The Consumer Price Index (CPI), a key measure of inflation, has been rising in recent months at a rate it hasn't in decades. Record government stimulus meant to help people through the pandemic, coupled with struggling supply chains, has resulted in higher prices for everyday items. Now investors are trying to figure out where to park their money.
Many speculators out there view Bitcoin (BTC 2.65%), the world's most valuable cryptocurrency, as an inflation hedge, meaning that its price should be climbing during times like these. This hasn't been the case at all, however, as the top crypto has fallen 55% since hitting a peak last November.
So is Bitcoin a poor inflation hedge? I don't think so. Let's take a closer look.
The traditional definition of an inflation hedge is flawed
If consumer prices are increasing rapidly across the economy, then in order for Bitcoin to be an effective hedge against inflation, it must rise as well. Therefore, we should just buy some of the crypto and wait until inflation cools down. Sounds pretty easy, right? Well, it isn't this simple at all.
For starters, there are a number of other forces at play that can impact an asset's price in the near term. Right now, the war in Ukraine and the Federal Reserve's plan to aggressively hike interest rates are scaring investors out of riskier assets. The general unpredictability of investor sentiment can cause wild swings in asset prices for really no reason at all.
Furthermore, if everyone believes something is an inflation hedge, then it's likely that the asset in question will already be priced accordingly based on higher demand from buyers in the market. Thus, it might be prudent to actually sell instead of buy. This is what famed investor Howard Marks calls second-order thinking.
Even gold, which is widely viewed as the inflation hedge of choice by investors, has a spotty history in this regard. In the early 1980s, for example, when the annual inflation rate was 6.5%, owning gold would've lost investors 10% per year. More recently, in 2022, the price of an ounce of gold is up just 2.5% -- far behind April's annual inflation rate of 8.3%.
Over a short time span, I don't think anything constitutes a legitimate inflation hedge, moving in step with the CPI figure. If it did, the market would arbitrage the opportunity away until the relationship no longer worked. I firmly believe that the consensus view of what an inflation hedge should be is seriously flawed, and it has everything to do with how far ahead one is willing to look.
Image source: Getty Images.
Time horizon matters
Based on the discussion above, I think the proper test of whether or not an asset is a true inflation hedge is measuring its performance over a long time horizon such as five or ten years, or even longer.
Bitcoin's trailing five-year return of 1,100% during a time when the CPI increased only 18.5% suggests that the world's top cryptocurrency is indeed an effective inflation hedge. Despite its extreme volatility, those who purchased Bitcoin would have seen their purchasing power skyrocket. And this is the whole premise of investing in the first place -- the idea is to raise one's spending ability over time, and not lose it.
In my opinion, investing would be a lot simpler if people would just extend their time horizons. As many readers are aware, literally anything can happen in the next month, quarter, or year. And trying to design a portfolio based on what might happen in such a short period of time is a losing game, because it really is unknowable.
Viewing Bitcoin in this light is the correct approach. Despite falling 35% so far in 2022, its performance over time speaks for itself.
