Thursday, April 16, 2015

More Financial Advice From the Idiot Media - Hedging Against Inflation?

Should you be worried about inflation?  Maybe.  Turns out there isn't much you can do about it.

In the 1970's we had stagflation.   Inflation rose at 10% or more, while the economy stagnated.   For some reason, economists think inflation is a good thing, and that deflation is bad.   I guess they are still scared by the great depression and its massive deflation.   But rampant inflation can be even worse, as evidenced by what is happening in Argentina - yet again.

For the retiree, inflation is worrisome.   In our modern era, the 401(k) generation won't get a defined benefit pension, so we have to live off our savings.   Imagine what will happen to your savings if inflation soared to 40% - or even "just" 10% or so.   If this continued for a few years, your savings would be wiped out.   Well, more correctly, your buying power from your savings would be wiped out.

So, is there something you can do to prevent this from happening?   No, not really.  Not anymore than you can prevent earthquakes or make it rain. 

But an article in the Idiot Media wants to say otherwise.   This "USA Today" article (Idiot Media if there ever was!) spends the first half of the article defining what inflation is (because let's face it, anyone under 50 really doesn't understand inflation, having not lived through it).

The second half of the article provides three possible investment alternatives as hedges against inflation.  All of them are horrific choices.   Why is this?

The first is TIPS or Treasury Inflation-Protected Securities, which are indexed with inflation.   These are designed to increase in value with the consumer price index (CPI) which is averaging about 1.85% these days.   The problem with these securities as an "investment" is that the rate of return is pitiful.   Yes, you protect your money from losing value but it doesn't gain anything in value, either.   Putting your money into these investments now based on fear of inflation makes no sense.  Even a crappy portfolio of stocks, bonds, and mutual funds is going to trounce this - and likely will even if inflation goes up.

The second is Gold, and we've talked a lot about why gold is a bad investment.   Lately you don't hear people talking about gold much.  It has settled in price to the $1110 range and looks to stay there for the time being.   If the economy gets better, it may go down.   But the highs of $1500 and up are not coming back anytime soon.   Gold's volatility illustrates why it is a bad investment - it is a fear metal and people tend to buy it in times of fear - when markets are uncertain - at a high price.  When markets recover, well, they sell their gold - at a low price.  Buy high, sell low.  A stupid thing to do.

Gold Bugs like to regale me with the great gains gold made in the past.  "Gold went from $500 an ounce to $1500 an ounce!  That's a 300% gain!!!"   Of course, these same gold bugs didn't buy their gold at $500 an ounce, but rather at $1500.

On the other hand, I bought AVIS stock in February of 2009 - when people were running away from stocks and buying gold because "the world was going to end".   That stock went up in value by 3000% within a year and over 7000% to date.

You read that right, 7000%.   So please, don't regale me with how it would have been possible, if you had a time machine, to triple your money in gold.   That ain't no big deal.  And since 2009, it turns out that the stock market is beating gold, in terms of rate of return.

At best, gold is a place to park money.  At worst, it is a commodity you can lose your shirt on.

Which brings us to their third recommendation:  Commodities.   In a way, this is redundant, as Gold is a commodity.  It is also horrifically bad advice, too.   Commodities trading is not for amateurs or for the faint of heart.  You can make a million overnight - or lost it all just as quickly.

Commodities markets were established to help suppliers and buyers hedge their bets.  Farmers can sell corn futures to insure the crops they plant will pay more than they cost to grow.   Buyers can lock in a price that is predictable.  Speculators can gamble their life's savings on the spread.

And as a small investor, that's where you fall into the mix - as a gambler.

Hillary Clinton famously got into commodities, made a quick hundred-grand, and then got out.  And there are a lot of questions as to why she did this, how she made so much money so quickly, and why she quit.  Some say it was because a lawyer for Tyson's foods helped her out by steering trades her way.  And there was a quid pro quo with her husband to settle some environmental issues in Arkansas.

The point is, you and I don't have that sort of insider knowledge of commodities.  We would lose our shirts.

The advice from USA TODAY is utter shit.

