Inflation - winning strategies

Today, lets look into how we can position our money to protect against, or even win in, an inflationary environment. To help us do that, let's take a look at who wins and who loses when inflation hits.

Losers

1)Savers When individual dollars lose their value, the most obvious losers are savers. It really doesn't matter if its cash in the bank or under the mattress, savers lose. Their dollars are no longer even worth the effort they put into earning them in the first place.
Avoid: Checking accounts, savings accounts, cash.

2) Lenders You might be thinking this doesn't apply to you. WRONG! If you bought a CD from a bank, you are a lender. Same goes if you bought a bond or a bond mutual fund. Once inflation begins to become an issue, the first thing the Federal Reserve thinks about is how to slow down the inflation rate. The method the Fed uses to slow inflation is to raise interest rates. Suppose you bought a 5-year CD that pays 6% per year and the Fed raised rates so that current CDs pay 9%. The bad news is that you are stuck with a cruddy return. The worse news is that inflation could easily be higher than the 6%. Bottom line is that you are actually losing money and you cannot get out without losing even more. Talk about a double-whammy!
Avoid: CDs, Bonds, Munis.

Winners

1) Stocks If inflation is a general increase in prices, then it makes sense that anyone able to sell things at the new, higher prices has some protection against inflation. But be careful because this isn't a sure thing for every stock. Inflation is generally painful for consumers. This means that most people will not be able to buy or spend as much as they could during the good times. The companies that will do best are the ones that sell goods and services that people must have. Companies selling large, expensive items that people don't have to buy will usually underperform.

2) Commodities If you pay attention to the financial news, you are already familiar with this one. The gold sellers are busy defining gold as "real money" while the oil and gas partnerships are busy hitting the phones dialing disaffected stock market investors. Commodities do have a good chance of performing well in an inflationary environment but it doesn't always happen the way one might think.

2a) Fuels For instance, Oil and other fuels can be a decent hedge against inflation if production and demand remain constant. If demand falls because of economic slowdowns, then the price of oil will fall too. Another worry is if producers guess wrong about the economy and produce too much, they could flood the market and drive prices down.

2b) Metals Gold and metals are another option. Industrial metals derive their demand from manufacturing and they are vulnerable to the same issues brought mentioned for fuels above. Gold, on the other hand is often labelled as a great inflation hedge. Dollar down, gold up, right? Wrong. truth is, there is very little correlation between the two. More details here: http://globaleconomicanalysis.blogspot.com/2007/02/is-gold-inflation-hedge.html
Now let's be fair. Even though the correlation is minimal, it is negative. That means that it can be a hedge against inflation, but you should only expect it work about 1 time out of 3. Its also important to remember that Gold is used in a decent number of manufacturing processes, especially in the computer industry. As the computer industry grows, gold will become more of an industrial metal.

Conclusion

What makes inflation tricky is that the losers are easy to pick and the winners are little more difficult. We believe that the smartest way to handle inflation is to pick a variety of potential winners and invest in the top 6 to 12 ideas. Our concentrated approach gives our investors a good opportunity to profit from inflation's winners without trying to bet the farm on one single idea.

Log in tomorrow to learn how we keep downside risk down even in nasty markets

Inflation vs Hyperinflation

So what are we looking at, here?

This chart shows that we have increased the money supply by over 10x in just one year. For those who may not remember, the money supply is the amount of dollars that are in the economy. In our current system, each dollar is only worth what the open market is willing to pay for it. There are two reasons why people and businesses would want to own dollars.

First, people use dollars for commerce. That is the easiest part of demand to understand. What to buy something in the USA? You'll need dollars. Want to buy something from an exporter based in the USA? You'll need dollars.

The second part of dollar demand is called "interest rate parity." This concept is simply common sense. Imagine that you, my reader, are a business executive in Europe and you need to find a safe place to invest some of your currency. Suppose that your home country offers an interest rate of 4% on its government bonds. Now imagine that US Treasury bonds offer an interest rate of 6%. Would you prefer the US bonds? Of course you would. So you would trade your Euros for dollars so that you could buy US bonds. This increase in demand for dollars would cause the value of the dollar to rise. Conversely, if US rates are lower than they are in other countries, then people would prefer to trade dollars out for Euros (or whatever currency applies), which would cause the value of the dollar to fall. That's how interest rates affect the dollar's value.

There is one more piece of the puzzle we need to understand before we can make sense of the the chart above. Both of the above concepts are simple to understand if the number of dollars available remains steady. This was one of the lessons economists thought we had learned from the Great Depression. Instability in the money supply makes it extremely difficult to accurately price goods, services and investments.

Here's why: imagine that our entire economy was comprised of 100 apples and we had 100 dollars to use for trading them. Each apple would be worth $1. Next, imagine that we decided to print 100 more dollars. Now, we have 200 dollars to account for 100 apples. How much is each apple worth, now? The answer is $2, of course. The orchard owner just grew his little economy from a $100 to a $200 one. But he didn't do a thing to actually increase production. He still only has 100 apples. All he did was create inflation.

You may by thinking this is a pretty foolish thing to do. I agree. It would be even more foolish if our apple farmer increased his dollars from 100 to 1000? You would need $10 just to buy an apple. Anyone who kept their money in a savings account or under the pillow would become destitute. But those people who bought apples would come out winners. And those people who invested in apple trees would become tremendously wealthy.

Take another look at our chart. Our government has increased the money supply at the same rate as our farmer. If interest rates remain constant, we are looking down the barrel hyperinflation (rates above 100% per year). To control this, the Fed is going to need to raise interest rates dramatically. Even with this band-aid, we might avoid hyperinflation but chances are very good that investors will still need to find ways to combat historically high inflation rates.

Log in tomorrow for our discussion on what type of investments we are using to turn the tables on inflation and make this a profit opportunity for our clients.