Inflation

My investments are well diversified. I’m invested in foreign and domestic real estate, commodities, precious metals, domestic and international equities and foreign sovereign debt. However, I haven’t spent much time analyzing my portfolio allocation. While making money through investments is good, protecting what you have is paramount. As I grow older each year, volatility becomes a greater issue. In a few more years I”m not sure I ‘ll be able to stomach a 40% loss that the market experienced in 2008. (Luckily, I my retirement account was down only 4% that year so I didn’t have to stomach anything!)

There are tons of great books available on the subject of portfolio allocation, but I wanted something easy to understand (and thus, remember). One of the better models I can across was Harry Browne’s Permanent Portfolio.

The basic premise is to cover all possible scenarios in your porfolio:

25% of portfolio to protect against Inflation (eg. Gold)
25% of portfolio to protect against Deflation (Cash)
25% of portfolio to do well in a Bull Market (equities)
25% of portfolio to do well in a Bear Market (bonds)

Taking it a step further you can add in protection against Devaluation (eg. invest in foreign currencies and foreign bonds).  You can also add in real estate or REITs as an inflation hedge, and foreign equities. The the basic premise is simple. You try and benefit from any sort of market. 

This is pretty simple to implement. All you need is to do is buy low-cost ETFs and check your portfolio once a quarter to rebalance to the appropriate percentages.

If you like this philosophy but don’t want to implement it, you might want to take a look at the Permanent Portfolio Fund (PRPFX) which is modeled and named after Harry Browne’s  Permanent Portfolio. Over the past 27 years, it’s been down only 4 years. Maximum annual loss was 12% in 1984. In 2008, it lost less than 9%! It’s expense ratio is also reasonable at 0.82%. It’s 5-year average return is a respectable 10.3% vs say an S&P 500 index fund like (SWPPX) which had a 5-year average return of 0.99%.

 It’s portfolio consists of gold, silver, Swiss franc assets such as Swiss franc denominated deposits and bonds of the federal government of Switzerland, stocks of U.S. and foreign real estate and natural resource companies, aggressive growth stocks and dollar assets such as U.S. Treasury securities and short-term corporate bonds.

Gold hit another record today and is currently trading over $1,100 as I write this. However, it hasn’t prevented several news stories coming out about how gold is a lousy investment. Investment stalwarts from Warren Buffet to Monish Pabrai have all denounced gold as an investment.

And despite the decent performance of gold over the past 10 years, they’re correct. Gold is a lousy investment. It creates no income and just barely keeps up with inflation.

But do you know what the best performing asset class was during the past 10 years? No, it wasn’t your stock portfolio or your real estate. It was gold, and it returned a decent 270% over that period.

10-year-returns-by-asset-class

Despite its out-performance of all major asset classes, gold still gets no respect from the investment community. That’s because it is only a store of value and typically only does well in periods of currency crisis, or times of poor monetary policy.

For example, during post-WW2 Germany and in post-Mugabe-school-of-economic-policy Zimbabwe, their currencies have faced severe devaluation and gold prices sky-rocketed against those currencies. Faced with hyperinflation and an inability to buy basic necessities, people flock to gold causing the price to soar.

But that wouldn’t happen in the US right?

Economic research has shown that consumer psychology is affected by the amount of wealth people feel they have. If they’re broke and living pay-check to pay-check, but have tons of equity in their homes, they still feel wealthy. But even if they still have a job, but are upside down on the mortgage and have negative equity in their home, they feel poor and their spending decreases. Since the US is a consumer spending driven society, with spending constituting 70% of our GDP, the Federal Reserve has been trying desperately to get the consumer to start spending again.  Part of this entails propping up housing prices by keeping mortgage rates low, and another part is keeping interest rates low on non-collateralized consumer debt (that’s credit cards and student loans).

