Four Inflation Hedging Investment Strategies

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 MoneyNet.inc 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.

Comments

[Larry House:]

All sound ideas. I like silver too.

Jun 25 10:03 AM

[fxmaven:]

KMP is more of a transit utility than an energy company. Their rates do not increase if commodity prices increase, so i dont see the logic of KMP as a commodity linked asset, even if it is a nice source of income. Anyway if prices go up, doesn't demand usually decrease ?? It did in my Ivy League Econ 101, so I think this is also faulty cause and effect.

I would also stay away from TIPS, which seem to perhaps prevent losing than earning money. Dollar bear funds or Foreign Currencies linked to commodities (Aussie Dollar, NZ Dollar, Loonie) seem better alternatives.

Jun 25 10:30 AM

[TwiceShy:]

US$9.2T + US$1.3T = US$10.5T "money on the sidelines". When I compare that to the US$1.6Q (1 quadrillion = 1000 trillion) in the bubble made up of credit default swaps and other derivatives (the same bubble that started to deflate last year when Lehman failed, which was only stopped by the Fed making trillion plus dollar "loans" to those who had to cover their highly leveraged derivative bets), it just seems to me that money is "on the sidelines" for very good reason: to cover the very real risk that more highly leveraged derivative bets may come due and need to be covered. That US$1.6Q bubble is what was fueling all of the other bubbles we have seen over the past decade or more; it was extremely inflationary. Now that it is beginning to deflate, and the highly leveraged bets is was based upon are coming due, that is extremely deflationary. Yes, the result of efforts by the Fed and the politician to keep that bubble from deflating (or at least transfer the bad effect of that deflation to the rest of us) will likely cause massive inflation for the rest of us (a dilution of the value of all US$ that we hold) but the deep underlying issue is deflation (a correction of the massive inflation previously caused by the US$1.6Q bubble), not inflation. The "inflation" that most see is really instead a massive transfer of wealth from the rest of us to those who seem to believe the rest of us should cover their bad bets and make them whole and is caused when the Fed dilutes the value of all dollars held by the rest of us (by creating new dollars without any new assets to cover them) in order to "loan" that value to their friends and owners. But the US$1.6Q derivatives bubble will with certainty eventually continue to deflate and the counter intuitive result will be that these four investments will not provide the protection anticipated. Consider what happened last year, when Lehman failed and the bubble began to deflate. Did any bonds, including TIPS, hold value well? Did gold or commodities or shorting the US dollar? The answer is no and I'm sorry to say that we are in for more of the same as the economy continues to unwind the massive leveraging of that US$1.6Q derivatives bubble.

Jun 25 02:35 PM

[rant0065:]

fxmaven: Price is an effect, not a cause. It is the interplay between supply and demand which causes prices to change. An increase in demand due to rising inflation causes the demand curve to shift outward along the supply curve, setting a new, higher, price. Higher demand = higher price

I'dve thought you would have learned that in your Ivy League Econ 101 ;)

Jun 25 03:33 PM

[rant0065:]

Just to clarify, increasing inflation is a material change, resetting the equilibrium point. A good that is highly desired gets bid up by the market.

Jun 25 03:36 PM

[Carlos Lam:]

I like all your recommendations except for the TIPS. The TIPS calculations are based off of the CPI, which is a flawed measure of inflation. Specifically, the CPI uses hedonic adjustments and substitutions to calculate cost of living; it no longer uses a fixed basket of goods.

Jun 25 03:43 PM

[baydat:]

good article, good to see different ideas out there

Jun 25 03:43 PM

[Shonkypom:]

Currencies don't do what they are supposed to do based on the fundamentals. Your Economic reasoning may be sound, but everyone will forget to tell the dollar. The only strategy that is even slightly predictable with currencies is trend following (so in that sense it isn't even really prediction, its just an observation of past prices as an entry indicator). There is no 'Investing' in currency, it is pure speculation , and therefore falls under 'Trading'. To succeed in Trading, you need a defined set of rules, entry price (which is what you refer to when you make a statement about where you believe the market is headed) makes up no more than 10% of your overall Trading result; far more important is your position size and initial risk protection. Anyone that makes a call on the USD ends up looking dumb, and I include all the best known international investment faces who have variously pontificated on the subject. Those that work directly trading in currency are much more humble about their abilites to predict. Good luck Trading though.

Jun 25 05:33 PM

[Living4Divi...:]

the four elements of his strategy:

1. Protect your cash with Treasury Inflation Protected Securities (TIPS). and the SPDR DB International Government Inflation Protected Bond ETF (NYSE: WIP).

good idea

2. Own some gold.

bad idea


3. Consider commodities. I

good idea in equity form (commodity producers)

4. Short the US dollar to hedge your bets further.

Further, to ensure you're at least partially protected, consider the PowerShares DB U.S. Dollar Index Bearish Fund (NYSE: UDN),

Bad idea - These funds use options - some don't track their indexes

Jun 25 06:08 PM

[Boxed Merlot:]

Could someone help me out here? There was a recent post re: a "banker's holiday" and some referenced but bogus looking You Tube diatribe on the liklihood of it happening again. Is there any reputable evidence such an event is in our, (the US), future? And if so, how would that effect / affect, (sorry, I'm a product of our educational system), these allocations?

Jun 25 08:30 PM

[Ponce:]

My only "strategy" is of holding physical gold and silver.

