Monday, June 06, 2011

Inflation: What it means & how to protect our investments

By Rajiv Hargunani

"Inflation is when you pay fifteen dollars for the ten dollar haircut you used to get for five dollars when you had hair.” — Sam Ewing

Inflation can be defined as a sustained increase in general level of prices for goods and services. It can be viewed as a broad measure of the overall increase in prices or the cost of living in a country. This definition would imply that every dollar you have in your pocket today is going to buy you a smaller percentage of goods or service in the future.

Inflation can occurs in many ways but here are the two commonly accepted theories:

Demand – When demand is growing faster than supply, prices will increase. It can also be the case of too much money chasing too few goods.

Cost – Companies sometimes increase the price of their products when their cost to manufacture or produce them goes up. Costs could increase for a variety of reasons ranging from raw materials, labor, wages, shipping & transportation etc.

Two widely used measures of inflation are the Consumer Price Index (CPI) and the Producer Price Index (PPI). Inflation (as measured by the CPI) has been averaging at 3% since 1914. However, there have been periods where the rate has been in double digits such as in the late 70s, caused partly due to the oil crisis.

By definition, inflation erodes our purchasing power. We need more dollars today to purchase the same goods that cost less a few years back. In 1965, a Hershey chocolate bar cost $0.05, a Ford Mustang starting price was $2,368 and one year’s tuition at Harvard was $2,400 (http://beta2.americanheritage.com/articles/magazine/ah/2006/5/2006_5_55.shtml).

Inflation, it seems, has been around forever. Debasing the currency is not a new phenomenon in the US or Japan. It has occurred in many different societies throughout history, changing with different forms of money used. For instance, when gold was used as currency, the government could collect gold coins, melt them down, mix them with other metals such as silver, copper or lead, and reissue them at the same nominal value. By diluting the gold with other metals, the government could issue more coins without needing to increase the amount of gold used to make them. This practice increased the money supply but at the same time, the relative value of each coin got lower. As the relative value of the coins became less, consumers needed to give more coins in exchange for the same goods and services as before. As a result, the goods and services experienced a price increase as the value of each coin was reduced. We are experiencing this right now with the debasement of the U.S. Dollar. With most commodities being priced in Dollars, it is no surprise to see the commodities spike up as the Dollar heads lower.

How can you fight the effects of inflation?

The unprecedented stimulus by the world central banks in response to the global financial crisis has prompted many folks to inspect the vulnerability of their portfolio to an inflation spike. Knowing that inflation can greatly eat into their purchasing power investors realize they will need to save much more for their retirement just to maintain current lifestyle. Even at the current 3% inflation rate, the prices of goods (or services) will double roughly every 25 years.  Most investment portfolios are not designed specifically taking inflation risk into account. For retirees’ living on a fixed income, the cost of living rises with inflation and when you add the impact to investments from inflation, it can jeopardize the retirement lifestyle many have planned for.

Equities

Stocks are also considered a pretty good inflation hedge. Inflation causes earnings of the companies to grow when inflation accelerates, partly in response to increased demand for goods and /or services. That is companies are able to raise prices faster because they have greater pricing power. However, stock prices are based on discounting future earnings to their present value. Therefore, even though the companies may see higher revenues and therefore higher cash flows in periods of high inflation, the markets will apply a higher discount rate to those cash flows. Investing in companies that have this kind of pricing power, coupled with low-to-no debt could offer a good hedge against inflation. Companies that can pass on the price increase and generate higher cash flow will be able to increase the dividend paid out to the shareholder. The rate of dividend increase should help mitigate some of the effects of inflation.  The last time the US had high inflation rates was in the 70s, and here are the returns of the S&P 500 in that time period. One striking observation in looking at these numbers, the S&P 500 had its best years when the inflation rate was lower than the year before. Therefore, it is possible that the direction of future inflation has some impact on stock price returns.