In an effort to stem the free-fall in the housing market, the Federal Reserve has been trying to keep the interest rates for mortgages as low as possible. Historically, the Fed has tried to manipulate the short-end of the yield curve by adjusting the shortest of short-term rates – the Inter Bank Overnight Rate (also called the Federal funds rate in the US. The UK has something similar called the LIBOR). This is supposed to have a trickle down affect the interest rates of long-term interest rates (such as the 10 year and 30 year Treasuries).  The rates for 3o year fixed rate mortgages are impacted by the rates on the 10 year Treasuries. So by keeping the federal funds rate at zero (or 0.2% which is close to 0%), mortgages rates should stay quite low. However, given the fact that this is not a typical economic scenario, the fed isn’t quite sure that mortgage rates would stay below 5%. So it has been buying billions of long-term Treasury bonds as well as mortgages, which is a quite a bold move away from its historic stance. When the 800 pound gorilla starts buying bonds, the prices rise and the yields go down.  When the Federal Reserve decides to buy $300 Billion dollars worth of mortgages and government bonds, something is definitely wrong with the economy.

I’m  interested to see the effect on mortgage rates once the Fed stops buying Treasuries and mortgages.

The government is increasing its deficit spending at a steady clip. If this continues, eventually we will be unable to repay the debt and barely just able to service the debt. Obviously this is not a viable long-term strategy, but it doesn’t look like there is any other back-up just in case helicopter Ben’s strategy of throwing money at the problem doesn’t pan out.

Clearly, we are currently in a crisis period in regards to fiscal policy and gold prices are likely to keep going up. During times of good fiscal policy, gold does nothing. This does not seem to be one those times.

A well-known hedge fund manager (and world poker champion) David Einhorn shares the sentiment.  And someone else who agrees with him is Liu Mingkang, chairman of the China Banking Regulatory Commission. He recently said, “Low U.S. interest rates and a weaker greenback have “seriously affected global asset prices, fuelled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.”

Someone I know who works at a very well-known bond fund company recently advised me to sell my gold holdings. He advised me the same thing last year when gold was only $800/ounce. And I told him the same thing I said last year – Not yet.

Disclaimer: I’m long gold/silver bullion, gold mining stocks and short long term treasuries.

Last week, gold prices briefly touched $1,100/oz before settling just under that number.  Apparently the Indian government decided to sell US dollars and make a 200 ton gold purchase from the IMF, which created the spike in gold prices. Right now, the spot price for the yellow metal is $1,106.

price_of_gold

The IMF still has another 203 tons of gold to sell and the hot favorite to make the purchase has been China.  However, according to a report by Reuters, its a lot cheaper for China to buy domestically mined gold than purchase bullion from the IMF at the current spot price. According to Li Yang, a former adviser to the People’s Bank, “China’s gold is much cheaper than that.”

You may not realize it, but China is the world’s No. 1 gold producer, and its mine costs are much less than $1,100 per ounce. And given China’s propensity to put national well-being over any private individual or firm, they’re likely to just pay for the gold being mined at cost, which would be a lot lower than the spot price.

According to another Chinese Central Bank official,

China is the world’s biggest gold producer, so there’s no urgency for us, as there is for India, to snap up big volumes whenever they come onto the global market. It’s cheaper for us to buy gold from the Chinese market, but it doesn’t help diversify our huge foreign exchange reserves.

To diversify our portfolio, we should spend dollars on things like gold. But the catch is that even if China bought half the world’s annual gold supply, it would only cost a few tens of billions of dollars, which is tiny compared to China’s huge reserves.

China has 2.27 trillion dollars in reserves. Spending 25 Billion a year buying gold is chump change. The question that’s relevant is whether they will, because that will put upward pressure on gold prices.

While no one knows whether China will or will not buying gold on the open market, the one thing we do know is that the monetary base of the US Dollar is growing exponentially making each existing dollar less valuable. Check out this graph from the St. Louis Fed:

money_supply

While its not obvious from the graph, the monetary base has in the past year. Its true that this money hasn’t worked its way in to the economy, but if and when it does we should expect higher inflation and a spike in prices of real assets like gold, silver and real estate.

If I had a few trillion dollars, I’d be buying a few hundred tons of gold every year!

According to a quote in the Telegraph, HSBC has issued a new report stating that the Federal Reserve’s ultra-loose monetary policy is forcing China and other emerging countries to create a new global currency “order”. According to David Bloom, HSBC’s currency chief, the dollar looks like the sterling did after World War I.