"If you don't hold it, you don't own it"... Ponce

Jun 25 10:00 PM

[MGA_1:]

It's important to note that this is NOT a normal downturn or recession. We were in a deflationary decline that was very much akin to the early phases of the great depression. The difference between now and then is that we have a highly interventionist fed chairman who abhors deflation and a president who wants to try and spend his way out of this thing.
Good inflation hedges:
* Precious metals (gold/silver)
* Commodities
* Real Estate
* Some equities
Good deflation hedges:
* CASH
* Some bonds
Will inflation or deflation win out? My bet is for inflation and the possibility of quite a bit of it the way the govt and fed is throwing money around. I disagree in that gold actually does seem to be a pretty darn good inflation hedge - also there is a quite a bit of chatter out there about central banks are holding the price down to mask underlying inflation. If this is the case, when they lose the ability to do this, the yellow metal will take off. I wouldn't purchase TIPS simply because I don't trust govt numbers. There are also a lot of deflationary forces still out there that will last for several years - in particular residential & commercial real estate loans. If you bet on inflation, you are betting on govt printing to try and save the economy.

Jun 26 02:29 AM

[Dividend Gr...:]

The best inflation hedge available to investors is common stocks. Stock represent small portions of real businesses which buy and sell stuff/services to consumers. If a business sells a hot dog at $1 and it costs $0.50 to produce it, then it earns $0.50/hotdog. If inflation happens, a hot dog could sell for $2 and it could cost $1 to produce. At the same time the liabilities ( debt, accounts payable) of the business would be worth less, while its fixed assets would be worth more.

Jun 26 05:01 AM

[Living4Divi...:]

"2. Despite widespread belief to the contrary, gold has never been statistically proven as an inflation hedge. "

I strongly disagree

Jun 26 06:54 AM

[fireball:]

aft deck
first i wish to thank you for mondays article. npws and nxhz were both great tips. a very strong thank you.
my main focus is gold and silver right now. i feel silver is what to buy while waiting for a better price on gold. i will most definitely give much thought to your other 3 points.

Jun 26 09:36 AM

[Aldebert:]

I agree with 1 through 3, but note that TIP cannot yield 7.46%.

Jun 26 09:47 AM

[Robert Mart...:]

I find that I agree with you about TIP, and about the inverse ETFs (expensive and poorly correlated--it's better to buy a put).
Isn't cash an asset class that hedges against inflation? Short-term interest rates generally follow current inflationary expectations. The investment industry rarely talks about cash as an asset class since it doesn't generate advisory fees.

On Jun 25 06:08 PM Living4Dividends wrote:

> the four elements of his strategy:
>
> 1. Protect your cash with Treasury Inflation Protected Securities
> (seekingalpha.com/symbo...). and the SPDR DB International
> Government Inflation Protected Bond ETF (NYSE: seekingalpha.com/symbo...).
>
>
> good idea
>
> 2. Own some gold.
>
> bad idea
>
>
> 3. Consider commodities. I
>
> good idea in equity form (commodity producers)
>
> 4. Short the US dollar to hedge your bets further.
>
> Further, to ensure you're at least partially protected, consider
> the PowerShares DB U.S. Dollar Index Bearish Fund (NYSE: seekingalpha.com/symbo...),
>
>
> Bad idea - These funds use options - some don't track their indexes

Jun 26 11:55 AM

[The Recusant:]

"Forget the hyperinflation scenario so many people are hyping at the moment...what is likely is a dramatic realignment of the dollar and a general increase in worldwide living expenses."

And that's not hyperinflation? Let me know if I have to pay ten dollars for a gallon of milk if that's not hyperinflation.

Jun 26 12:53 PM

[hksche2000:]

Since Black Rock Hedge Fund bought Barclay's I-shares (and overpaid handsomely!), do we investors soon have to anticipate i-shares returns to be reduced across the board (or selectively) for Black Rock to recoup its investment?
Hence, are Pro-shares perhaps the better investment now?
Any insiders in the know about this?

Jun 26 02:32 PM

[hksche2000:]

TAD, how did you come up with the "healthy 7.46%" TIP's yield?
What investment period are we talking about and, if true, would you anticipate yields in that range for tips over any extended period of time?
Why would anybody buy anything else, if that were the case: total safety with awesome returns?
Why would there be any money on the sidelines, not to mention 10T?

Jun 26 03:11 PM

[MadScientist:]

If the assumption of significant inflation is correct (and I personally think it will be), I would suggest the following:

1. Look at commodity ETFs like DBA (agriculture ETF),and DBC or UCD (commodities basket ETFs, the latter being a 2x long).

2. Long on gold and silver (silver having a greater upside potential right now). Either own the ETF or the physical material - I am agnostic on this point, but recognize that having a stake in PMs makes sense.

3. Oil for the adventurous - it is denominated in $USD, but trades against stocks and political events as much as it does against the dollar. It is seasonal as well, so it probably makes for a better trade than investment.

4. I would rather short the 20 yr with TBT than buy UDN. For example, looking at TBT versus UDN from April 1st - June 1st of this year, TBT went up 29.7% while UDN rose only a modest 7.4% (the ^DXY lost 7.8% during this time). This is a 2x inverse on the 20 yr Treasury, so it's leveraged - makes for a trade stock rather than an investment stock given the depreciation seen in these types of ETFs over time.

Jun 26 10:26 PM

[Econ Base:]

TIPs are unproven. Be careful.
Read: portfolioforlife.blogs...

Jun 28 07:13 PM