little we have.

HUI_index_1996_2013

If you’d compare the above chart to the gold investment demand chart from earlier, you’d find that the index performs well whenever the demand for gold investment rises – and vice-versa. On the other hand, when the index is compared to inflation rate in the chart below, you’d find that there is no particular trend. In fact, during the period between 2001 and 2002, when inflation rate dropped, the index was on its way up – a period during which demand for gold investment rose.

Although, during the period between 1997 and 1998, the index dropped as inflation rate dipped, nothing can be concluded from this since it was a period during which demand for gold investment dipped as well.

inflation_rate_US_1995_2012

Conclusion

From above, we’ve seen that the price of gold isn’t entirely dependent on inflation rate. As such, whenever you choose to invest in gold or its stocks, you shouldn’t do it with the sole intention of hedging your retirement savings against inflation. With more people becoming increasingly aware of this truth, increase in investment demand for gold might not accompany the next inflationary cycle – as history has shown us – which could diminish the value of gold. The bottom line is investing in gold is a great way to diversify your portfolio – nothing more.

About the author: Craig Adeyanju is passionate about writing about financial topics and investing. He has been a contributor on sites like Fool.com and SeekingAlpha.com. His goal is to provide real world retirement investing opportunities for baby boomers and early retirees. You can connect with him on Twitter and Google plus.

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