2011-04-23

What To Do In The Current Inflationary Climate?

It's no secret that the dollar is turning into dust. It has been depreciating since it went off the gold standard over 40 years ago. And it is now depreciating faster given current government intervention. Just check out the news and expert commentaries:
Of course, there are those who believe the opposite is true, such as Mish and Vijay Boyapati. The argument pro deflation is that the government won't have the political will to allow rampant inflation and their means to trickle down newly-printed money within the economy is limited, barring political suicide.

The truth is that no one on the deflation camp believes the dollar is getting any stronger nor that inflation will not return in the future.

Inflation is the tried and true method that works to reduce government debt. It's what's been going on for decades ever since we've had fiat money. And it will continue in the future,  in spite of short periods of deflation.

Becoming Inflation Agnostic

Regardless of what will happen in the next six months or a year, the fact is that investing is about the long term. And long term we will have inflation, like we've always had, plus more, given the increasing deficit this country is running.

So, what's the best way to protect hard-earned money? 

There are many ways of doing this, and they all have pros and cons. Here are the ones I know of. I'll break them down into smaller categories, even though everything eventually rolls up as either "cash-flow positive assets", "limited supply entities" or "mixed".
  • Business Interests (stocks, private businesses)
  • Precious Metals (gold, silver)
  • Commodities (gas, oil and agriculturals such as corn, wheat and cotton)
  • Collectibles ex-precious metals (art in general, rare objects)
  • Real Estate (land, houses)
  • Paper Instruments/Derivatives (TIPS, bonds, futures)
  • Other income-producing assets (patents, royalties)
For simplicity, I will ignore the bottom two classes. I'll just say this about TIPS: while an interesting asset to have some exposure to, its inflation-protection comes from the people creating inflation (i.e. government), so in the long run TIPS are unlikely to offer much real purchasing-power protection.

Business Interests

I believe this is the best way to generate wealth. Having businesses generating income for me is the most scalable way to attract money. After all, I can't have ten day jobs to generate 10x my income. But by owning businesses (or their stock) not only is this realistically achieved, but even more is possible. 

And having multiple sources of income is, in my mind, the best way to offset inflation. After all, profitable businesses want to stay profitable, so they increase prices with inflation when they can (unless they are airlines, in which case just don't invest in them, like I did and regret).

But stocks are unpredictable in the short-run and they can be at times grossly over-valued. 

The other way is to create businesses from scratch or invest in them privately (private equity) or very early (angel investing). I've tried my hand at all of these. Results will vary and these are hard things to do well. So, if you're not in this camp yet, start to learn or move on to the next one.

Precious Metals

There is no way to value precious metals. And they don't pay a dividend either. 

Nonetheless, precious metals have historically more or less retained purchasing power relative to fiat currencies. They can be especially useful in times of crisis when a race to the bottom in currency debasement is in effect, like it is right now.

I would advise people to have some small amount of physical gold or silver with them, such as 5% of their net worth. Timing the purchase of these metals is tricky.  I wouldn't hurry to buy right now that they've gone up by record amounts. If you haven't exhausted other alternatives yet, hold off on buying metals until no one is talking about them again. However, if you buy as a contingency reserve and never sell otherwise, then almost any time is a good time to buy.

Commodities

With commodities I see roughly two classes that mostly only exist in theory: those that should go down in price over time, such as agriculturals, and those that should go up, such as oil and gas.

The reason why agriculturals should go down in price over time (all else equal) is because agriculture is becoming more efficient and mechanized -- we produce more food per acre than we've ever did in the past. Oil and gas, on the other hand, are being depleted and we'll eventually run out of them.

However, theory and practice are very different. While oil is going up in price due to depletion (and also instability and speculation), reserves of natural gas are a lot bigger. Natural gas prices have been all over the place and can remain like that for a long time, depending only on supply and demand, both variables which I cannot predict.

Meanwhile, agriculturals have gone up in price, mostly because oil has gone up and the dollar is losing value.

So, what's an investor to do? I believe a diversified portfolio needs some exposure to commodities. However, the vehicles for that exposure are complex and time-consuming. Pure commodities ETFs and ETNs such as OIL, USO and DBA, are not ideal. In fact, they are harmful, because traders take advantage of them in ways I don't want to delve into right now.