So, what should you to do hedge your bets with regard to inflation?   The answer is, largely nothing, at the present time.   Inflation is currently very low, so there is little point in gambling with your money or putting it in low-rate-of-return investments, as a "hedge" against anything.  If you put money into a 1.85% T-bill, you are missing out on greater investment opportunities out there (and yes, that is an opportunity cost argument, but one that makes sense, as we are comparing investments, not investments to buying a car).

Going into an inflationary market, the best thing you can do is start out with the most amount of money.  And in an inflationary market, rates of return will adjust themselves to inflation, to some extent.   During the "Stagflation" era of the late 1970's, inflation ran about 10%.  But interest rates were high also, for both borrowers and investors.   No one is going to loan money at 5% when inflation is double that.

So in a way, the system will adjust itself in an inflationary market.   And if you really want to, you can decide at that point, to buy your government TIPS bonds, although I suspect the stock market will still outperform them.

A reader wrote a few months back, making the argument that a mortgage is a good hedge against inflation.   His argument (which he read somewhere online) was that if you are borrowing money at 4% today, and interest rates and inflation go up to 10% or more, you are "paying back" the money you borrowed with dollars that are worth far less.

If we faced Weimar republic like hyper-inflation, perhaps this might be true.  You buy a house for $400,000 today, and then hyper-inflation strikes, and you pay off the mortgage with what is now the equivalent amount needed to buy a Starbucks Mocha-Frappachino.  

That could happen, I suppose.  But I think what is more likely to happen is that inflation doesn't rise that high, and instead, you are still paying off a mortgage, over time, paying as much in interest as you do in principal.   Moreover, since most folks move every 5-10 years, by the time you sell your house, you find out that you've paid darn little off in terms of principal, but paid mostly interest.

In other words, you have to hope the economy goes to hell in order to "win" in scenarios like that.   Gold bugs work the same way.  If the apocalypse comes, well, the gold-bugs win.  Betting on the apocalypse, historically, has never been a good bet.  A lot of people through the ages have ended up with useless backyard bunkers, ammo caches, and gold coins worth half what they paid for them, betting on the end times (and all of this, just in my lifetime!).

Will we have rampant inflation?  This is a tough question to answer.   People worldwide keep buying our debt - at discounted prices.  We borrow a lot of money as a country, but the interest rates we are paying are little or nothing.  Yet people still look to us as a safe place to park cash.

One possible concern, that I have, is what I call the rubber-band effect.   In control theory, there is something known as hysteresis in a system.  You turn up the thermostat in your house.   The furnace kicks in, and slowly the temperature starts to rise to the new set point.   It keeps rising until that point is reached, and then shuts off.  But the temperature may keep rising past the setpoint for some time.   Then, it will drop a degree or two below setpoint before it kicks on again.   If we set the thermostat to keep an exact temperature, the furnace would go on and off constantly, and moreover, would overshoot its set points worse and worse.

Compounding this is the problem with the person using the thermostat.  You are cold, so you turn it up.  The furnace kicks on, and the house slowly heats up.  It takes time.  You are impatient.  So you turn it up further, thinking, "this will make it heat up faster!" which of course, it doesn't.   So you turn it up more and more, until it is set at 80 degrees.  The house overheats and you turn it down to 60 in a panic and start the A/C going.   And so on - creating an undamped roller-coaster effect.

And in the back of my mind, it does bother me a bit that the Fed seems paranoid about raising rates these days - not even a tiny fraction of a percent.   Whenever someone talks about raising rates, the market panics and tanks.  So they hurriedly retract such statements and the market zooms up.   It strikes me as an unstable system.

And if rates are left too low, too long, then the entire thing could eventually rebound with a vengeance, as cheap money fuels higher prices much as cheap money allowed houses and college educations to skyrocket in price in the recent past.

Too late, the Fed will raise rates, which at that point is throwing gasoline on the fire, as interest rates will rise again, and we are back to the stagflation of the 1970s.   And what could trigger this all could be a spike in the price of oil, just as it was triggered by the Arab Oil Embargo of 1973.

But that may be a long way off, and America has not yet developed too many bad habits based on the "cheap" oil of today.

But if it happens, well, I am not sure that buying gold or commodities or TIPS or a mortgage is going to make things better for you on a personal level.