For those a little dusty on their history, the British pound sterling (so called because it’s value was backed by sterling silver) was the world reserve currency until the 1930’s. After that, the sun set on the British Empire and the sterling was replaced by the US dollar. Now it seems the dollars time in the sun has come to end as well. The Telegraph article states:

Crucially, China and rising Asia have reached the point where they can no longer keep holding down their currencies to boost exports because this is causing mayhem to their own economies, stoking asset bubbles. Asia’s “mercantilist mindset” of recent decades is about to be broken by the spectre of an inflation spiral.

A monetary policy of near zero rates – further juiced by quantitative easing – is completely incompatible with circumstances in most of Asia, the Middle East, Latin America, and Africa. Divorce is inevitable. The US is expected to hold rates near zero through 2010 to tackle its own crisis.

Mr Bloom said regional currencies would emerge as the anchor for their smaller trading partners, with China, Brazil, or South Africa substituting the role of the US. Australia is already linking its fortunes to China through commodity ties.

This is nothing new, but it is the first time a major bank has openly stated this. But the important question hasn’t been answered.

What does it mean to the average American?

In order to obtain the necessary financing to fund the multi-trillion dollar stimulus/bailout package the government needs to sell bonds. Traditionally, the Chinese and other foreign governments have used their excess reserves of US dollars to purchase these bonds. If we switch to some other currency (or mixture of different currencies), the amount of US dollars held by foreign governments will decrease and the demand for US treasuries that yield next to nothing will decrease substantially. In order to entice the buying of these treasuries, the interest rates will have to jump substantially higher. And when this happens, the cost of the US government’s debt will start to rise. As will the cost of borrowing for US citizens and businesses. The government already pays nearly a billion dollars a day in interest payments (hat tip: Silver Bars Direct: Why $1,000 gold is now significant). If this cost were to double, and we add in the additional $9 trillion in debt the white house has admitted it is likely to borrow, we’re looking at over a trillion dollars a year in debt payments.

In order to repay this interest (and maybe the original principle too), do you think the government is likely to raise taxes or just print more money? If it prints more more, its just fueling the debt spiral which will lead to Zimbabwe-type hyper-inflation.

So what should you do?

Invest in hard assets that have been proven to keep their buying power during inflationary times.  Along with gold and silver bullion, buy some cheap land to either farm, hunt or bury your precious metals! And if you’re one of those people who think buying gold and silver is useless then hold on to your dollars and watch them become even more worthless. Since 1900, when the dollar coin actually contained silver, the dollar’s purchasing power has dropped to only4 cents. This trend is only like to get worse.

Purchasing-Power-of-the-US-Dollar-1900-2005

Disclosure: I own gold & silver bullion, numismatic coins and mining stocks.

Almost a year after the historic collapse of Lehman Brother, Fed Chairman Dr. Ben Bernanke announced that the worst recession since 1930 is finally over!

recession next exitHowever, this is only from a “technical perspective”, and unemployment for 15 million Americans (officially 9.7%) will continue, if not get worse. In fact, it may stay this way for nearly 4 more years according to other economists.

So what does this mean? The operation was a success but the patient still died!

Apparently pumping a trillion dollars in to the economy will create a technical expansion even if the net benefit to society is negative. What happens when the government pulls the plug on throwing money at the ecnomy? Won’t the GDP decline again, pushing us back in to a double dip recession?

And what happens if our lenders make this decision for us? Supposing China and Japan no longer want to buy our 30 years bonds at a measley 3 or 4%. What if the interest rates go up to 8%? Will we be able to afford $1 trillion dollars a year in interest payments? Will we start issuing notes for the interest payments? Nah, we’ll just devalue the currency and let inflation help us out of this mess. Either that or the government stimulus will continue indefinitely, aka monetary policy Zimbabwe-style! Oh wait, isn’t that the same thing?

Here are some must-read articles I’ve read this week. None of them talk about gold breaking a $1000, dividend stocks or things you’ve probably read in the news.

