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Inflation/Deflation IV: Why Is Gold Outperforming Global Stock Markets?   (January 11, 2007)

Frequent contributor Harun I. was kind enough to send in these charts of various stock indices from around the globe and their relative performance to gold. The most obvious characteristic--which is shared by all of these indices--is the divergence from gold (the ratio of the index to gold) as the indices soared upward.

Simply put: all the indices once rose and fell in tandem with gold. The divergence began with the global Bull Market which started in late 2002/early 2003. Even as global stock indices have risen to dizzying heights, they have seriously underperformed gold.

Here's how to understand the index-to-gold ratio. Let's say a hypothetical index stood at 1,500 in 1999 and gold was $300 (priced for simplicity's sake in dollars for this example). The ratio would be 5. As the dot-com bubble pushed the index to, say, 5,000, and gold fell to $250, then the ratio rose to 20--tracking the parabolic rise in the index.

But the recent "Bull market" has seen the index/gold ratio stay level while the indices rocketed higher. As our hypothetical index rose from 1,500 in 2002 (yes, it retraced from its dot-com glory back to where it started) to 3,000, gold rose from $250 to $600, yielding a ratio of 5--the same level as in 1999, even as the stock index has surged. The flattening of this ratio shows that gold has dramatically outperformed all the major global stock markets since 2002.

Take a look at the charts and then catch the concluding commentary.

If deflation is about to conquer the global economy, why is gold--that traditional hedge against inflation--outperforming the apparently "golden" stock markets? This is not a rhetorical question; why has the key global hedge against inflation and/or uncertainty been rising steadily for years against all major stock markets in an era of "low inflation" and "low-risk growth"?

If we're about to enter a massively deflationary period, then cash will be King. Every month, your cash will buy more of everything than it did the previous month/year. Why would investors be buying gold when cash will be King? Why would gold rise when every other product and commodity can be had cheaper next month? One explanation would be that all paper assets have fallen from favor, regardless of their nation of origin; but what sort of global environment would cause all currencies to be spurned with equal fear/distain?

Please note these are non-U.S. indices priced in currencies other than dollars. The argument that gold will be a hedge against a falling dollar explains nothing about these charts.

I am not being clever in posing the question. (My heartfelt thanks to Harun for sharing these charts, which if studied with the proper care, will be recognized as valuable guidance.) Gold's rise presages not deflation but either inflation or a massive simultaneous decline in the value of all currencies. There are no other interpretations.

Sometimes the best investment strategy is to follow what the charts suggest, and leave the explanations until after the fact. If you decide ahead of time what the working explanation must be (to fit into your belief system or school of economics, etc.), perhaps you're blinding yourself to what is actually unfolding. In other words, gold is outperforming stock markets, even as they rally to new heights. Regardless of the reason, which asset class do you think will outperform in the next 5 years?

Are there reasons to believe prices for commodities, goods and services might drop? Sure, in two words: recession and overproduction. But as yesterday's post explained, there are real-world limits (called losses) on how much prices can drop. Prices can only drop until businesses run out of savings and credit. Once the majority of unprofitable businesses fold, competition eases and prices stabilize/rise.

Perhaps inflationary pressures are building which could overwhelm the rather modest forces of deflation. After all, how much copper or steel are you going to buy when you decide to cut back and start saving? How much plasticware or tools from China are you going to buy as you stick to a tight budget? Those prices can drop through the floor but if nobody's buying, then who's reaping the "deflationary" prices? Perhaps the items which you have to buy--energy, food and medicine, for instance--are rising, along with the cost of borrowed money (interest rates).

But perhaps gold is rising not as an inflation hedge but as "safe money" in a global devaluation of all currencies. Knowledgeable reader U. Doran was kind enough to send this link to a LewRockwell.com piece entitled Gold and Deflation. The author suggests gold is not an inflationary hedge but a deflationary hedge in times of uncertainty and decline (bank failures, etc.).

Whatever the reason, gold has been outperforming global stock markets. Perhaps the question should be rephrased from "are we facing a deflationary or inflationary future?" to "what is the best asset class to own over the next 5 - 10 years?" These charts suggest the tangible asset of gold may well outperform all paper assets--stocks and bonds alike.

More on bonds and the dollar tomorrow.

For more on this subject and a wide array of other topics, please visit my weblog.


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