Bonds and Gold

David Malpass hit the nail on the head with his editorial Beyond the Gold and Bond Bubbles in the Wall Street Journal today: bonds and gold have done well because people fear both deflation and inflation.

I've been surprised to see both gold and bonds do so well over the last decade.  After all, deflation and inflation are opposites: when one performs well the other usually doesn't.  This makes bonds and gold both doing well a bit of a paradox. 

But in today's mixed message environment, it makes sense from a certain perspective.  Investors are running scared.  They seek safety in some form--any form. 

They correctly see that bad debt (lending which can't be repaid) leads to deflation, so they want to own bonds as protection.  Just look at Japan over the last 20 years: bonds performed much better than stocks.  Or, look at America during the Great Depression: bonds did much better than stocks.

But, investors also fear inflation, which is caused by too much currency growth relative to goods and services.  Witness Weimar Germany in the 1920's or the United States during the 1970's.  In both cases gold protected wealth better than stocks or bonds.

The problem with this reasoning is that it works...until it doesn't.  Let's look at what Paul Harvey called "the rest of the story." 

Bonds were a lousy investment from the bottom of the Great Depression until the 1970's.  Bonds will likely be a very poor investment in Japan over the coming 20 years.

Gold was a great investment in Weimar Germany...until hyperinflation ended.  Then it tanked.  Same with 1970's inflation here in the U.S.: gold was great...until it declined 6% a year for 20 years.

Investing to catch the waves of inflation and deflation require excellent market timing.  It only pays to ride the wave as long as you know exactly when to get off.  Getting the timing wrong--even by a little--will lead to poor results.  But, in case you don't know, no one is good at consistently timing the market (despite all the time, effort and brainpower devoted to it). 

Warren Buffet doesn't time the market.  Neither did Peter Lynch.  Look at the Forbes 400 some time and scout out the market timers--you won't find a single one.  Trying to time the market doesn't lead to permanent wealth--it leads either to temporary or decreasing wealth.

Which is why most investors shouldn't focus on bonds and gold.  If you can time the market perfectly--and good luck on that--you can ride bond/deflation or gold/inflation.  If you are a mere mortal, then don't try juggling nitroglycerin. 

If you want to build permanent wealth, you should do what Warren Buffett and a herd of other smart investors do--buy productive assets at cheap prices, which is when everyone hates them.  Productive assets are things that generate cash.  Gold doesn't.  Bonds do, but the cash they generate isn't protected against inflation (except for TIPS, but they have their own problems).  You have to own productive assets to really be protected against both inflation and deflation.

Examples include real estate, stocks, businesses, rental equipment, employment, education, etc.  These are assets you put money into and get back over time.  They can adjust to both inflation and deflation. 

Does that mean they do well in all markets?  NO!  Investing is not about what does well over a week, month, quarter, year, or even 5 years.  You invest for the long term, not for a short term kick-back--that's speculation!

But, producing assets work like a charm during both inflation and deflation.  Look at the record of stocks, real estate, owning a business, rental equipment, education, or any employment during periods of inflation and deflation.  They do poorly initially, but work very well over time.  That's because they can adjust to inflation and deflation, whereas bonds and gold cannot (gold will maintain, but not grow, value over the full cycle).

Investors flooding into bonds and gold are likely to look brilliant for a while...until they get slaughtered.  The cycle on bonds and gold tend to turn very quickly.  It will only be obvious in hindsight that the tide has turned--and by then it will be too late.

Investors patient enough to invest in producing assets at cheap prices will do well--over the long run--regardless of whether we experience inflation or deflation.  That's how I'm betting.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.