Gold’s utility as a hedge has come under serious fire. New empirical data on gold’s track record are bound to challenge many of your assumptions.

Rarely does anyone question a trade when it’s working and gold was definitely a winner in the previous decade. Gold started the 2000s fetching about $280 per ounce and by the end of 2010 it had soared to $1,380 for a gain of 393 percent, peaking at $1,921 in intraday trade on September 6, 2011.

But since the end of the aughts and the start of the teens, gold has taken us on a wild ride, falling 15.7 percent over the past year alone (see graph below).



Gold’s slide has taken many people by surprise, since gold’s role as a hedge against inflation has long been accepted as an article of faith. And while the government has been telling us that there’s no real inflation to speak of, we all know better than that. So why has gold nosedived of late?

For one thing, a lot of recent academic research has shown that gold isn’t really the inflation hedge many of us thought, with other assets outperforming gold even in an inflationary environment.

This past February, economists Robert Barro and Sanjay Misra published a paper through the National Bureau of Economic Research that tracked the real return of gold from 1836 to 2011, a period that included the “stagflationary” 1970s.

Their research showed that over that period, gold’s inflation-adjusted return was just 1.1 percent, versus 1 percent for Treasury bills, 2.9 percent for long-term bonds and 7.4 percent for stocks. And while stocks were more volatile with a standard deviation of 16.1 percent over that period, 10-year bonds produced a superior return with a standard deviation of just 7.7 percent compared to gold’s 13.1 percent.

Even looking at the period of 1975 – 2011, which included both stagflation and big runs in gold prices, stocks and bonds still outperformed with lower volatility.

Another pair of economists, Claude Erb and Campbell Harvey, also published a study in the past year that looked at 2,500 years of historical gold price data. (Yes, you read right: they studied two and a half millennia worth of data. Apparently, the ever-organized Romans maintained detailed records on gold, which they used to pay soldiers and for other purposes.)

Erb and Harvey found that the real return of gold wasn’t driven by inflation. In fact, the value of gold actually lagged inflation in many rolling 1-, 5-, 10-, and even 20-year periods.

Their research shows that gold returns are essentially demand driven, rather than inflation driven, and have a disturbing tendency for mean reversion. As a result, jewelry and central bank demand for gold are the most critical long-term determinants of gold prices, although price spikes can occur when investors expect a sharp bump up in inflation. Unfortunately, investors tend to be poor predictors of when those inflationary bubbles will occur and how long they will last.

Based on that poor predicative ability and gold’s mean reversion tendencies, Harvey has said he wouldn’t be surprised to see the price of gold fall back to about $800 per ounce, but he doesn’t give a time frame for that prediction.

His research did show that while gold is a poor short-term inflation hedge, it’s effective when you look at long-term periods of 75 years or more. Regrettably, no one’s investment horizon runs quite that far out.

So why isn’t gold an inflation hedge even if most of us think it is?

The most significant factor is that gold is a global commodity in a world where inflation rates are extremely uneven on a country-by-country basis, so it is impossible for the global price of gold to accurately reflect inflation in any single market.

Consequently, while gold production will flow to wherever it can fetch the highest price over the extremely short term, eventually demand evens back out and local prices will fall.

The other issue with gold as an inflation hedge is that it’s an entirely discretionary purchase. We all need oil to make our cars go, agricultural commodities to feed us and industrial commodities to fuel our demand for everyday items. While consumption of any one of those commodities may fall as prices rise and rationing takes effect, the inelastic quality of global demand for those goods makes them much more responsive to inflation.

In effect, gold is basically an insurance policy against a short-term crisis.

But don’t get me wrong. Although I’m convinced that better inflation hedges than gold are available, I’m not panning the Midas metal entirely.

We do have exposure to gold in our Survive Portfolio through our position in GreenHaven Continuous Commodity Index (NYSE: GCC). Included in its basket of 17 equally weighted commodities is a 5.88 percent allocation to gold futures contracts.

I’m also adding Goldcorp (NSYSE: GG) to our Thrive Portfolio.

Given gold’s sharp decline over the past year, Goldcorp is definitely a contrarian bet. But one of the best ways to hedge against inflation is to buy high quality businesses when they are cheap, which occurs when they are out of favor. And Goldcorp is definitely out of favor.

The largest gold mining company in the world as measured by market capitalization, Goldcorp has seen its shares decline nearly 18 percent over the trailing year, as falling gold prices have pressured earnings. In the second quarter, the company posted an operating loss of $2.4 billion versus a gain of $401 million in the same period a year ago.

An impairment charge of $2.6 billion on the company’s Mexican assets as a result of lower gold prices played a role in the drop. However, the most significant driver was a 15 percent decrease in the company’s average realized gold price to $1,358 per ounce in the quarter. At the same time, its production cost came in at $713 per ounce versus $619 a year ago, largely due to higher labor costs. As a result, the company posted a $2.38 per share loss for the second quarter.

It’s easy to see why investors might have fled after those results, particularly since nearly a decade-long run in gold prices had attracted a lot of hot money to the miners. But several bright spots in the quarter also shone through.

Production rose more than 10 percent year-over-year and 4 percent sequentially, hitting 646,000 ounces. That increase in production came even as many miners are struggling to maintain production at current levels, much less increase it.

Goldcorp’s key advantage is its strong financial position. While it does currently have about $2 billion in debt on its balance sheet, that’s largely offset by the $1.5 billion in cash and equivalents it’s carrying. As a result, it has a current ratio of 2.54 and a quick ratio of 1.57, so it is well positioned to continue meeting its obligations while maintaining growth from a financial perspective. Even given the volatile gold price environment, it will easily be able to fund its full-year capital expenditure plan of $2.6 billion.

The company is also working to bring down costs by shaving 10 percent off its general and administrative expenses for the year, as well as striving for an 11 percent reduction in exploration costs in the second half of the year.

Meanwhile, I look for gold prices to firm up throughout the second half of the year.

The major driving force behind gold’s recent decline is the drop off in the “crisis premium” it’s been fetching over the past several years. As the global economy continues to firm, investors who had flocked into gold are feeling confident enough to start exiting those positions.

But jewelry demand for gold, an important propellent of prices, has continued to grow. According to the World Gold Council, demand rose 37 percent in the second quarter to 575.5 tons, its highest volume in 5 years. Indian and Chinese consumers were a major driver of that, taking advantage of the metal’s lower price and providing a floor.

Central banks also added 71.1 tons of the yellow metal to their official reserves in the quarter, the tenth consecutive quarter of increases. While central bank purchases are showing signs of slowing, I look for them to continue as net buyers of gold as they diversify their reserves away from US dollars.

Gold recycling has fallen along with the price of gold. Fewer consumers are willing to sell their scrap gold to those “Cash for Gold” outlets that have popped up seemingly everywhere, as they’ve become conditioned to higher prices. In all, recycling was down by 21 percent in the quarter, more than offsetting the 4 percent year-over-year increase in mine production for a 6 percent decrease in total supply.

Based on my outlook for a firming in gold prices and Goldcorp’s strength in the industry, I’m adding the stock to the Thrive Portfolio as a buy up to 39.