My recommendation: if you have the inclination, time and stomach to use futures, go for it. Setup a small account and keep rolling some exposure to grains.

If you don't want to go into the futures market, then get some exposure to the agricultural commodities sector by buying stock in companies such as ADM. Or, for a more diversified (and more expensive) exposure to agribusinesses, try MOO or PAGG.

The disadvantage of having stock in agribusiness companies is that it increases one's exposure to stock market and hence this may offset some of the benefit of being invested in commodities.

As for oil and gas, I believe it's best to own exploration and pipeline companies instead of futures. The reason is that owning oil futures or oil in the ground is very similar: the stock price of companies like XOM should go up as oil goes up (with agriculturals, the wheat and corn are not there all the time, they must be grown, so owning the business is not a great proxy for owning the commodity). So for oil and gas, there's no need to forfeit getting the juicy dividends these companies pay just to offset the stock market risk. But again, if you have the inclination to do futures, that's a fine option too.

Collectibles


Owning a Picasso painting or a Rodin sculpture is a great way to store wealth. It seems to be a trick the rich know and that the poor don't usually understand -- many people think buying art is squandering money, a vain waste of resources. But the value of these rare objects should go up over time. So it serves a dual purpose of decorating the home and storing wealth.

However, the drawbacks are obvious: they are illiquid, non-fungible and extremely hard to deal with.

During times of extreme distress (wars), good luck trading your Rembrandt for food at a decent exchange rate. You may have better luck with a Patek Phillippe, but you first need to find an original item and a qualified buyer.

Finally, this leads us into another category.

Real Estate

Real estate was the darling of the easy-money policy era. Until 2007.

And then it became taboo to even talk about a "recovery" in real estate prices.

Real estate cooled in America and became hot in other parts of the world such as China, Australia and Brazil. In fact, the last two seem to be nearing bubbly conditions, though the make up of these conditions are very different than those in the go-go years of free-houses-to-everyone-with-a-pulse in America.

That's exactly why real estate is now the right place to invest -- because no one is talking about it other than saying how bad it is and how slow it will be for a long time.

What most are missing though is that price appreciation is only part of the equation. Income is the other. Even though prices can continue to tumble into the near future, they must eventually find a floor on rents. Especially in desirable and growing areas.

It is now possible to own real estate essentially for free in many desirable zip codes across America. Right now. For example, in Silicon Valley, companies are hiring, builders have slowed down and yet there are houses on the market that after a down payment can generate enough rent to cover mortgage, closing costs, insurance, taxes and even HOA fees (in case of condos).

Now, depending on the terms, it might even be possible to generate a 6% annual return on investment. Plus any future price appreciation. And that with almost full immunity to inflation, since rents will keep pace with inflation. Add to this equation a fixed-rate mortgage and I see not better inflation protection right now than a cash-flow positive rental property.

Of course, there are drawbacks: the market is not very liquid, tenants are not all the same and managing rentals can be a time-consuming and headache-prone activity. If you're not up for it, the alternative is to go the ETF route, such as RWR or IYR.

Final Thoughts


When fighting inflation there is no silver bullet. It's important to be broadly diversified. And that doesn't mean having many mutual funds. One needs to think in terms of assets that tend to retain value. My favorites are those in the category of income-generating assets, especially business ownership and real estate rentals.

I think now is a good time to buy real estate in America, particularly in areas with positive job growth. Prices may continue to slide, but timing purchases perfectly is tricky. Plan on buying properties that can generate enough income to at least pay for the mortgage. In 2-3 years they will likely turn cash-flow positive and in 5-10 years you'll get price appreciation on top of that.

In the end, you get inflation protection, income and price appreciation. It doesn't get any better than this.

Disclosures: I own RWR at the time of writing.

2 comments:

  1. THANK YOU for posting this! I'm glad I found your blog!!

    Steve
    Common Cents
    http://www.commoncts.blogspot.com

    ReplyDelete
  2. Thanks for this awesome post. Very useful information

    ReplyDelete