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Inflation is going up now, particularly in food and fuel prices. We do not know where it is going, but still the question remains: As an investor, how can I protect against inflation?

Before I go into that, let me point out something that is very important–there is no perfect inflation hedge that always works. I am not knocking investments such as real estate, commodities, Treasury Inflation Protected Securities (TIPS), precious metals, stocks or anything else. However, with each and every one of these examples, price matters.

The only way to protect your portfolio against inflation is to invest in assets that go up in value after you buy them. This may seem obvious, but there are no magic pills or potions or investments that always protect against inflation. Just because you have heard that TIPS or farmland or commodities are a good hedge against inflation that does not mean you can buy any of these at any price and do well.

Real estate is a good hedge against inflation, right?

Let’s take real estate as an example. For years, pundits and prognosticators have been saying that real estate has to go up in value over time because ‘they don’t make it anymore.’ In its defense, real estate has generally done very well during inflationary times, but that does not mean it will always work.

Case in point: Real estate purchased in the past five years or so. Check out this chart which follows three different surveys on home prices:

(Click to enlarge) Source: Calculated Risk

The vertical shaded areas indicates times of recession and the lines show three different real estate indexes. The blue line is the CoreLogic HPI Index. The yellow and red lines are two different indexes from Case Shiller / S&P.

As you can see, the top of the market for U.S. homes was in early 2006 well before the recession hit in late 2007. Since then, home prices have fallen sharply. Even purchases made a few years earlier are likely to be under water.

For years, we were told that real estate was a good hedge against inflation. And, it was during the 1970s and 1980s and 1990s. However, what happened in 2006? Real estate prices peaked and began heading south. Those who invested in real estate over the past five or six years did not have a hedge against inflation because the value of their investment went down.

So, be careful out there, because protecting against inflation is not as easy or straightforward as some would have you think. The key takeaway I have for you is that you should seek investments that you believe are undervalued and likely to go up in value over the long haul. That’s how you keep your portfolio growing.

Is inflation an immediate problem?

Inflation is not as big a problem now as it was throughout the 1970s and early 1980s. For example, inflation is now running in the range of 1-3% according the Consumer Price Index. However, given all the monetary stimulus and government spending we have seen, inflation is definitely a threat. I do not expect us to get back to the inflationary climate we saw in the 1970s, but none of us knows what lies ahead. What happens if inflation really takes off?

What happens if we enter high inflation?

My experience with inflation dates back to the 1970s and early 1980s. Inflation averaged almost 8% for the entire decade of the ’70s, but it cranked up into double digits in 1979, 1980 and 1981. By 1979, the Federal Reserve and the Carter administration realized something had to be done.

Paul Volcker and the Fed

In 1979, the Federal Reserve (under Chairman Paul Volcker) decided to really attack inflation by raising the Fed Funds rate (short-term interest rates). As you saw in the chart above, interest rates on home mortgages went way up. As rates went up, economic activity fell off and we entered a recession.

Where in the inflation cycle are we?

If you believe inflation is on the way, you also need to figure out where in the inflationary process we are. If, like the early 1970s, you think inflation is underway and the Federal Reserve will not attack it for quite a while, then inflation hedges make some sense because they are likely to be out of favor in terms of price. Also, they could have a long, multi-year bull market.

Buying gold in 1973: I bought gold in 1973 at just over $100 per ounce. The high that year was $124 or so. In 1980, it peaked briefly at $875. So, anyone who held on for that ride did very well. I sold out at a bit over $400 an ounce so I did well, but I missed part of the ride. My Dad bought my gold and held on until close to the peak so at least the profits I missed stayed in the family.

Inflation did not peak until 1981, but the Fed’s aggressive stance against inflation, beginning in 1979, made the decline in inflation likely. So, if you think the Fed might be planning to attack inflation soon, then a different strategy is in order. In order to attack inflation, the Fed typically would raise interest rates and that would result in a quick boost to the dollar and a hit to inflation hedges. That is what happened in 1980 to gold.

Gold in 1980 — from darling to dog in two years

In fact, gold hit a high point in 1980 of $875 per ounce, but it fell as low as $463 within a few months. Gold prices went back up into the $700 range, but by 1982, gold prices had fallen to a low of $298 per ounce. That’s right. From a high of $875, the price of gold fell to around $300 within a couple of years. Beginning in 1982, inflation fell quickly from the double digit level, but gold prices fell much more quickly as gold had a 60% price decline.

Now, 31 years later, gold is hitting new highs. However, the bull market in gold and commodities has been underway since 2001 or so. That’s a long run and prices could in no way be called cheap. The rise in gold and oil and commodities is largely due, in my opinion, to the weakness of the U.S. dollar. That is, Americans and other investors have lost faith in the dollar. There are other factors at work in the price of gold, but for U.S. investors the dominant issue at work is the falling dollar. The point here is that you need to make sure you are buying gold — or any other asset — for good, solid, long-term reasons. If you are just jumping on the bandwagon, you could get bruised when the bandwagon hits a pothole.

What should I do about inflation?

If you believe high inflation is coming our way, how do you protect your portfolio? Take these three steps:

  1. Determine where we are in the inflation cycle — early, late or middle. My view is that we are in the middle of a moderate inflation cycle. Inflation is going up and the Fed is unlikely to take aggressive action against inflation until after the presidential election next year, which means early 2013. Therefore, commodity prices and other standard inflation hedges could do quite well for a while.
  2. Seek undervalued assets. The goal as an investor is to find undervalued assets. Unfortunately, truly undervalued assets are hard to find right now. Stocks are not cheap in terms of valuation nor are commodities or precious metals. This does not mean stocks or commodities or precious metals could not go up further. They could and may well do so. However, they are not undervalued in my view. Unfortunately, there are not that many obviously undervalued assets right now. Real estate could be undervalued depending on how aggressively you look for bargains.
  3. Be careful with income investments. Once the Fed does get serious about fighting inflation, then interest rates are likely to go up. Already, the bond market has voted for higher rates and bonds have languished this year. Once the Fed gets aggressive in fighting inflation, then interest rates could go up quite a bit. I do not see us returning to the rates of the early 1980s, far from it, but rates could easily go up. If you have income investments, you need to be careful because a spike in rates could put a big dent in your bond funds.

There is lots of hype and hoopla about inflation right now, but do not get caught up in it. Keep your head and follow the three points above. And, let me know what you are doing. I like to get feedback.

Source: 3 Rules for Protecting Your Portfolio Against Inflation