Follow-Up: Gold and Inflation

My last post argued that the media and a great many people are currently misunderstanding the actual mechanisms of “money printing” occurring at the US Fed today.

People know there is “money printing”, but far too many people think it literally means running the HP laser printer, which isn’t true. If this was truly the case, it would be shocking if we don’t see inflation at all.

(Many people will also say “but prices have gone up A LOT for many common goods since 2008!” Yes…but that’s what happens when you have 2-3% inflation per year…it leads to 20-40% higher prices over 10 years if you do the math, which means…there are a great many people that also do not understand the power of compounding. Small numbers can lead to big differences when compounded over many years.)

Like politics, Capital Flywheels generally tries to avoid talking about certain subjects because of how in-grained certain assumptions are. And fighting the narrative around “money printing” is likely too heroic an effort. However, the good thing is that fighting that narrative is not to our advantage. The more people misunderstand what is going on, the greater our ability to make money in the capital markets.

The one area that Capital Flywheels thinks is worth spending a few more minutes on is gold and the performance of gold because it will ultimately inform us about whether we should be investing in stocks.

And it all hinges on whether inflation is coming or not.

Many investors (and speculators) prefer gold and other real assets (like real estate) as an inflation hedge because these things tend to have relatively fixed supply. If the supply of money goes up, things like gold and real estate that have relatively fixed supply will go up in value relative to the currency.

That makes sense.

But why has gold gone up since the financial crisis if there has been minimal inflation? It hasn’t gone up as much as stocks but it’s certainly up more than inflation.

As a reminder, here’s the price of gold over the last 10 years:

Capital Flywheels fervently believes that gold investors have been “right” about gold but for the wrong reasons. Gold has performed well (but not great), not because we have seen massive inflation but because gold benefitted from the similar dynamics that have benefitted stocks.

As argued in my last post, while the Fed has not printed a lot of new physical bills / money, it has reduced the supply of investable assets by buying treasuries (and now corporate bonds). The “money” that was previously held in the form of treasuries and bonds have been turned into cash. But investors don’t want to hold cash in a low yield environment. That money is trying to find investments in a shrinking universe. And part of that money has gone into gold!

There’s a very important nuance here – gold has gone up not because inflation has gone up but because the universe of investable assets has gone down. Therefore people are increasingly considering things outside of what they would normally consider. They are moving UP the risk curve into stocks, crypto currencies, and…yes…gold (gold is risky because it produces no cash flows and has almost no utility…producing no cash flows is a very risky proposition for money that would have otherwise been held in interest-bearing instruments like treasuries / bonds.).

This may seem to be as heretical of an idea as my argument that the Fed is NOT “printing money” but there is plenty of evidence that this is the correct interpretation.

But let’s take this to the logical conclusion – If gold is going up does it matter why? Does it matter that it is going up because of a shrinking investable universe rather than runaway inflation?

YES because gold has a fixed supply (which is why it becomes more valuable as investable universe shrinks) BUT stocks (and treasuries and bonds) are even better because the amount of stocks (and treasuries and bonds) available to the market is SHRINKING.

The Fed is actively removing treasuries and bonds from the market. However, yields are quite low so it doesn’t take too much before it stops producing cash flows like gold…the Fed isn’t buying stocks (yet?) but it is buying some ETFs. However, companies (especially the most cash flow generative companies) have been removing their own stock from the market since the financial crisis. These cash flow generative companies also tend to have better balance sheets and higher (secular) growth.

This is the primary reason why Capital Flywheels continues to believe owning the highest quality companies in secular growth industries is the best course of action (unless the Fed truly starts monetizing debt by directly financing the US Treasury). Gold investors will one day realize they have made the exact same bet as us, but only in an asset that benefits less from what is actually happening at the Fed.

What would make us wrong? Inflation.

While a great many companies have “pricing power”, many companies do not have as much pricing power as they would like you to think.