In the last post we saw that China was slowly diversifying away from it’s usual investments in US Treasury Bonds and investing in hard assets, natural resources and maybe other currencies.

There probably a very good reason why the world’s second largest holder of US Dollars is weaning itself away from bonds issued by the world’s largest debtor nation.  If you believe the Chinese know what they are doing, it might make sense to imitate their investment strategy.

While you don’t need to buy $80 Billion worth of gold, you might do well buying gold equal to at least 5% of your net worth. Gold is not an investment in itself but a historic store of value. Regardless what anyone tells you, the US Dollar is not a store of value. During times when governments print money hand-over-fist, gold typically does well. In fact, over the past 10 years, gold has appreciated against every single currency.

You can either buy the physical gold, gold ETF(GLD) & gold mining stock ETF (GDX), gold certificates or a custodial account. You can also buy silver and silver ETFs in a similar fashion. There was a recent Chinese news report recommending Chinese investors buy silver since its a better value than gold!

You can also exchange your US dollars directly for foreign currencies. Everbank currently has a Marketsafe BRIC CD, which invests in a basket of Brazilian Real, Russian Ruble, Indian Rupee and Chinese Remnimbi.  This CD doesn’t pay any interest but the principle is protected against loss! But if you’d rather take a risk and earn some interest, Everbank has a slew of CD products in several European and Asian currencies.

Another option are the CurrencyShare ETFs for Australian Dollars(FXA), British Pounds(FXB), Swiss Francs(FXF), Japanese Yen(FXY) and Euros(FXE).  Another ETF worth considering is UDN, an inverse US Dollar ETF, which is a basket of the above mentioned currencies. (However, inverse ETFs may not accurately follow the downward movement so you’re cautioned to do some research).

I do not recommend forex-trading as a means of hedging yourself against Dollar devaluation. Forex trading is a highly leveraged, zero-sum speculation. In a zero-sum game, a participant can only win at the expense of another participant. In fact, it may be considerably less than zero-sum becauase your brokerage can run your stops (which it can see) and effectively trade against you.

If you are thinking of investing in currencies, definitely check out Everbank’s free newsletter, the Daily Pfenning. It provides a very informative (and entertaining) look at global economics and investing. Actually, you should subscribe if you do any sort of investing! Everbank also has a low-cost custodial account for gold and from time to time (whenever the price of gold drops dramatically) they offer a MarketSafe (which means principle-protected) Gold CD. Sign up for the newsletter and they’ll inform you whenver they come out with new products.

If you have a penchant for natural resources, you should look into Master Limited Partnerships (MLPs) like Tortoise Energy (TYY) or Kinder Morgan (KMP). Both pay a juicy dividend that is considered a return of principle and thus non-taxable (although it does alter cost-basis). However both have appreciated significantly this year. Canadian Royalty Trusts like Enerplus Resources (ERF)  are also an option.

You can also buy natural resource stocks like Rio Tinto (RTP) or BHP Biliton(BHP). China has been trying to buy multi-billion dollar stakes in companies like these and is currently unsuccesful. If you think that a day may come where Chinalco will be successful, you might want to get in before that happens.

IRSA International (IRS) is an Argentinian company that trades on the ADRs.  It owns farm land, resorts, hotels and shopping malls in prime locations.  After decades of “quantitative easing” (another word for printing money) wreaked havoc on their economy and standard of living, Argentinians don’t trust banks or central bankers. They trust gold and farmland. The way the US economy is going, we too may come to that same conclusion. Just to be safe, I bought some of the stock. On the other hand, you might be better off buying farmland or a ranch for hunting. I’m pretty sure, buying farmland is next on China’s list!

Disclosure: I own ERF, TYY,FXA, IRS, Everbank MarketSafe Japanese REIT CD, GDX and physical gold/silver.

Finally Warren Buffett said what I’ve been harping on about for two years. In his NYT op-ed piece titled “The Greenback Effect” he admited that the government is setting us up for massive inflation and destruction of the US Dollar.

This fiscal year, though, the deficit will rise to about 13 percent of G.D.P., more than twice the non-wartime record. In dollars, that equates to a staggering $1.8 trillion.

