DKE Partners

If you watch any financial, sports or news programs you've probably seen numerous ads for a variety of firms offering to sell gold. The usual rationale is that the plunging dollar or skyrocketing public debt is going to result in a wave of inflation. Listeners are urged to protect their assets by investing in gold.



In our previous post we examined the correlation of inflation with just these trends. We discovered that the historical record lends little support to the assertion that current developments in the currency markets, monetary policy or fiscal policy will necessarily result in runaway or even accelerating inflation. In a presentation by Inmoo Lee at the DFA College, Mr. Lee examined the correlation between the performance of several commodity based assets and the Consumer Price Index. He examined historical returns for a broad basket of equities (the CRSP 1-10), the Goldman Sachs Commodity Index, gold, oil, TIPS and long, short and intermediate US Treasury instruments. His conclusions would not be well received by gold merchants.



At the outset of his presentation, Mr. Lee made the observation that an investor seeking to effectively hedge against inflation was in reality seeking a real return of zero; not something to which many of us would aspire. Based on his examination of a series of regresssion and return studies for the assets above, his conclusion was that an investor desiring to combat inflation should seek a portfolio with the highest expected return at an appropriate volatility level.



Without delving into the detailed analysis in the presentation linked below, the overall conclusion derived from the studies is that there is in fact a relatively low correlation between the various perceived inflation hedges and the actual inflation rate. While a keen observer might comment that these instruments are leading indicators so would not be expected to evidence a close correlation, the data do not such an hypothesis. What is apparent from the work is that all these instruments but in particular gold and oil, have historically been extremely volatile. Mr. Lee's conclusion is that this excess volatility is not explained by inflationary expectations or underlying inflation rates alone. Other statistical measures (Standard Error and T-statistic) suggest that returns from the GSCI, gold and oil are more random than expected in nature.



The presentation is detailed and heavy on statistical analysis, but the conclusions are clear. Investors seeking to protect their assets from inflation are better served by investing in equities, which have outperformed the inflation hedges in both nominal and real terms. In addition, the high standard deviations associated with these investments can have a detrimental effect on a portfolio, especially one supporting regular distributions. Clients wishing to participate in commodities should understand that a transaction which represents a zero sum, i.e. in which one parties wins at the expense of the other is not an investment but a bet with an essentially random outcome. The seller of an equity does not lose if the purchaser eventually makes money, nor does he gain if the equity declines after the sale. This is not the case with commodities. In the final analysis, only TIPS provided investors with an effective means to mitigate inflation, but at the expense of the higher nominal and real long term returns available from equities.

Inmoo Lee, Inflation and Investment Decisions

http://sites.google.com/site/dkepartners/files?pli=1