Four Inflation Hedging Investment Strategies

 |  Includes: GLD, KMP, TIP, UDN, WIP
by: The Aft Deck

Right now there’s more than US$9.2T in cash on the sidelines; that is more than twice the amount of money currently invested in stock mutual funds, according to and the US Federal Reserve. Plus, private equity firms alone are believed to hold as much as an additional US$1.3T.

You may doubt that the “money on the sidelines” statement is real, but according to a recently released report from Harris Private Bank of Chicago (part of the U.S. arm of the Bank of Montreal), stocks have rallied for the next two years whenever money market assets have exceeded 25% of the capitalization of the S&P 500 index.

An article in the Los Angeles Times states that the figure is now 43%, down from 58% after having peaked in December, and that's even after the 30%-plus run-up in the S&P 500 since March.

It is interesting to note that many investors holding large cash positions view their money as an asset, when, it is really more of a liability at this point in the game. The fact is that cash, correctly deployed, can allow an investor to sidestep the worst stretches of a financial crisis, like the one we are currently perceived to be in.

When the markets are as hammered down as they have been since last September, history suggests there is likely more upside than downside. There is a large body of research to support that contention

There is also a lot of published data, i.e. Yale Economics Professor Robert J. Shiller has found that when you look at 10 year periods of price/earnings (P/E) data dating all the way back to 1871, the markets tend to rise when the average P/E is low, as it is now. Conversely, when the average price/earnings values are high as they were in late 1999, and again in 2007, a decline in stock prices is much more likely.

There are, of course, no guarantees that history will repeat itself, but should it, the same data implies we could see real returns of 10% a year or more "for years to come," as Shiller noted in a recent interview with Kiplinger's Personal Finance.

What is just as important in here is that inflation usually accompanies growth big time, and that means that investors who are sitting on cash "until the time is right" may have their hearts in the right place but are relying on the wrong protection strategy.

A respected analyst and investment advisor that I read recommends the following plan that could help lock in respectable returns, while protecting the investor’s cash from inflation.

Let's take a look at each of the four elements of his strategy:

1. Protect your cash with Treasury Inflation Protected Securities (TIPS). Even though the trillions of dollars the Fed has injected into the system seem to be having some effect on the critically ill patient the US central bank is trying to fix, we're likely to pay a terrible price in the future. Forget the hyperinflation scenario so many people are hyping at the moment. While that's certainly possible, it's not probable. However, what is likely is a dramatic realignment of the dollar and a general increase in worldwide living expenses.

If you're based in the US and have mostly US assets, you may want to consider something as simple as the iShares Barclays TIPS Bond Fund (NYSE: TIP) to offset this risk. The TIPS portfolio is chock full of inflation-indexed securities, but it also offers a healthy 7.46% yield.

If you've got international exposure, you may also want to consider the SPDR DB International Government Inflation Protected Bond ETF (NYSE: WIP). It's a collection of internationally diversified government inflation-indexed bonds that provides similar protection.

Make sure you talk with your tax advisor about both, though. Depending on your tax situation, you may find that because of the tax liability on inflation-related accretion, these are generally best held in tax-exempt accounts.

2. Own some gold. Despite widespread belief to the contrary, gold has never been statistically proven as an inflation hedge. But the yellow metal has proven to be a great crisis hedge because of the 10:1 relationship between gold prices and bond coupon rates, which obviously are directly related to inflation.

Over time, the two move in such a way that having US$1 for every US$9 in bond principal can help immunize the value of your bond portfolio. So to the extent that you own gold, do so not because you expect it to rise sharply, but because it will offset the inflationary damage to your bonds.

A good place to start is the SPDR Gold Trust (NYSE: GLD) because it's tied directly to the underlying asset without the hassles or risks of direct personal storage associated with bullion.

3. Consider commodities. It's too early to tell if the so-called "green shoots" that everybody is talking about will flower. So it makes sense to concentrate on some resource-based investments. History shows that these are less susceptible to downturns and rise at rates that far exceed inflation when the recovery really begins.

Look at companies like Kinder Morgan Energy Partners LP (NYSE: KMP), that are less dependent on the underlying cost of energy than they are on actual growth in demand. That way, if energy prices don't take off immediately for reasons related to deflation or stagflation, they still will benefit from demand growth. It's a fine point, but one that merits attention for serious investors. KMP, incidentally, yields an appealing 8.68% now.

4. Short the US dollar to hedge your bets further. Not only is the government going to borrow nearly four times more than it did last year, but when you add the complete federal fiscal obligations into the picture, our government owes nearly US$14T. This makes the US dollar, as legendary investor Jim Rogers put it, "a terribly flawed currency" that could fail at any time.

Further, to ensure you're at least partially protected, consider the PowerShares DB U.S. Dollar Index Bearish Fund (NYSE: UDN), which will rise as the dollar falls. It's essentially one big dollar short against the European euro, the Japanese yen, the British pound sterling and the Norwegian kroner, among other currencies.

Lastly here is one key point to consider. You rarely get a second chance to do anything, especially when it comes to investing. So it may be wise to act now before the markets make it cost-prohibitive to protect yourself. When the economic recovery gets here, you will likely be happy you did.