NEW YORK (TheStreet) -- With gold's big decline over the last two years, many may be searching for answers about what's to come. And suggestions abound -- some hinging on the notion gold can protect your portfolio from inflation.
In an environment where many fear quantitative easing (QE) will drive inflation higher, it's not surprising to hear gold bugs offer similar advice: Don't sell -- hang on and profit when QE-driven inflation increases gold's value. In our opinion, however, there are severe problems with this thesis. Here are two key ones: Quantitative easing isn't inflationary, it's dis- or deflationary, and gold isn't a reliable hedge against inflation.
For starters, QE has existed for nearly five years, and inflation's been nothing more than sluggish. The
may be buying bonds and adding to banks' excess reserves, but that money isn't going anywhere, as you can see in Exhibit 1.
Inflation can't rise on money supply alone. It needs velocity to send prices higher. But thanks to QE, the yield curve has flattened -- stifling loan growth, thereby reducing velocity. A flatter yield curve makes lending long-term less profitable.
So, when choosing between a relatively risky endeavor with little reward or storing savings safely at a tiny gain, banks are disincentivized to lend. Less, not more, QE would fix this. As long as reserves created through QE sit on the deposit at the Fed rather than coursing through the economy, inflation will likely remain on its current low, slow trajectory.
Even if inflation did rise, though, gold still wouldn't be an investor's saving grace. Simply, gold isn't a hugely effective inflation hedge. If it were, then it would always (or at least, the vast majority of the time) move with inflation -- but it hasn't.
Throughout the 1990s, gold fell while inflation rose, leaving those invested in the shiny metal missing out (Exhibit 2). Of course, gold did extremely well in the 2000s, but inflation was low -- very low, by historical standards.
Now, maybe you argue inflation is understated in the government's measures. We don't totally disagree. But realistically, that makes gold look worse historically as a hedge, not better.
Today, gold is down 31.5% from its 2011 peak as of July 17, according to the St. Louis Fed -- by definition, a bear market, illustrating that not only is gold not an inflation hedge, it's also not a stable store of value. Neither is it an effective hedge against equity market volatility -- just consider the 2000s: Gold rose alongside stocks from late 2002 through 2007. When the financial panic hit, gold fell, as did stocks. There was divergence briefly (from roughly November 2008 to February 2009), but even when gold has risen and stocks fallen, equities have gained more value over the years than gold.
So why do some investors insist on gilding their portfolios?
Most likely because myths persist despite gold's historical performance. Since the end of post-Bretton Woods controls allowed gold to begin trading freely in 1973, the shiny metal has traded like any other commodity, and it's one with very few physical demand drivers. It trades largely on sentiment, which explains its historical volatility.
But investors haven't historically been compensated for this volatility. According to finance theory, volatile assets like gold should have potential for equally high returns to make them worth the risk. Yet, over time, gold has underperformed stocks.
In our view, investors seeking long-term returns should leave the golden nest egg to the golden goose. Other investments seem much more attractive, in our view.
This article was written by an independent contributor, separate from TheStreet's regular news coverage.