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Why Gold Is an Excellent Deflationary Hedge

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Deflation is here now -- and it may be with us for a while. Uninformed observers contend that the central bank has an unlimited capacity to print money, hence deflation can be avoided, but as we can see by the collapse in housing prices and the inflation indexes of late, this is easier said than done.

Last month, I wrote a short piece on deflation, but I think the topic deserves more time.

Cash for gold
If you've not read the entire "helicopter" speech by Fed Chairman Ben Bernanke, I encourage you to do so. (It's available here.) The speech provides more details on deflation, but Bernanke also compares the U.S. dollar to gold:

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Now, in my view, it is the very collapse of the credit mechanism that has resulted in this deflationary cycle, and printing money will not be able to compensate for it for some time. Money and credit are not the same things. You can give the banks all the money in the world, but if they don't lend it, it will not make much difference.

Why did gold touch $1,000 an ounce this month if we have falling prices? Wasn't gold a classic inflation hedge?

Here's the thing: Gold is an asset, not a liability on anyone else's balance sheet. Remember the Primary Reserve fund? Lehman Brothers' short-term bonds (i.e., liabilities) were the fund's assets. When Lehman blew up, so did the fund. This would never have happened if the fund held gold bars as assets; they are no one's liability.

Bullion vs. stocks
In my opinion, the most egregious error investors make is to use gold stocks as substitutes for gold bullion. They are not the same thing.

Gold stocks are financial assets that have claims on gold bullion, while gold bullion is a real asset that, again, is not a liability on anyone else's balance sheet. In deflationary 2008, gold bullion was up 5.8%, while the larger-cap PHLX Gold and Silver Index (XAU) was down 27.7%. This was driven by fund liquidations because of investor redemptions, resulting in gold stocks' cheapest valuation since the bull market began in 2000 in relation to the price of gold. You can see that by simply dividing the value of the XAU index and the gold price.

Since the central bank has embarked on quantitative easing, much as was outlined in Bernanke's helicopter speech, I expect more dollars to chase a finite supply of gold for some time to come, even in a deflationary environment caused by tight credit conditions. This is likely to put upward pressure on gold prices.

Gold bullion is investable through the SPDR Gold Shares (GLD), which trade at one-tenth the price of gold and will deliver nearly identical performance. For those who can take the risk, there is a new product called the Deutsche Bank Double Long Gold (DGP), which delivers double the monthly performance of gold bullion. But keep in mind that while the GLD is an exchange-traded fund that holds physical bullion, the DGP is an exchange-traded note (ETN) that holds no bullion. Instead, the DGP is a liability of Deutsche to pay double the return of gold to those who buy the ETN. If Deutsche fails -- and it really is too big to fail, as it is the biggest financial institution in Germany -- the ETN is worthless, as was the case with similar ETNs from Lehman Brothers.

Another way to have leverage to the gold price is via the purchase of gold stocks. The Market Vectors Gold Miners ETF (NYSE: GDX  ) offers a nice broad participation in both large and medium precious-metals producers. Among the ETF's top holdings are AngloGold (NYSE: AU  ) , Barrick Gold (NYSE: ABX  ) , and Gold Fields (NYSE: GFI  ) .

The last time gold was near $1,000 an ounce in March 2008, the GDX was trading near $55. Eleven months later, gold is again near $1,000 an ounce and the GDX is trading near $35, while gold mining costs have declined courtesy of the collapse in the price of oil. Due to the use of heavy diesel-powered mining equipment and many chemicals, the price of oil is a big component of mining costs. In other words, gold stocks look like a great buy on any pullback here.

A great fund that tends to invest in smaller, more leveraged gold stocks is Tocqueville Gold (TGLDX). The fund has about $500 million in assets under management and currently has large stakes in Randgold Resources (Nasdaq: GOLD  ) and Goldcorp (NYSE: GG  ) . Its expense ratio of 1.44% is right at the category average. The manager, John Hathaway, has been there for 10 years and has done a great job over that period. The bad performance in 2008 is not his fault, so it may be a good time to consider the fund.

