By Brad Zigler

We've groused before about gold's much-vaunted role as an inflation hedge. When we looked at gold's long-term performance last year (see our January 2008 rant, "A Picture's Worth A Thousand Words (Or Dollars)"), we wondered if, indeed, the yellow metal would match its 1980 highs on an inflation-adjusted basis. As it turned out, gold didn't. But crude oil did.

We figured gold would have to average $1,563 an ounce in 2008 to equal its 1980 record when rises in the U.S. Consumer Price Index [CPI] were factored. Gold, loco London, managed to run up to $1,023 in March, but only averaged $872 for the year. West Texas Intermediate [WTI] crude, by contrast, needed a CPI-adjusted mean price of $95 a barrel in 2008 to equal its 1980 performance. Spot oil delivered to Cushing, Okla., averaged $100 last year.

Traditionally, gold's risen in tandem with oil. That's still the case - more or less, though it's been "less" than "more" recently. The relative strength of the two commodities is readily observed in the gold/oil ratio. Gold's purchasing power is waning now owing to a resurgence in oil prices. An ounce of gold currently buys 17 barrels of oil. Back in February, though, when oil prices cratered, the gold/oil ratio approached 28-to-1. At oil's zenith in 2008, the ratio neared its record low of 6-to-1. Over the long run, gold's multiple averages a shade under 16x, though the metal's leverage has been slipping recently. Over the past five years, an ounce of gold has been worth about nine barrels of oil.

Gold/Oil Ratio

De-leveraging had a lot to do with the run-up in the gold/oil ratio. You'd have a hard time making a fundamental case for the eight-month swoon in oil prices from $145 a barrel to $34. Slackening demand certainly contributed to oil's downtrend, but the fire sale of assets in the wake of the Lehman Brothers collapse, led by hedge fund selling, really pitched oil prices into the abyss, making gold look relatively strong.

Oil, in large part, fell upon its own sword. After all, it was oil's price rise preceding the banks' collapse that was the source of much of the inflation measured by CPI. Since 1986, the year the U.S. Energy Information Administration began collecting spot price data, the WTI price compounded at an average annual rate of 8.6%. CPI's contemporaneous growth rate was 3.0%.

And gold? Gold ended up appreciating at a 3.8% annual rate over the 23-year period.

Asset Performance 1986-2008 (Yearly Average Prices)

Keep in mind, though, that we're looking at raw asset values here. The picture looks a bit different when the effects of inflation are considered.

Inflation-Adjusted Asset Performance 1986-2008 (Yearly Average Prices)

Net of CPI inflation, gold's appreciation rate falls to 0.8% per annum. Crude oil's rate declines, too, but remains above CPI's at 5.4%.

Take note, however, of the price trajectory of large-cap U.S. stocks represented by the S&P 500 index. On both a raw basis (at 7.4% per annum) and adjusted for inflation (at 4.2% per annum), stocks pretty much stayed ahead of inflation each and every year while commodity appreciation was, until recently, sub-par. Oil's price velocity, in fact, languished below the inflation rate from 1991 until 2005. Gold's rate of rise is still playing catch-up to CPI's

Therein, though, lies the rub. While oil appreciated at a rate better than gold and CPI over the long run, it may not be the better hedge. At least, not a better hedge for a stock portfolio. Sure, one can hedge against inflation, but there are other adversities for investors to consider. In the strictest definition of the word, a hedge is an instrument that moves in opposition to a target asset. The object of hedging is to smooth out portfolio volatility until such time as assets can be liquidated.

Consider this: the 23-year correlation between the S&P 500 and WTI crude is 4.2%. Not a high correlation certainly, but a positive one nonetheless. Gold, however, is negatively correlated, at -38.6%, to stocks.

In a hedge, you want the hedge vehicle to zag when your primary asset zigs. Simply put, there just may be more zag in gold than there is in oil for long-term stock investors.

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