Analysis from AdvisorAnalyst.com

A Magic Bullet for Inflation and Deflation?

During the better part of the last 18 months, since the financial crisis erupted, the debate over whether we are in store for inflation or deflation has dominated the investment decision making thoughts of all market participants, from retail investors to hedge fund managers.

The burning question – "Are we heading for inflation or deflation?" – is the toughest one to hurdle. Since there is no way of knowing, you have to make a decision based on what you know about each, then, make a decision about how to invest, based on your decision. Its precarious at best. Many investors, however, unable to settle on an outlook, will choose the option that requires the least amount of thought – cash, GICs, and short term bonds – and wait for things to be clarified.

That's why something hedge fund manager David Einhorn, of Greenlight Capital wrote last year has got my attention again.

It was his irreverent, seemingly uncomplicated, thesis that gold is a bulletproof investment, no matter what you believe is in store for the U.S. economy.

"If the chairman of the Fed is determined to debase the currency, he will succeed," wrote Einhorn. "Our instinct is that gold will do well either way: deflation will lead to further steps to debase the currency, while inflation speaks for itself."

I remember how it caused me to raise my left eyebrow, the first time I read Einhorn's unique thesis. It reminded me of another time, when I reacted to Lisa Myers, of Franklin Templeton, when she was asked, in July 2009, whether we were in a bear or bull market rally; she answered, "It doesn't matter." At the time, I remember thinking she put it that way to placate shell-shocked investors, but now I realize it was wisdom. In hindsight, she was right.

Einhorn is correct that a bout of deflation or rather the mere threat, would prompt further steps to debase the currency, but the passage through the deflationary period would be marked by volatility, so this is by no means a worry-free investment thesis.

I believe Einhorn's position is strictly a longer-term thesis as he has taken into account several well thought out considerations. At the Value Investing Congress in October 2009, he said. "I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when FDR debased the currency. It did well again in the money printing 1970s, but collapsed in response to Paul Volcker's austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked."

"Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely. Of course, gold should do very well if there is a sovereign debt default or currency crisis."

It's difficult to know if Einhorn's thesis is water-tight. As a long term holding, however, a portfolio allocation in gold bullion may be an appropriate choice to consider. Whether you agree with this or not, take the time to read David Einhorn's speech from last October 19. Einhorn is one of the most emboldened, and enlightened professional investors of this era.