Year	Inflation Rate	S&P 500 Return
1971	3.27%	14.54%
1972	3.4%	19.15%
1973	8.8%	-15.03%
1974	12.2%	-26.95%
1975	7.0%	38.46%
1976	4.8%	24.20%
1977	6.8%	-7.78%
1978	9.0%	6.41%
1979	13.3%	18.69%
1980	12.4%	32.76%

The S&P 500 is an unmanaged index of 500 widely held stocks. Inclusion of this index is for illustrative purposes only. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results. Dividends are not guaranteed and must be authorized by the company's board of directors.

Commodities

There is a direct link between commodities and inflation as food and energy are large components of both commodity and inflation indices. Commodities are sometimes referred to as hard assets because they tend to maintain their intrinsic value. Commodities typically rise in price when there is inflation, making it very correlated with inflation. This makes sense because commodities are the basis for many raw materials used in production and manufacturing; their prices tend to increase with rising production costs. In addition to being a good inflation hedge, historically, the return correlation of commodities with equities & bonds has been low. This makes commodities a vital part of a well-diversified portfolio.

The chart of the commodities index (as represented by the Reuters/Jefferies-CRB index) offers some insights into the relation between commodities and inflation (as measured by the CPI). From the early 70s, to the early 80s the CRB index tripled in value going from a value of 103.90 in Jan 1970 to 308.40 by July of 1980. I should point out that the composition of the CRB index was different at that time than what it is today. What is interesting is that after 1980, even though the CPI continued to average 2-3% annually, over the next 25 years, the CRB index did not reflect that change.

The obvious risk in investing in the commodity sector is that it is more volatile than traditional asset classes such as equities & fixed income. Additional factors that need to be considered that can affect specific commodity markets are liquidity, supply and demand etc.

Precious Metals

Historically, precious metals, such as Gold and Silver have offered a good hedge against inflation. Gold has been perceived by many as a symbol of wealth and as an asset that holds its value. If you believe inflation is going to be an issue because of the debasement of the US Dollar, due to unprecedented monetary & fiscal stimulus actions taken by the Fed, then precious metals may offer you some protection. Along those lines, investment in precious metals could then be viewed as a bearish bet on the US Dollar i.e. the dollar will be debased further and gold, as the only store of real value, will appreciate. This can be seen quite clearly comparing the US Dollar Index (is an index of the value of the US dollar relative to a basket of foreign currencies) and Gold over a 20 year period.

The chart below shows the performance of Gold over the last 40 years. In periods of high inflation, such as witnessed in the 70s, the price of gold outpaced the rate of inflation.

However, from the early 80s, when the back of inflation was broken via higher interest rates, gold prices fell steeply, reaching multi decade lows over the next 20 years.

Precious metals are subject to special risks, including but not limited to: price may be subject to wide fluctuation; the market is relatively limited; the sources are concentrated in countries that have the potential for instability; and the market is unregulated.

Conclusion

It is not easy to completely protect our investments from the effects of inflation. At best, each idea can be considered similar to an insurance policy against an unforeseen calamity of inflation. As with most insurance policies, the best one is the one where you never have to collect on the policy.

Because each investor’s objectives/goals are different, there cannot be one single idea to fight inflation that fits all investors. The primary factors driving the appropriate type of inflation protection will be the investor’s tolerance for risk and how vulnerable their financial objectives are to inflation.

Other articles by Rajiv Hargunani:

• Emotional Investing: How Fear & Greed can impact your bottom line
• Early Distributions From Retirement Plans
• Profit From Your Losses
• A New Approach to Making Money: Buy and “Know when to sell”
• Health Insurance:  Decisions, Decisions
• Common Insurance Mistakes - Are YOU making one?   
• Managing Risk in Volatile Markets
• 2010 Roth IRA Conversion – To do Or Not to Do
• Changing Jobs? Don’t let your 401(k) slip away

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Rajiv Hargunani and not necessarily those of RJFS or Raymond James. Diversification does not assure a profit or protect against a loss. This information is not intended as a solicitation or an offer to buy or sell any investment referred to herein. Investments mentioned may not be suitable for all investors. Investing involves risk and investors may incur a profit or a loss. There is no assurance any strategy will be successful.

 

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