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Could Gold Perform Well In a Deflation, Contrary to Commonly-Accepted Wisdom?
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Could Gold Perform Well In a Deflation, Contrary to Commonly-Accepted Wisdom?
Absolute Return Partners wrote in their July letter:
The most important investment decision you will have to make this year and possibly for years to come is whether to structure your portfolio for deflation or inflation.
As I have previously noted, there is substantial evidence that we are currently in a deflationary period.
Commonly-accepted wisdom is that gold does poorly during deflation. But is that true?
Homestake Mining and the Great Depression
The stock of the biggest U.S. gold company - Homestake - soared during the Great Depression.
Gold bugs argue that Homestake's success proves that gold does well during periods of deflation.
For example, a goldbug named Joel Uqagmire breathlessly writes:
Homestake stock sold for about $65 per share in 1929. By 1933, the average stock price for Homestake was around $370. This represents a gain of more than 450% over the course of four years. The Dow Jones Industrial Average fell 89% over the three years between its 1929 peak to its 1932 bottom. Not only did stock prices increase for Homestake, but dividends also skyrocketed. In 1929, Homestake paid dividends of about $7 per share. By 1935, dividends had increased to $56, a staggering rate of 800% over six years. During these deflationary times, gold stocks not only retained their values but provided significant returns for investors.
Deflation, the underlying crisis during the Great Depression, results in heightened gold stock prices. The reason why is that deflation diluted the value of the U.S. dollar while the price of gold was fixed by the government. While some would argue that this fixed gold price ensured the rise for gold stock prices, this fallacy is simple to debunk by examining the positive effects on gold stocks after the removal of the gold standard in 1971. Even though the gold price was no longer fixed, gold stocks performed normally. Interestingly, Congress passed the Gold Reserve Act of 1934 and gave the government permanent title to all gold assets. Most importantly, it increased the gold price to $35 and further devalued the dollar. This certainly contributed to the spike in Homestake's share price from 1934 to 1935.
Looking forward, gold stocks are very promising under the current market as deflation is likely. Should deflation enter the 2009 economic crisis, gold stocks will be set to perform at record highs. Gold prices would cross the $1000 barrier and further elevate gold company shares. The magnitude could be far greater than what was witnessed during the Great Depression when Homestake had annualized gains of more than 100%.
Well-known commodity investment advisor Aden Forecast is endorsing a slightly more toned-down analysis of Homestake by Jeff Clark, which concludes:
If history is any guide, gold stocks can hold their own against deflation.
But many writers do not agree. For example, as one writer puts it:
As well informed as they are, gold bugs will not acquiesce to the idea that, generally, gold and silver stocks don't, can't and won't go up during a general stock market decline of 10% or more. Some gold bugs are willing to reference periods like 1929-1932 as a rationale for why gold is a necessary hedge during a stock market collapse. To respond to such spurious claims from the gold bugs, I have included the price history of gold and silver stocks from 1924 to 1933. This data is from Poor's, the company that pre-dated the merger of Standard and Poor's.
click to enlarge
(click to enlarge)
The price data of the 21 precious metal stocks is resounding since it puts to rest the idea that a decline in the general stock market would result in an increase in the price of gold and gold stocks. Even with the price of gold being fixed at a $20.67 per ounce, investors were not overwhelmed by the idea of jumping into gold stocks as the highest quality blue-chip stocks crashed 89% from 1929 to 1932.
Notice that some gold stocks ran up in price and peaked before 1929. For the remaining stocks that did peak in 1929, take a look at the high and then the low in 1930. All of these stocks fell by at least 50% during this two year period. Some stocks would stabilize, while the majority would collapse until 1931 or 1932. Once hitting their bottom in 1931 or 1932, the stocks would then recover, along with the rest of the stock market...
The lone glaring exception to this survey is Homestake Mining. I would have loved to have bought Homestake in 1924 at $35 and never have to watch it fall back to where I got in. However, Homestake is a special situation that is completely unrelated to the general conditions of the market. Homestake Mining has become the rallying cry for gold bugs despite the fact that there are numerous special situations that can be pointed out in other industries during the same timeframe. Homestake Mining will be the subject of future postings on this blog for an understanding of the reason(s) why it went up in price in the face of a crashing stock market.
The only reason that gold was a place where money flooded in periods of panic (1807, 1819, 1826, 1837, 1842, 1861, 1865, 1876, 1884, 1893, 1904, 1907, 1932) was because of government price fixing. If I lived through a panic during any of the prior periods and found that everything was falling in value but the official price of gold was being propped by the government then, of course, I would seek safety in gold. However, without a gold standard, the price of gold has proven to be at the whims of the market as a commodity. Unfortunately, gold bugs have mistaken gold as a safe haven during a panic for the wrong reason. This explains why James Dines, the world’s most renowned gold bug, openly wondered in his October 31st newsletter, “…why aren’t the prices of gold and silver commodities higher…”
Again, when the general stock market declines 10% or more then gold and silver will likely fall as well and may actually lead the decline on a percentage basis
So if Homestake mining does not settle the argument, are there other indications that gold might do well during a period of deflation?
Forget Homestake, What Else Have You Got?
