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By Michael Johnson

The Problem

Anyone who has watched the news in the last few years is probably aware of the current fiscal issues in the United States, which currently has a $16 trillion dollar national debt to pay off, representing slightly over 100% of GDP. Historically speaking, this is not an insurmountable problem and the U.S. and the 113% peak in the debt/GDP did very little to prevent the post-war economic growth in the U.S.

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What frightens me is the direction we are heading in and I am not referring to the additional $6 trillion added to the national debt since Obama took office. I am referring to longer-term secular trends that will take serious political effort in order for any meaningful changes to take place. The United States currently has $86.8 trillion in unfunded liabilities between Social Security, Medicare and federal employees' future retirement benefits.

The government will also have to spend money on things like education, transportation and a tremendous military, which I think is a good idea if we plan on owing more money than we can ever possibly pay back. There are also a host of other questionable government expenses, including $400,000 to study gay sex in Argentina bars, $2.6 million to teach Chinese prostitutes to drink responsibly, and $30 million to subsidize the production of mangoes in Pakistan.

I think it is a safe bet that the government will wait until the last possible minute to make any significant changes in spending and by the time it makes those changes, there will be only three possible options on how to do deal with the nation's debt problem.

  1. Default - This option is completely unacceptable. A default on its debt would ruin America's status as the world's reserve currency and would most likely cause the most damage to the U.S. economy, considering that two thirds of the national debt is owned by Americans.
  2. Austerity - This option would be most unpopular among U.S. citizens. Tens of millions of people have become dependent upon entitlement programs for their survival. Making the cuts to entitlement programs that are necessary to return America to fiscal responsibility would be a political suicide mission.
  3. Monetization - In my opinion, this is the most probable solution to the debt problem and is not an option Greece, Spain, Italy, or Ireland have the option of choosing from, since they do not individually have sovereignty over the decision to print more euros. The overwhelming bulk of U.S. debt is held in the form of U.S. dollars, which gives the Federal Reserve the ability to print more money to pay off debt. Of course this option will result in increased inflation and higher interest rates moving forward, but ultimately I believe this is the decision politicians will end up making. No one is going to get elected or re-elected by promising to make catastrophic cuts to entitlement programs that tens of millions of people have become dependent upon. The monetization option allows politicians to deal with a problem, without taking on a significant amount of personal accountability, which is why I am convinced it is the option that politicians will ultimately choose.

Unfortunately, none of the options I have listed above help me sleep better at night, but as a realist I see those as the only possible options on the table by the time Capitol Hill realizes that the solution to a debt problem is not more debt and that spending money you don't have is not a path to prosperity.

What Not To Do

People are probably going to think I'm crazy for saying this, but I do not believe gold is the same hedge against inflationary risk as it used to be. The first reason I would not invest in gold is because a decade ago it was trading below $400 USD/oz and today it is trading $1575 USD/oz. I think anyone investing in gold at current prices is a little late to the party and is trying to get a piece of an overcrowded trade. The second reason is quite simply because the Buffettologist inside me does not allow me to do so. Last year he gave his opinion on gold during an interview on CNBC's Squawkbox and said the following:

"When we took over Berkshire, it was selling at $15 a share and gold was selling at $20 an ounce. Gold is now $1600 and Berkshire is $120,000. Or you can take a broader example. If you buy an ounce of gold today and you hold it at hundred years, you can go to it every day and you could coo to it and fondle it and a hundred years from now, you'll have one ounce of gold and it won't have done anything for you in between. You buy 100 acres of farm land and it will produce for you every year. You can buy more farmland, and all kinds of things, and you still have 100 acres of farmland at the end of 100 years. You could you buy the Dow Jones Industrial Average for 66 at the start of 1900. Gold was then $20. At the end of the century, it was 11,400, and you would also have gotten dividends for a hundred years. So a decent productive asset will kill an unproductive asset."

Obviously, not every company is capable achieving the same annualized returns as Berkshire Hathaway (NYSE:BRK.B), but I will always stand behind the words "….a decent productive asset will kill an unproductive asset." I suggest that investors who insist on having exposure to gold do so by investing in gold producers such as Randgold Resources (NASDAQ:GOLD) or Barrick Gold Corporation (NYSE:ABX), rather than the commodity itself or similar plays on the asset, such as SPDR Gold Trust ETF (NYSEARCA:GLD).

