Monday, October 18, 2010

Annaly Salvos: On the Value of Insurance

How to value gold is an age old frustration. As every schoolboy knows, it yields nothing and so can’t be valued on cash flows. It has very little industrial use. There is, however, a natural human tendency toward the use of currency so gold is an obvious candidate for a rare, durable, portable, and transferable form of money. There is no printing press (or helicopter) for gold. Thus, throughout history, the yellow metal has been an indisputable store of value, including during periods of inflation like the 1970s. However, its price is volatile and has certainly managed to lose some money for investors over periods shorter than, say, a few decades. In the chart below, we illustrate the point by plotting the inflation-adjusted gold price versus the year-over-year change in Core CPI.

As inflation came down in the early 1980s, gold fell with it. The relationship between real gold prices and inflation seems to break down during the 2000 recession, where inflation began to decline but gold began a new bull market. Current real gold prices are back to levels not seen since 1980, when inflation was running at over 12%, despite current levels of inflation below 1%. Gold must be in a bubble, right?

Not necessarily. Another way to think about gold is as insurance against the debasement of the currency, and against future inflation. Insurance against policies that debase the currency is worth something, because a falling dollar erodes your global purchasing power just like inflation erodes your purchasing power at home.