The best dollar hedge

I'm sure by now you are well aware of the tear that most commodities have been on thus far in 2008. But last week was particularly worth noting. As you know, gold hit $1,000 per ounce. $1,000 is merely a psychological number, but it is very impressive, nonetheless.

Gold isn't the only commodity on a tear. Gold's little brother silver has surpassed the $20 per ounce level, oil hit $110 per barrel, natural gas is above $10, soybeans traded as high as $16, and wheat surpassed $20 per bushel. The currencies have been on a tear, as well, the most noteworthy being the yen, trading in the 100 handle, and the euro, trading as high as $1.56.

Supply and demand fundamentals, as well as the commodities supercycle, have affected many of these markets, but when you have a move across the board as we have, must look at the other side of the equation. I am, obviously, talking about the falling dollar.

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Investing in any one of these commodities is a fine way to hedge the falling dollar, and investing in a broad array of these commodities is even better. But I would like to use this post to discuss the two most common dollar hedges.

I was recently contacted by a friend who is in Germany on an extended stay. He is set to return to the U.S. in a couple of months. The reason he e-mailed me was to inform me that he has been accumulating euros as a hedge against the falling dollar. We opened up a dialogue comparing euros and gold as dollar hedges in the past and going forward.

The obvious reason you would buy euros or gold is because you are short the dollar. I don't need to state that we agree with that position. So let's start off by looking at the past performances of the euro and gold versus the U.S. dollar, starting in 2001. The reason I chose 2001 is because that is when the most recent bear market for the dollar began. For obvious reasons, this approximately coincides with the bottoming of the euro and gold markets.

In 2001, approximately 95 cents bought you one euro. Today, it will take $1.56 to buy one euro. So if you had bought euros in 2001, you would have had a cumulative return of 64 percent.

How about gold? If you had bought an ounce of gold in 2001, you would have paid approximately $260. With gold hitting $1,000 per ounce, you would have made a cumulative return of 285 percent

So the question of which dollar hedge has been the most effective thus far is a no-brainer. Gold has significantly outperformed the euro over the past six-plus years. In order to pursue this question further and make some predictions going forward, we need to ask ourselves why gold has outperformed the euro as a dollar hedge.

I believe the reason is very simple. The euro, just like the dollar, is a fiat currency. It is not backed by a gold or silver standard, therefore leaving the value of the currency up to the good, or not-so-good, nature of the monetary authority. If history has shown us one thing, it is that central banks are good at devaluing currencies. The reason the euro has appreciated against the dollar is because the Fed is inflating much faster than the ECB. So more or less, the 64 percent gain is equal to the cumulative inflation of the money supply of the dollar minus the cumulative inflation of the money supply of the euro.

Gold is a different story. Although global monetary authorities, including the IMF and BIS, have attempted manipulation of the gold markets, the real effect in the long run is essentially zero. Simply put, gold is probably the only asset left in the world that is no one else's liability. There is one thing we can look at. The closest thing in the gold market that compares with the inflation of the euro is gold mined out of the ground. Because of the commodities supercycle and changing financial tendencies, growth in global demand for gold has grossly outstripped newly mined gold and gold sold by central banks. So for lack of a better word, gold supply is deflating.

So the euro has appreciated against the dollar, but it has been inflated in its own right, while at the same time, it is impossible to inflate gold. The best way to sum this up is to look at the price of gold in euros. You will see that gold priced in euros has increased by 133 percent since 2001. The price of gold is as good a judge of inflation as any. So theoretically, the difference in inflation between the euro and the dollar should approximately equal the difference in price increase between gold valued in euros and gold valued in dollars. That difference is actually 153 percent, which doesn't exactly equal the 64 percent appreciation of the euro against the dollar.

So where does the additional 89 percent come from? It's hard to say. It could easily be attributed to the fact that the euro was still a very young currency, it could be because of the commodity supercycle, or it could be due to some other reason. This is not a question that I have looked very deeply into. Regardless, it does not affect the analysis of the past, present, or future relationship between the dollar, euro, and gold.

Moving on, the final aspect of this piece is to figure out what the future will bring for the two most popular dollar hedges. The question we have to ask ourselves is will the trend change? Will gold be the best dollar hedge going forward? The simple answer to that question is no, but there never really seems to be a simple answer.

Watch out for a gold bubble

So to restate my answer, over the next couple of years, gold will continue to be the best hedge against a falling dollar. In fact, I expect gold to outperform the euro more significantly in the near future than it has over the past six years. This view doesn't have any fundamental basis to it. If the end of the precious metals bull market in the early 80s is any foretelling of how the current gold bull will end, we have some fireworks to come. What I mean is that as the Johnny-come-latelys enter the precious metals market, it will exceed its true value and balloon into a bubble that will be remembered for some time to come.

It is at this point that the trend of gold outperforming the euro as an inflation hedge will no longer hold true. The new trend will be the transition into the euro as the new reserve currency of the world and that is a discussion for a future day.

But for the time being, I strongly recommend owning gold over euros as the best inflation hedge against the dollar. It doesn't really matter exactly how you do it, whether it be with physical metals, mining stocks, exchange traded funds, futures, or options. It all depends on which investment style suits you best. But the more diversified your portfolio, the better.

That is why I recommend owning not only gold, but also a broad array of commodities investments, ranging from the energy sector to agricultural commodities and precious metals. And yes, even some foreign currencies aren't a bad idea.