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Gold & Deflation: A Surprising Relationship at Trader’s Narrative

As a corollary to yesterday’s deflation discussion, I thought I’d cover the consequence for gold and gold stocks. The relationship between gold and deflation is a contentious one so I don’t think it will ever be put to rest. In any case, I wanted to point out an interesting relationship which you’ll be hard pressed to find elsewhere.

Referring back to the chart in our previous discussion on the consequences of deflation you can see that we’ve had several periods of negative real interest rates. Naturally, these are when the inflation rate is higher than the nominal interest rate.

These periods coincide with great opportunities for buying gold and gold stocks. For example, in early to mid 1970’s and again in 2003. This doesn’t always hold true however. For example, the gold mini-bull of the mid 1980’s happened without a negative real interest rate environment.

In the 1970’s inflation was rampant and pushed real interest rates below zero. Until Volcker’s ‘take-no-prisoner’ style of monetary policy choked off inflation and brought real rates above zero. But of course, the situation in 2003 wasn’t that we had excess inflation but that nominal interest rates were being kept much lower than they should have been by the Federal Reserve (and we all know how that played out eventually).

performance of gold in recessions spreadsheetSince deflation usually arrives at times of economic slack, one way to try to measure the relationship between the performance of gold and deflation is to look at how it did during recessions. Click the thumbnail to the left to take a look at a spreadsheet showing this data since 1945. The data is courtesy of EWI - they are also giving away a free 60 page eBook on Understanding Deflation which is chock full of similarly interesting tidbits.

The average performance of gold during recessions since 1945 is a miserly 4.8%. What about this most recent recession? We know the start of it but while many are prognosticating its end, we don’t have an official end date from the NBER. So let’s see how gold has done since December 2007:

gold performance recession Dec 2007 so far

That’s much better than the average but much lower than the outlier from the mid-1970’s. Still, it is not even enough to marginally move the average over the past 11 recessions. So according to this, holding an investment in gold during deflation is not usually a smart idea.

Trading gold and gold stocks however is still lucrative. One of my favorite indicators is the K-Ratio which is a ratio of gold stocks to gold itself. Here are two long term charts of the K-Ratio (using the Philadelphia Gold Bugs Index and the CBOE Gold Index to approximate gold stock prices):

k-ratio long term chart HUI Aug 2009.png
k-ratio long term chart GOX Aug 2009

Right now, the K-Ratio is trading mid-way and not really giving any signals. If it does fall again to previous lows, then we could have another set up for a ramp higher. Until then, I’m not too excited about gold.

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5 Responses to “Gold & Deflation: A Surprising Relationship”  

  1. 1 stantam

    K-ratio…not sure I am reading it right. Is it gold price / vs gold stocks in essence? Akin to the ratio that Hussman uses? … or other?

  2. 2 Babak

    stantam, the k-ratio was developed by Jay Kaeppel. It is the ratio of the Barron’s Gold stocks index and the Handy Harmon price of gold but you can use almost any index as long as you are consistent.

  3. 3 jeremy

    Hussman writes good copy, but most of the time in the real world comes to the wrong conclusions, if you follow him you will do the same.
    If the K (??) ratio is not giving any signals, perhaps you should ignore it completely.

  4. 4 Michael

    We can’t really look at gold’s performance during the great depression (because it was outlawed/confiscated) but we can look at gold stocks. There is plenty of published data that shows gold stocks being up (depending on which you owned)anywhere from 200%-00 during the early 30’s and throughout that decade.

  5. 5 stantam

    Jeremy, You should not attempt to duplicate Hussman to profit from him. Most importantly, he sees the big picture better than most. The big picture should be your guide for the bigger possibilities. The “traders” picture can be finessed with daily input like mine:

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