Why Now Is The Time To Buy Gold

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John Maynard Keynes called it a barbarous relic. Warren Buffett said it has no utility. It’s a curious yellow metal that miners dig out of the ground only to melt down and bury again in carefully guarded vaults. So why invest in gold? As Ray Dalio once said, “If you don’t own gold, you know neither history nor economics.”

This article examines the fundamental and technical reasons why investors should hold gold now. Furthermore, taking Sharpe ratio analysis and macroeconomic trends into account, I conclude that a 10% allocation to gold provides the most risk-adjusted returns and portfolio diversification.

Gold as a hedge

First and foremost, gold serves as a hedge against inflation and the gradual monetary debasement apparent in all paper currency regimes. The chart below shows how cost of living (as measured by CPI) changes over time, providing a visual example of the point made above. Historically, inflation remained steady from 1750-1914, experienced turbulence from 1914-1970, and propelled exponentially higher since 1970. The reason? As economist Peter Bernholz suggests, global monetary regimes shifted from the gold standard, to a limited gold standard, to a paper currency standard.

(Source: Monetary Regimes and Inflation, p. 11)

In a gold/silver standard, governments cannot increase the money supply without an equal increase in gold/silver reserves as citizens can freely convert one for the other. During World Wars I and II, countries moved off and on the gold standard to finance wars, settling on limiting convertibility to central banks under the Bretton Woods system and creating a weakened gold standard. Then, after an official break of the gold standard in 1971, inflation skyrocketed as governments technically had no limit on their ability to expand the money supply. Inflation is strictly a characteristic of paper money regimes, with every episode of hyperinflation (thirty total) except Revolutionary France and the denouement of Rome occurring after 1914.

I am not calling for a return to the gold standard. A break from the gold standard gives central banks the flexibility to reflate economies following recessions. However, one method central banks use to reflate economies involves increasing the money supply. Additionally, governments are tempted to finance deficits by issuing debt or creating money. In fact, every hyperinflation began with large public deficits and unpayable liabilities.

This is the crux of Dalio’s statement. Paper currency regimes, with no mechanism to regulate increases in the money supply, have an inflationary tendency as evidenced by the cost of living chart above. While paper currencies lose value over time, gold has served as a store of value for over 5,000 years. Due to its ability to retain value in the face of a declining currency, I believe gold plays an important role in every portfolio. Think of it as an insurance policy for your portfolio.

How Much Gold?

Gold performs differently depending on the macroeconomic regime. For determining the macroeconomic regime, I use the four quadrants of rising/falling growth and rising/falling inflation frequently used by Hedgeye and Bridgewater Associates. Under normal economic conditions of rising growth (measured by GDP) and inflation (measured by CPI), gold provides an average return of 6.3% YoY compared to 10.6% return of equities. Since 1973, the U.S. has been under “normal” conditions 80.6% of the time.

Under conditions of rising growth and falling inflation, oftentimes considered the “ideal” quadrant, gold returns -2.4% compared to equities’ 19.24%. This ideal condition is a staple of the current bull market. However, it typically occurred 8.2% of the time since 1973.

Under deflationary conditions, both gold and equities provide returns in the realm of -25%, with treasuries serving as the only safe haven. Lastly, during periods of stagflation characterized by falling growth and rising inflation, gold provides an average return of 22.6% compared to 1.8% of equities.

A study conducted by Flexible Plan Investments used these average returns and the average time spent in each quadrant to determine the optimal allocation of gold to a portfolio. It determined that a 20% allocation to gold, with 48% in equities, and 32% in treasuries provided the highest Sharpe ratio as evidenced in the chart below.

(Source: Proactive Advisor Magazine)

As the adage goes, past performance does not necessarily predict future results. Saddled with rising debt and a wave of retiring baby boomers, there’s a chance that the U.S. remains stuck in a Japan-like deflationary spiral. The chart below shows that Japan’s inflation rate poked its head above 2% only twice since 1985, oftentimes falling into negative territory. This “Japanification” of the western world thesis is one to take seriously. The 1970s inflation was largely demographic-based, as baby boomers entered the workforce en masse, purchasing new homes and cars in the process. With demographic trends skewing the numbers in the study above, I would reduce the optimal allocation of gold from 20% to 10%.

(Source: inflation.eu)

However, the U.S. may not follow Japan’s playbook of negative rates and indefinite large scale asset purchases. In the next section, I explore how monetary policy run amok could be a catalyst for a stagflationary era.

The Catalyst to Gold $5,000

With corporate debt at record highs and 50% of corporate credit ratings one level above junk, I believe over-levered corporations, not necessarily banks, will be at risk of defaulting when corporate profits drop in the next recession. When they ask for bailout packages that banks got in 2008, the U.S. will more than likely not have the political will knowing now that QE disproportionately benefited the wealthy. I initially explored this idea in a previous article here. The Fed and the Treasury will have to find other ways to reflate the economy. I will examine two ideas espoused by Modern Monetary Theory (NYSE:MMT) and explain why I believe they will be highly inflationary.

The first MMT idea is debt monetization. This is where the government creates money to finance deficit spending. Increases in the money supply following the 2008 global financial crisis did not lead to inflation for two reason: 1) it was replacing lost credit/combating deflation. 2) the money given to banks was done so with the assumption that they would lend again, when instead banks hoarded the money and shored up their balance sheets.

However, debt monetization is constant, not performed solely under extreme circumstances to combat deflation. Printing money under conditions of expanding growth will bring about inflation. Bernholtz’s in-depth study of historical hyperinflations concluded in the following: “the creation of money to finance a public budget deficit has been the reason for hyperinflations” (Monetary Regimes…, p. 80). Printing money to finance large deficits was disastrous for Argentina, Bolivia, 1920s Germany, Zimbabwe, and 1990s Ukraine. This list only scratches the surface. Debt monetization is the equivalent of an economic poison pill.

Another MMT solution is universal basic income (UBI), sometimes referred to as “QE for the people.” As previously mentioned, QE did not create inflation because it remained in the financial system. However, if you give people money, they will spend it. Like consistent debt monetization, UBI may benefit the economy under deflationary conditions, but consistent helicopter money will create demand-pull inflation. This is common sense in my eyes. If the $4.4 trillion created by QE went straight to the people, most of it would have gone to goods and services, driving their prices up.

In conclusion, gold may chronically underperform if the Fed implements the same monetary policy as Japan. However, if current MMT rumblings come to fruition, gold will skyrocket while other asset classes lag. With 10% being a reasonable percentage allocation given past Sharpe ratio analysis and current trends, I recommend investors insure their portfolios now.

Disclosure: I am/we are long GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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