My second piece of advice on what not to do is to stay away from long-term Treasury bonds. The current yield on 10-year Treasury bonds is a measly 1.9% and 2.72% on 20-year Treasury bonds. At current valuations, I have no choice but to declare Treasuries a bubble, rather than a safe haven. The risk of an inflationary spiral within the next decade is way too great to consider investing at current levels and when interest rates start to rise, long-term bond holders are going to get burned. I would avoid iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT) at all costs.

How to Play It

As the 1980s have shown us, just because the country is in the middle of an inflationary crisis, does not mean stocks can't keep going up. I have two primary objectives in this article. The first is protecting investors from what I believe to be an impending inflationary spiral. The second is to provide investors with a steady source of income, without resorting to buying Treasury bills or Treasury bonds.

At this point in time, I believe blue-chip stocks with a stable dividend are actually less risky than investing in traditional safety plays such as gold and long-term Treasury bonds. The reasoning behind this is that long-term Treasury bonds that pay a fixed rate of interest over a long period of time will be absolutely crushed in the event of an inflationary spiral. Companies are much more suitable to adapt to inflationary spirals and can simply increase their prices as more money goes into circulation.

My advice is to invest in blue-chip stocks that meet the following criteria:

  1. Must be a business that is resistant to inflationary spirals.
  2. Must be a quality business that I feel comfortable holding onto for the foreseeable future. There is a big difference between the ordinary dividend tax rate and the qualified dividend tax rate, not to mention the difference between the long-term capital gains tax rate and the short-term capital tax rate. It makes sense for dividend investors to put themselves in a position where they have to reallocate their portfolio as seldom as possible.
  3. Low debt and a bankruptcy risk near zero.
  4. Pay a dividend yield greater than 2.5%.
  5. A strong track record of consistently growing earnings. I am not as concerned with the dividend growth history because dividends can always be increased at the expense of the long-term sustainability of future growth.

Name

Dividend Yield

Trailing P/E

Earnings Growth Past 5 Years (per annum)

Cisco

(NASDAQ:CSCO)

2.7%

12.46

6.82%

Exxon Mobile

(NYSE:XOM)

2.5%

9.21

5.08%

Chevron

(NYSE:CVX)

3.10%

8.90

12.32%

McDonald's

(NYSE:MCD)

3.2%

18.05

12.36%

Johnson & Johnson (NYSE:JNJ)

3.2%

20.02

6.82%

Wal-Mart

(NYSE:WMT)

2.6%

14.62

9.64%

Microsoft

(NASDAQ:MSFT)

3.3%

15.44

10.76%

Pepsi

(NYSE:PEP)

2.8%

19.55

5.67%

Coca-Cola

(NYSE:KO)

2.9%

19.80

8.19%

Apple

(NASDAQ:AAPL)

2.5%

9.68

71.66%

The stocks listed above are all conservative blue-chip dividend plays, that I am confident will remain in business no matter what the economy does. Typically, I would suggest that long-term investors try to stay away from tech stocks because it is difficult to predict when a new disruptive technology will shake up the landscape of the industry. The reason I am making an exception this time is because Microsoft, Cisco, and Apple all have more than enough cash on their balance sheets to deal with any future problems that may arise. Furthermore, they have all been in business for a long time and I don't see any start-ups making significant dents in market share any time soon, especially Microsoft, which essentially has a monopoly on PC operating systems.

Not only do I believe blue-chip stocks offer less risk at this point in time than long-term Treasury bonds, but they clearly offer more of a reward as well. A recent study by NYU clearly demonstrates that over the long run stocks tend to outperform popular fixed income investments, such as 3-month Treasury bills and 10-year Treasury bonds. From 1928-2012, the S&P 500 put up an average annual return of 11.26%, while 3-month Treasury bills put up an average annual return of 3.61% and 10-year Treasury bonds put up and annual return of 5.38% over the same time period. I do not believe it is wise to bet against stocks in the long run of things and I will always have more exposure to stocks than any financial advisor would recommend.

Conclusion

I am bearish on gold and long-term Treasury bonds over the next five years. I think the best way to prepare for the looming inflationary spiral for conservative income investors is to invest in blue-chip stocks that pay a solid dividend.

Source: Income Investors And The Looming Inflationary Spiral