Well, Eric Sprott - who manages $4.5 billion in assets, and correctly predicted in March of 2008 a "systemic financial meltdown” - says:
“I believe no matter what environment you’re in - deflation or inflation - people will run to gold,” Sprott said. “Gold is proving exactly what we all would have expected, that in almost any environment, it’s a go-to asset.”
And investment analyst and financial writer Yves Smith argues that gold does well during both periods of deflation and high inflation. She argues:
Historically, gold does well [in] hyperinflation and deflationary [periods]. Gold does poorly under more normal conditions, and gets hammered in disinflationary conditions, a falling but positive rate of inflation.
Analyst Adrian Ash argues that gold's value actually increases during periods of deflation even if its price drops:
Does the price of gold rise or fall in a deflation?Hint: It’s a trick question, already tripping up plenty of would-be advisors...
Absent the money-supply limits which the gold standard imposed on the world, people rightly guess that double-digit inflation would prove rocket-fuel for the bull market in gold. Yet the purchasing power of gold nearly doubled during the Great Depression, and it’s risen four-fold during this decade’s low consumer-price inflation as well.Why? Because both those periods of low price-inflation saw the money-issuing authorities devalue the currency, first with explicit reference to gold but now without daring to name it. Roosevelt in the mid-30s slashed the dollar’s gold content by 40%; the Greenspan/Bernanke Fed devalued the Dollar again to sidestep a DotCom Depression, keeping real interest rates at less than zero, between 2002-2005.
The maestro’s apprentice applied the same trick in the back-half of 2008, but so far to no avail. And now even the European Central Bank is pumping out money – a near half-trillion euros today alone – in a bid to revive bank lending, swamp the currency markets, and pull Germany out of its first flirt with deflation since the 1930s.
Just such a devaluation – and again, absent any stated reference to gold – was attempted by the Bank of Japan a little less than a decade ago.
Indeed, Japan is the only developed nation since the end of the gold standard to have suffered an extended deflation in prices. So far, at least. Germany and Switzerland look set to try for a re-wind, and unless the dollar can outpace the euro’s descent, we might yet see truly sub-zero inflation in the United States, too.
But whatever that should mean for gold prices, all other things being equal, just doesn’t matter. Because the gold price will not get a chance. All other things are not equal, and the policy solution – rank devaluation – can only make gold more appealing to investors and savers, whether the “monetarist experiment” of TARP, quantitative easing or a half-trillion euros proves successful or not.
Japan’s slump into deflation coincided with the Bank of Japan’s “zero interest rate policy” (ZIRP) at the start of this decade. It also saw the gold price worldwide hit rock-bottom and turn higher, a move that analysts (including us) have typically linked to US monetary moves and investment cash looking for safety as the Dotcom Bubble exploded.
But zero-rate money from the world’s second-largest economy shouldn’t be ignored. And today, zero-rate money is all the developed world has to offer – a trick that might not beat deflation, but might just spur a whole new rush into gold.
In other words, Ash argues that you can't take inflation or deflation in a vacuum. During deflationary periods - like we have now - governments always increase the money supply with a flood of new dollars, which is bullish for gold.
And PhD economist Marc Faber wrote in October 2007 that gold will do well even in a deflation:
How would gold perform in a deflationary global recession? Initially gold could come under some pressure as well but once the realization sinks in how messy deflation would be for over-indebted countries and households, its price would likely soar.
Therefore, under both scenarios - stagflation or deflationary recession - gold, gold equities and other precious metals should continue to perform better than financial assets.
Looking At the Charts
Is Faber right?
Well, take a look at the following charts showing gold's performance as compared to the yen during Japan's "lost decade" of deflation:
Japan's deflation didn't definitively end until 2007 or 2008.
This provides some evidence that gold may tend to hold or increase its value at least in the later part of the deflationary period as compared with the relevant national currency.
Moreover - approximately half the time - gold has risen during recessions in the United States:
(The grey vertical bars show periods of recession; the chart gives gold prices in monthly averages; click here for larger image).
If you study the above chart, you will see that gold seems to often fall during the beginning stages of a recession, then rise in the later stages of the recession (before 1971, the dollar was still backed by gold at a fixed price, and so gold did not fluctuate).
But what about Ash's theory?
The American Enterprises Institute notes:
After five years in a deflationary economic wilderness, the Bank of Japan switched during the spring of 2001 to a policy of quantitative easing--targeting the growth of the money supply instead of nominal interest rates--in order to engineer a rebound in demand growth.
Look again at the first gold chart for Japan, above. Gold appears to start increasing against the Yen in 2001.
This may provide some evidence for Ash's thesis that it is an expansion of the money supply which pushes the price of gold up in the later stages of deflationary periods.
Uncertainty
Finally, Chris Martenson argues that - in prolonged periods of deflation - we usually see failures of large and significant banks, institutions, and perhaps even states and countries. Because gold traditionally does well during periods of uncertainty, Martenson likes gold during periods of deflation.
I hope, of course, that government policy leads to a quick recovery and not a sustained period of deflation. But it is good to know that gold may do well even during a prolonged period of deflation.
Update: Merrill Lynch apparently agrees.
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