Gold tends to do well in financial turmoil -- be it deflationary or inflationary -- and poorly in good times. Since this economic mess is far from over, now's a great time to take a look at getting some.

More on gold:

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.

Read/Post Comments (8) | Recommend This Article (25)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 27, 2009, at 3:30 PM, XMFSinchiruna wrote:

    Nice job, Ivan! :)

    I agree that gold will exhibit strength through both the deflationary and the inflationary phases of this turmoil.

    And for more for prospective investors to chew on:

    Fool on!

  • Report this Comment On March 01, 2009, at 8:32 AM, none0such wrote:

    If you believe this then why not just hold any liquid asset or better yet cash? Probably stagflation will be the overall course of the US economy - as you mention in the article, it will take time for the injection of dollars to catch up with the economy; so too will the drop in the CPI as people take pay cuts, house prices and land find a bottom, and investor sentiments turn around. But your point is compelling.

  • Report this Comment On February 24, 2010, at 2:20 PM, topsecret10 wrote:

    Deflation Is Coming and There's Nothing Bernanke Can Do About It, Says Robert Prechter

    Posted Feb 24, 2010

    Contrary to popular belief, noted technical analyst Robert Prechter says the extraordinary action taken by the Federal Reserve to bail out the economy will not lead to runaway inflation.

    "Deflation is gaining the upper hand very, very slowly, but it's happening," Prechter the founder of Elliott Wave International tells Tech Ticker. Of course, as anyone familiar with his work knows, he's been saying this for years.

    Why should we believe him now?

    For the first time since 1982 core inflation fell in January as measured by the consumer price index. Prechter says it's even more noteworthy that it's happening "in the face of this tremendous amount of stimulus...from the government and a real attempt at stimulus from the central bank."

    Prechter describes the forces of deflation as a "socio-nomic" shift in social mood that will prevent Federal Reserve Chairman from printing too much money. "At some point, the voters - as you can already see from the Tea Parties - are going to start saying we've had enough" with government spending and bailouts.

    How should you invest in a deflationary environment? We'll get to that in a forthcoming clip.

  • Report this Comment On February 24, 2010, at 2:33 PM, TopAustrianFool wrote:

    No its not. It only hides inflation, because it goes up when deflation sets, and goes down when inflation returns. Since we run on inflation 80% of the time, then gold will leave you behind in returns. The best hedge against deflation and inflation is good stocks. The problem in your gold calculation is that you are assuming that inflation = real prices. And that deflation is when the price drops in those assets. If you accept that high prices are inflated, then it will make sense. The only problem is that it is not easy to identify inflation and how much inflated prices are. The CPI is useless, and you can never tell what the Fed is doing. So if you want to have no net loss or gain due to inflation, meaning hedge against inflation, then you have to put your dough in stocks, which go up with inflation and go down with deflation.

    Since no one barters with gold, gold is only good for cataclisms. So I suggest you buy some lead too. And something to shoot the lead with.

  • Report this Comment On February 24, 2010, at 2:35 PM, TopAustrianFool wrote:

    Robert Prechter is a quack. We are already going through inflation again. Look at the unemployment and demand and look at how little prices have dropped. The reason is the $600B the Fed has injected into the market. The useless CPI can't even account for that.

  • Report this Comment On February 24, 2010, at 2:39 PM, TopAustrianFool wrote:

    "Deflation is here now "

    You are late. Deflation started about a year ago. And the Fed panicked and started injecting $$ into the market. The stabilization in prices they achieve is the inflation they have generated by printing $$. We are inflated again and it will remain so until the new crisis. So there will be another deflationary period at some point.

  • Report this Comment On February 24, 2010, at 2:40 PM, outoffocus wrote:

    You lost me at "deflation is here now". Try telling that to my bills and expenses.

  • Report this Comment On February 26, 2010, at 9:31 AM, TopAustrianFool wrote:

    "Why did gold touch $1,000 an ounce this month if we have falling prices? Wasn't gold a classic inflation hedge?"

    Because people are hoarding it in the erroneous believe that gold is an inflation hedge. But gold cannot be an inflation hedge unless we start using it as money.

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