Is gold a hedge against price inflation during crises?

Gold goes up and down

The primary purpose of investing in anything is to generate or at least preserve wealth, especially when currencies depreciate over time and bank deposit interest could not keep up with price increases.

However, when investor confidence goes down as a result of unstable financial policies, we see markets tumble, including that of gold, which is often called a ‘store of value’ or ‘safe haven.’

During the time when Lehman Brothers and Washington Mutual went bankrupt, the price of gold dropped from S$1,300 in July 2008 to about S$1,080 in September the same year. After a brief boost, the price stayed at the S$1,000/oz. level for a couple of months after.

Can we then still call gold an inflation hedge?

The factors of a falling price

We first have to ask, why do markets fall? When the financial situation of large institutions is put in jeopardy as a result of bad loans defaulting, people become uncertain of the markets, and thus are more likely to get rid of their shares. In addition, a loose-money policy makes for riskier margin trading.

Margin trading is where investors buy shares that are multiple times the amount they place with a brokerage firm. The smaller the margin, the more shares can be bought with the same amount of money. If the value of the stocks drops below the minimum margin, then the investor will receive a ‘margin call’ from their broker requesting to fund the account to meet the minimum margin.

When a market crash occurs, and stocks plummet, the more numerous the margin calls. And because more stocks are liquidated to meet margin calls, an even greater sell-off ensues. Prices spiral downwards.

The price of gold, which is also traded on margin in the futures market, is likewise affected. In addition, when gold’s value rises relative to currencies and outperforms other assets, people turn to gold when they require liquidity. This makes gold subject to sudden drops in price.

As an aside, the instability of gold futures is yet another case for holding physical, fully allocated gold.

Looking at the long term

One should not read bearishness from such short-term declines. It is important to note the overall direction of gold — upwards — and why it is going up. If we look at the 2008 example awhile ago, gold has since risen beyond its previous levels, hitting the S$1,550 level by the end of 2009, the S$1,800 level by end-2010, and has since gone past the $2,000/oz. level.

No asset goes up in a straight line. Corrections, which can go on for extended periods, should be factored in your investing decisions.

Invest accordingly

As an investor, you can use the knowledge of gold price fluctuations to maintain discipline in holding for the long term amidst panic selling.

Other investors, instead of a ‘buy-and-hold’ strategy, would look to prevailing economic trends in timing their purchases and sales.

When investing in gold, the important thing is to be aware of the different stages of the economic cycle so as not to get caught flat-footed, and to invest accordingly.