During this fiscal year, [our net debt] will increase more than one percentage point per month, climbing to about 56 percent of G.D.P. from 41 percent. Admittedly, other countries, like Japan and Italy, have far higher ratios and no one can know the precise level of net debt to G.D.P. at which the United States will lose its reputation for financial integrity. But a few more years like this one and we will find out.

The US debt is currently financed by foreigners. Foreigners who have excess Dollars because we used to import everything from them. Three years ago during the height of the housing boom, consumers refinanced their homes every year and bought stuff they couldn’t afford, most of it imported from these same foreign countries. Indeed, consumer spending was 75% of our GDP. But with the collapse in housing, what has happend to consumer spending at the retail level?

Monthly US Retail Sales Total YoY

Retail spending has dropped off a cliff. Click on the image to go to retailsails.com which is has a lot of indepth information about the dismal level of retail sales.

And with the decline in spending, imports decline and in turn the ability of foreigners to finance our deficit spending. As they decide they no longer want to buy US treasuries at 3.5% but instead would like to buy stock in undervalued companies, real estate or maybe gold, the Federal Reserve is going to have to work overtime to print all the money it needs to fund the government spending. Buffett projects that the Treasury will need to finance at least $900 billion this way!

With government expenditures now running 185 percent of receipts, truly major changes in both taxes and outlays will be required.

Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes. In fact, John Maynard Keynes long ago laid out a road map for political survival amid an economic disaster of just this sort: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens…. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

I forget who said it but inflation is essentially taxation without representation!

Rampant inflation will cause the Dollar to lose its purchasing power against foreign currencies and precious metals like gold and silver which have been stores of value for 5,000 years. Unlike paper money, gold and silver are not subject to the human greed of rulers and maintain their value since their supply cannot be increased exponentially.

Buffett knows that the reputation of the Almighty Dollar is at risk.

Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.

Will Congress do the right thing or just do what’s easy and keeps them in office? Buffett is betting on the later and has slowly been converting his hoard of of billions of dollars in to foreign currencies like the Brazilian real.

At least I’m sure I did the right now when I started buying gold at $495/ounce!

While the debate between inflation and deflation keeps on going, I’m firmly in the camp of inflation. And so is Warren Buffett, as are many other investment advisors. So how do you protect yourself and your investments from the effects of inflation?

Investment newsletter editor, Keith Fitz-Gerald, recently had a post on his blog regarding the 4 ways to protect your investments against inflation. Here’s an excerpt:

What’s interesting is that many investors holding large cash positions view their money as an asset, when, ironically, it’s really more of a liability at this stage of the game.
Some might take issue with that statement. After all, even we at Money Morning have counseled readers that cash – correctly deployed – can allow an investor to sidestep the worst stretches of a financial crisis, like the one from which we’re currently attempting to extricate ourselves.

But when the markets are as beat up as they as they have been, history suggests there’s probably more upside than downside – even if we haven’t bottomed out yet.
And there’s a broad body of research to support that contention – including our own newly created “LSV (LIBOR/Sentiment/Value) Index” (published as a part of The Money Map Report, the monthly investment newsletter that’s affiliated with Money Morning).

There’s also data sets widely published by others, such as Yale Economics Professor Robert J. Shiller. Shiller has found that when you look at 10-year periods of Price/Earnings (P/E) data dating all the way back to 1871, the markets tend to rise when the average P/E is low, as it is right now. Conversely, when the average Price/Earnings values are high – as they were in late 1999, and again in 2007 – a decline in stock prices is much more likely.

There are obviously no guarantees that history will repeat itself. But if it does, the same data implies we could see real returns of 10% a year or more “for years to come,” as Shiller noted in a recent interview with Kiplinger’s Personal Finance.

My own research seconds the general-market-increase theory, but I’m much more conservative in my expectations of returns and think that returns of 7% are more likely.

Perhaps what’s more important right now is that inflation typically accompanies growth – and with a vengeance. And that means that investors who are sitting on cash “until the time is right” may have their hearts in the right place but are relying on the wrong protection strategy.

