Kuta Beach

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Wednesday, 14 January 2009

Using Precious Metals to Protect Against Rising Food Prices

Now that we are in a new year, the world is going through what looks like a deflationary recession. Deflation is feared by economists because there is little they can do about it. If we have inflation, the central bank can raise interest rates or increase taxes. When there is deflation, central banks can lower interest rates, but once interest rates hit zero, it can't go any further.

Now that everyone is worried about deflation (and some people worried about future hyperinflation), I am still worried about stagflation, which is a combination of economic stagnation and inflation. This means that you are likely to lose your job, the share market performs poorly, and to make life difficult, the price of everything goes up.

Personally, if the price of luxury cars go up, I am not bothers because I don't buy luxury cars. But if the price of necessities like food and petrol go up, that is going to hurt.

The chart below compares for the last two years the price of oil (measured using USO, the oil commodity ETF), the price of food (measured using DBA, an ETF that tracks the prices of wheat, soybeans, corn, and sugar), as well as the S&P500 index (GSPC). To measure the performance of the real economy, I should probably be using GDP figures, but using the S&P500 I think is good enough.


At about May 2007 what we see is a divergence between the S&P500 and the price of oil and food. Oil and food go up while the S&P500 stagnates. This is stagflation. Just about everyone was complaining about expensive food and oil. Many were talking about peak oil.

Then at about October 2008, we had a violent transition from stagflation to deflation. As the chart shows, everything went down. The share markets tanked, food prices fell, and oil prices especially plummeted from about US$160 to around US$35.

How can we protect ourselves from stagflation? One method suggested is to buy precious metals like gold and silver. Below is a chart of oil and food prices against prices of gold (measured using GLD, the gold ETF) and the price of silver (measured using SLV, the silver ETF).


What we see, interestingly, is that silver and gold would have protected us very well during the stagflation era of 2007-08. The price of silver and gold seems to move together with the price of food. The price of oil went even higher than the price of food, silver, and gold, but I believe oil was way overvalued and because oil went up so high, a hard fall was inevitable.

What is also interesting is that during the transition from stagflation to deflation, silver prices went down with food prices. However, gold prices seem to have held up. Gold investors don't seem to have realized that stagflation is over now.

Could gold be overvalued? Perhaps it's time to short gold.

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