How to invest with inflation still in the distance

Every Friday we review and rework a post we’d written months earlier for someone else’s site. This lets us test our theories, and the content-to-input payoff with these posts is pretty sweet, too.

This is from Consumerism Commentary. Updated notes in blue:

People have feared inflation ever since… well, since the dollar’s last rampant bout of inflation in 1977. However, there’s every reason to believe that this time inflationary pressures are too overwhelming to discount. (The consumer price index rose 1.1% in 2010. In other words, inflation remains low thanks to the Fed’s tight monetary policy. Now if we keep predicting inflation, sooner or later we’ll be right. But for the last 10 months, prices have been even stabler than they were the previous 10 months – when annualized inflation was 1.9%. In short, we were wrong in the short-term.) Or two colossal reasons, at least:

1. Legislative and executive leaders of the federal government, for whom fiscal restraint is a dirty term. No matter how laudable their objectives, they propose to spend and borrow an ungodly amount to achieve them. Any non-politician reading this blog knows the term “regardless of cost” can never be taken literally, but our elected betters think otherwise and aren’t concerned about the inevitable results.

2. A federal funds rate that resembles Carlos Pena’s batting average, or Countdown with Keith Olbermann’s Nielsen ratings. Here’s a really quick primer, because a lot of people act like they know this stuff but don’t:

The Fed (Federal Reserve) is the nation’s central bank. It actually creates our money out of thin air, which it sells to the federal government to conduct its business with. Commercial and investment banks like Chase and Wachovia (whoops. Wachovia, now a subsidiary of Wells Fargo) also borrow from the Fed. The interest rate those banks pay is determined by the Fed and called the federal funds rate, which thus serves as a basis for just about every interest rate in the economy.

Most countries’ central banks set a single rate. The Fed instead sets a range — the more you borrow, the less you pay. This of course favors larger banks, although “favors larger banks” has been a relative term ever since the federal government confiscated $678 per United States citizen and gave lent it to AIG. Since December the range has been 0% to 0.25%, an all-time nadir. (Well, how about that. It hasn’t moved since. And Carlos Pena finished the season at .196, the worst batting average in the majors among guys who qualified for the title.) Inflation has kept pace (see above), barely registering and keeping the dollar’s value intact while jobs disappear. The range eventually has to rise, since it can’t go in any other direction. Once it rises, in concert with the demand for additional dollars that government spending is creating, inflation should ensue.

What does this mean in practical terms? It means getting your assets the hell out of cash, or at least out of U.S. dollars.

(Note: We’ve long advocated quoting the price of a dollar in terms of gold, instead of the other way around. Details here, but suffice it to say that the dollar has lost an annualized 28% of its value since this post first ran.)

The immediate temptation is to shop the world for the currencies the dollar will lose the most money against. There are candidates such as the New Zealand dollar and the CFA franc, but again, your investment will only then be as safe as that government’s fiscal conservatism.

One strategy that goes a step farther is to look at blue chip stocks that don’t trade in U.S. dollars. If the stock’s fundamentals are strong enough, it shouldn’t matter if it’s measured in Swedish kronor, Swiss francs, or almost any currency short of Zimbabwean dollars. Even if a localized bout of inflation causes the stock’s nominal price to artificially rise, its real price should remain consistently strong.

Here are some examples of giant corporations that don’t necessarily trade on the Big Board nor NASDAQ:

  • Royal Dutch Shell (which trades under the symbol RDSA on the London Exchange)
  • British Petroleum (BP, London)
  • Toyota (TYO, Tokyo)

Yes, Toyota. Exhale. And while extolling the benefits of a particular security might make the author come across as a boiler room stock promoter, I’m not telling you to buy anything. I’m telling you to look critically at the reasons for a stock’s atypical behavior.

The fun part! What did those stocks do since then?

Let’s start by looking at which ones we chose. One of those companies had some bad if undeserved PR since we posted. That company’s public image would have taken a historic beating, the worst of the year, if another company on the list didn’t have a problem was 1000 times worse. Yeah, BP won’t want to relive last summer anytime soon. We chose these stocks 3 weeks before the Gulf of Mexico disaster, too.)

This is all syncopatic, to use a pseudo-word. We’ve also written at length about what a bargain BP stock is. But that was after Deepwater Horizon.

Royal Dutch Shell, up an annualized 41%.
BP, down an annualized 43%. However, it’s up almost an annualized 100% since its July nadir and continues rising.
Toyota, down since April on the Nikkei but making huge strides since the fall. Here’s the chart. Toyota was trading at 3750 when our exercise began. Prices in yen:


If you think a week of questionable publicity in one market can turn the world’s largest and most respected automotive company into a bad investment, you shouldn’t be investing in anything more demanding than an index fund. A few months from now, no one will remember the recent uncomfortable performance that the parent company of two of Toyota’s major competitors forced the company to undertake.

Furthermore, this is a perfect time to go contrarian. Toyota shares have dropped 20% in the last month. Think about why that might happen to a stock.

  1. Is it a volatile small-cap? No, it trades at $71. ($84.40 on the NYSE today)
  2. Are its financials questionable? No, they’re healthy. Toyota made money last quarter after several quarters of losses. The company routinely buys back treasury stock, showing that on the investor relations side, it cares about preserving value. (Annual report won’t be out for a few weeks yet.)
  3. Did it suffer a one-time public relations hit, illustrated by unconvincing former customers telling stories of narrowly averted carnage and crying into the camera on cue? You can field that one.
  4. Gold is the traditional inflation hedge, but when you see an investment being sold during commercial breaks on general-interest TV shows, that opportunity has clearly evaporated. Besides, gold’s value has quadrupled in the last 8 years. (And has been growing even faster ever since.) That’s swell, but if you’re looking to preserve wealth, remember that time continues to move forward, not backward.

    What about Treasury Inflation-Protected Securities, whose defensive strength is written right into their very name? These are a type of U.S. bond whose interest rate, as you can probably figure out, factors inflation in. TIPS are great in theory, as long as you can trust the government’s consumer price index numbers and you can trust the government’s ability to honor its debts. “Full faith and credit of the United States government” doesn’t mean quite the same now as it did when the phrase was coined.

    **This post is featured in the Totally Money Blog Carnival 2**

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