My recommendation is a four-part plan that can help lock in the expected returns you want, while also protecting your cash from the ravages of inflation. Let’s take a close look at each of the four elements of this strategy:

  • First, protect your cash with Treasury Inflation Protected Securities (TIPs). Even though the trillions of dollars the Fed has injected into the system seem to be having some effect on the critically ill patient the U.S. central bank is trying to fix, we’re likely to pay a terrible price in the future. Forget the hyperinflation scenario so many people are hyping at the moment. While that’s certainly possible, it’s not probable. However, what is likely is a dramatic realignment of the dollar and a general increase in worldwide living expenses.

If you’re based in the United States and have mostly U.S. assets, you may want to consider something as simple as the iShares Barclays TIPS Bond Fund (NYSE: TIP) to offset this risk. The TIP portfolio is chocked full of inflation-indexed securities, but it also offers a healthy 7.46% yield. If you’ve got international exposure, you may also want to consider the SPDR DB International Government Inflation Protected Bond ETF (NYSE: WIP). It’s a collection of internationally diversified government inflation indexed bonds that provides similar protection. Make sure you talk with your tax advisor about both, though. Depending on your tax situation, you may find that because of the tax liability on inflation-related accretion, these are generally best held in tax-exempt accounts.

  • Buy gold but don’t go crazy. Despite widespread belief to the contrary, gold has never been statistically proven as an inflation hedge. But the yellow metal has proven to be a great crisis hedge because of the 10:1 relationship between gold prices and bond coupon rates – which obviously are directly related to inflation. Over time, the two move in such a way that having $1 for every $9 in bond principal can help immunize the value of your bond portfolio.

So to the extent that you own gold, do so not because you expect it to rise sharply, but because it will offset the inflationary damage to your bonds. A good place to start is the SPDR Gold Trust (NYSE: GLD) because it’s tied directly to the underlying asset without the hassles or risks of direct personal storage associated with bullion.

  • Consider commodities. It’s too early to tell if the so-called “green shoots” that everybody is so excited about are little more than weeds. Therefore, it makes sense to concentrate on picking up resource-based investments. History shows that these things are less susceptible to downturns, but more importantly, rise at rates that far exceed inflation when a recovery begins in earnest.

I prefer companies like Kinder Morgan Energy Partners LP (NYSE: KMP) that are less dependent on the underlying cost of energy than they are on actual growth in demand. That way, if energy prices don’t take off immediately for reasons related to deflation or stagflation, those still will benefit from demand growth. It’s a fine point, but one that merits attention for serious investors. KMP, incidentally, yields an appealing 8.68% at the moment.

  • Short the dollar to hedge your bets still further. Not only is the government going to borrow nearly four times more than it did last year, but when you add the complete federal fiscal obligations into the picture, our government owes nearly $14 trillion. This makes the dollar, as legendary investor Jim Rogers put it, “a terribly flawed currency” that could fail at any time.

To ensure you’re at least partially protected, consider the PowerShares DB U.S. Dollar Index Bearish Fund (NYSE: UDN), which will rise as the dollar falls. It’s essentially one big dollar short against the European euro, the Japanese yen, the British pound sterling and the Norwegian kroner, among other currencies.
In closing, there is one additional point to consider. You rarely get a second chance to do anything, especially when it comes to investing. So act now before the markets make it cost-prohibitive to protect yourself. When the economic recovery gets here, you’ll be glad you did.

Pretty sound advice. I was just thinking about converting my 401k into TIPS today when I came across this article. The rest of the advice I’ve followed in some form or another. Instead of directly shorting the dollar, I’m long FXA, which is the CurrencyShares Australian Dollar ETF and EDD which is an ETF of short-term foreign government and corporate bonds.

Another way to SHORT the dollar is buy going LONG foreign currencies. Everbank has multiple CDs you can open in various currencies. They also have some neat products where the principle is guaranteed against loss – there is no free lunch – the interest is used to hedge against loss – but you do get any upside appreciation of the currency. Check out their Marketsafe BRIC CD. Also check out their free newsletter, the Daily Pfennig, which is a good source of unbiased global macroeconomic/monetary and currency information.