Conventional wisdom (or is it a firmly-rooted popular misconception?) holds that Gold is the ultimate inflation hedge. Today’s consumer is convinced that inflation is here, because he winces at the gasoline pump and his wife tells him that food prices are increasing steadily. (Well, certainly the prices of any food products which contain corn are going up, because of the demand for tax-subsidized corn as a result of the demand for tax-subsidized ethanol, so we effectively pay for the food more than once at the checkout counter and poor farmers overseas can’t compete - and therefore they are rendered poorer still; but that’s another story).

So, Mr. and Mrs. Consumer dismiss Government numbers which say that something called “core inflation” is under control, when (magically) the definition of “core inflation” does not include certain key items which he and she buy frequently in order to keep the household functioning and the children fed.

And yet – is that an anomalous situation? We note that the sales of new homes are falling drastically, and that their prices are being shaved in order to move existing inventory; sales of existing homes are in disaster mode; and automobile dealers are pulling out the stops in order to bring potential buyers into car showrooms.

During a substantial part of 2007, there was a positive correlation between the prices of Crude Oil and Gold. Crude began a rapid ascent about the first of June, while Gold began its fast rise about the first of September. They both dipped a bit about December 1, and then rose again to the end of the year.

That’s when the correlation broke apart: From January 1 onward, Gold continued upward to a new high, whereas Crude Oil has fallen away quite substantially.

The disparity since January 1 is more clearly shown in the Daily charts:

(The outlining of bars in the Daily chart of Gold shows a “Bearish Engulfing Pattern” in Japanese Candlestick terminology. Prices have declined thereafter).

Until January, was the price of Crude Oil being driven, at least in part, by fear of inflation, or was it purely a reflection of actual supply and demand? Or was it both?

If it was partly by fear of inflation, and if Crude Oil is perceived to be somewhat of a hedge against inflation, then is it reasonable to suppose that the turndown in the price of Crude Oil since the first of January was a precursor of a decline in the price of Gold, which apparently has now begun – and, in general, was it a further confirmation of a deflationary cycle which was earlier foretold by the collapse of the sales of new and existing homes?

Investors in Gold may have been busily setting the table for an Inflation Party which will be poorly attended.

William G. Kurtz Jr. http://www.candlewave.com/candlewave.htm Feb. 5, 2008