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

Deflation - Do you need to worry?

Welcome back.

Yesterday, we discussed inflation and how it can affect your financial well-being. At the end of yesterday's article, I noted that inflation occurred in each an every one of the last 50 years in the United States. That's half the story.

Here's the other half. Let's spread our net a little wider and see what the historical chances of inflation are since, say 1914. Uh-oh. Now the story changes a little bit. Instead of looking at a 100% certainty that we lose value to inflation, we find an 11.4% chance that cash money sitting under the mattress will actually increase in value while it sits there doing nothing.

Deflation was strongest in the period of 1927 - 1933. In 1932, deflation rose above 10%, the worst deflationary year in our country's history. As any student of the Great Depression knows, 1932 was one of the most painful years of the period. Jobs were lost, companies went out of business and it seemed like no one was hiring or buying anything but the bare necessities. Why not? Because it made more sense not to. If you had a pile of cash and you knew that it would be worth more if you simply sat on it, why would you risk it on a business venture? And what business can afford to pay $1 for something that will only be worth $0.90 by the time they can sell it? If you owned that business, you would need to sell your goods extra-super-fast or else just shut the doors. And when all your customers are losing their jobs, too, chances are you'll choose to shut down and save your cash.

Fast forward to today

With all the economic uncertainty we face right now, there are many who argue that we run the risk of hitting another deflationary cycle. If they are correct, deflation could wreak havoc on our economy and virtually shut down commerce in this country. Their reasoning in rooted in the fact that many of the current political policies from the White House mirror those of Franklin Delano Roosevelt, who was President during the Great Depression. In short, these experts believe that similar policies will create the same results. But there is one very big difference.

At the start of the Great Depression, the United States currency was on the Gold Standard. That means that every dollar was worth a certain amount of gold. When the economy began to contract, people decided they would rather own the the gold instead. The effect of trading in paper money for gold was to make paper money more scarce. The supply of paper money fell at an even faster rate than the general economy. With less dollars chasing more goods, the value of the paper money increased. Thus, we had deflation.

My point to investors is that the money supply today is actually growing, not shrinking like it did at the start of the Great Depression. But our economy is shrinking. This means more dollars will be chasing fewer and fewer goods. And that, my friends, is the dictionary definition of inflation.

A detailed analysis of deflation can be found here and here.