The Financial Beacon, Doug Carey
Normally after a massive credit bust like we saw in 2008 and 2009, we see inflation rates decline dramatically. This held true to form and we even had several months of negative inflation as measured by the Consumer Price Index.
In 2009, at the depths of the recession, the CPI was running at -2%, which means average prices for consumers were falling by 2% per year. But that changed very quickly and inflation is on the rise yet again. Food prices are up nearly 2% over the past year and energy prices have increased nearly 8%.
It is a stated goal of the Federal Reserve to pump enough money into the banking system and economy in order to get CPI inflation back up to 2%. The latest reading shows a rate of 1.4% and climbing, so the Fed is well on its way to seeing the price increases it wants.
With savings accounts and money markets paying basically 0%, anybody who has money in either of these types of accounts is losing value every day due to inflation eating away at their dollars’ purchasing power. So the question becomes, how do investors protect themselves against the ravages of inflation? There is no simple answer to this, but there are several types of investments that provide some protection. Let’s look at a few ideas:
• Treasury Inflation Protected Securities: These are bonds issued by the federal government that pay a stated rate of interest and have their principal adjusted by the rate of CPI inflation each month.
Pros: Guaranteed by the federal government, principal moves in direct proportion to the CPI
Cons: Very low yield currently, CPI adjustment is taxed as income
Ways to Invest: Buy actual bonds, ETFs- TIP
Because the inflation adjustment is taxed as income, it is often recommended that these securities be held in retirement accounts such as an IRA or 401k.
• Stocks: Over time stocks have provided a decent hedge against inflation because companies’ earnings tend to rise with inflation and, therefore, so do their dividend payments and stock prices. Of course, the correlation between stocks and inflation can become meaningless in a general downturn in stock prices. It is also important to note that the general correlation between stocks and inflation has become lower over the past two decades and sits at only 3% as measured by the correlation between the S&P 500 and the CPI.
Pros: Long-term capital gains taxes lower than income tax, potential for large returns in excess of inflation
Cons: Correlation between stocks and inflation is lower than ever, riskier than Treasuries
Ways to Invest: Many funds and ETFs, Individual Stocks
• Gold: Gold has always been a great hedge against serious bouts of inflation. From 1970-1975 when inflation began skyrocketing, gold also rose to major heights, increasing by 375% in just five short years. However, from 1983-2003 gold actually fell by 51% ,even though CPI inflation rose by a cumulative 118% during this period. So gold does best during major inflation events, but over a long enough time period, gold generally protects investors’ wealth against currency debasement. Lastly, gold has proven to be an effective hedge against a general credit collapse, as its price has gone up over 100% since 2008 when the problems in the banking sector became clear.
Pros: Great hedge against serious inflation, also a hedge against a credit collapse
Cons: Does not pay dividends or interest, taxed at higher “collectibles” rate
Ways to Invest: Gold bars and coins, ETFs- GLD, SGOL
It is also important to point out which investments will do the worst if inflation moves higher from here: Long-term bonds. Already long-term treasury yields have been marching higher due to renewed fears of inflation. In just the last six months, the 10-year treasury yield is up a full 1%, giving it a total return over this time period of about -8%. If treasury yields move back to where they were in the year 2002, the 10-year bond will see its price fall by another 13% and an investment in the thirty year treasury will fall by about 28%.
To the readers of the Lyons Recorder:
I will be hosting a seminar on Wednesday, March 9, titled The Credit Collapse of 2008/2009: What Happened & How to Invest Now. The details are as follows:
Date: Wednesday, March 9, 2011
Time: 6 p.m. Welcome and Appetizers; 6:30 to 7:15 Seminar; 7:15-7:30 Q&A Session.
Where: The Boulder Cork - 3295 30th Street, Boulder, CO 80301
Charge: No charge. Appetizers are complimentary.
Other Details: Space is limited.