Archive for the 'debt' Category

INFLATION: Can you protect your portfolio?

Kurt Brouwer November 2nd, 2009

What happens when 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.  Let’s head back to those days of yesteryear — the early 1980s — and compare some key indicators to the situation back then.

Here is a good chart showing key interest rates plus inflation and unemployment, then and now:

Source: Carpe Diem

I suspect you could win some bets with some of these statistics.  How many folks remember that home mortgage rates hit 18% back then?  Or, another statistic that is not shown in the chart is that home mortgages rates averaged 12% from 1979 through 1985?

Is inflation an immediate problem?

Inflation is not a huge problem now as it was throughout the 1970s and early 1980s.  For example, inflation is now running in the Fed’s sweet spot of 1-2%.  However, given all the monetary stimulus and government spending we have seen, inflation is definitely a threat, but one that has not really manifested itself yet. 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.

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.  However, if you think the Fed might be planning to raise interest rates soon in order to counteract inflation, then inflation hedges could be a problem.  Here’s why.

If inflation went quite a bit higher, the Fed would eventually be forced to raise short-term interest rates.  Long-term interest rates would certainly go up and that would be bad for those holding long-term bonds.  Once interest rates begin moving up, then economic activity would probably slow down, bringing us into recession and that would hurt most other assets such as real estate and stocks.

For example, 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.  In that environment, most assets fell (real estate, stocks, bonds).  Gold prices lagged the decline in other assets, but they also fell.

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, gold is hitting new prices highs due, in my opinion, largely to the weakness of the U.S. 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.  A little further on I’ll give you my thoughts on the best way to buy gold.

What should I do about inflation?

If you believe high inflation is coming our way, how do you protect your portfolio? This piece from the Wall Street Journal covers some solutions and we add a few more ways to protect your portfolio from the ravages of high inflation.

However, be careful out there, because it 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.  That’s how you keep your portfolio growing:

Inflation-Protection Strategies Offer Investors No Guarantees (Wall Street Journal, October 5, 2020, Jeff D. Opdyke)

Worried investors have been looking for insurance in the form of assets such as mutual funds and exchange-traded funds focused on gold, commodities and Treasury inflation-protected securities, or TIPS. In the past year, interest in TIPS funds in particular has been running at record levels, with some weeks recording more than $400 million in sales.

But many of these investments have never been tested during a bout of meaningful inflation. The last time inflation ramped up significantly was three decades ago. Yet TIPS have been around only since the late 1990s, and commodity funds are of even more recent vintage, as are the gold funds that invest in bullion or track the metal’s market price.

This is a really important point.  Wall Street is great at coming up with new and complex investment opportunities.  However, the track record on Wall Street innovations is not good.

Be cautious with new or untested investments

I think of it just like new operating systems for a computer.  I never rush to upgrade my computer with the latest, groovy operating system because I know there will be bugs.  I wait a few years usually before upgrading so that the bugs will largely be fixed before I make the switch.

I view innovations from Wall Street with even more skepticism than I do new operating systems for my computer.  In general, if it is new — and complex — and it’s from Wall Street, I pass.

As an example, consider commodity-oriented exchange-traded funds (ETFs).  They are new and relatively untested, so be cautious.  One critical issue with commodity mutual funds or ETFs is whether or not they actually hold commodities or just a basket of futures contracts for a given commodity.  With precious metals, it is possible to actually hold a commodity such as gold.  However, some commodities such as agricultural products or even oil or gas are less likely to be owned directly by a given fund.  In many cases then, an ETF or mutual fund just holds future contracts or notes redeemable by a bank.

There are some mutual funds such as Pimco Commodity Real Return Fund (PCRDX) that seek to benefit from investments in commodity-related securities.  Here’s how Pimco describes the investment strategy:

PIMCO manages CommodityRealReturn Strategy by combining a position in commodity-linked derivative instruments backed primarily by a portfolio of inflation-indexed securities…Other fixed income instruments may also be used tactically in the portfolio. The commodity-linked derivatives capture the price return of the commodity futures market, while our active management of the fixed income assets seeks to add incremental return above those markets, along with additional inflation hedging…

This type of fund can give you exposure to commodity-related investments, but it is no walk in the park.  We use this fund a bit, but we do so knowing it can be very volatile.  For example, in 2008, it fell over 43%.

Tracking error

Commodity mutual funds or ETFs have the potential to go up in value due to inflation, but they are inherently volatile.  And, as we saw above, they often also invest in futures contracts and other so-called derivatives that can lead to unintended consequences as shown by this piece from MarketWatch.  It illustrates the point with examples of commodity or precious metals ETFs that had results wildly divergent from the actual commodity or metal they are tracking:

…The United States Natural Gas Fund (UNG) , for example, has tumbled 50% this year while natural gas prices are down about 12%…

Natural gas prices go down so you expect the fund to go down, but a loss of 50%? Ouch.

…PowerShares DB Oil Fund’s flexible strategy helps it navigate market conditions…Since the fund’s inception in early 2007, it has gained about 16% while oil prices have risen about 40%…

Nothing wrong with a gain of 16% since 2007, but that return significantly lags the actual increase in oil prices.  As long as you understand what a commodity or precious metal mutual fund or ETF does, then that’s fine.  I suspect many investors in UNG are a bit mystified though.

If you are interested in investing in precious metals, I would simply just own them directly.  That is, buy some gold coins or silver coins and hold them in a safe deposit box.  If you do go that route, you have the coins and there is no muss or fuss. As a second best choice, I would buy an ETF such as the SPDR Gold Trust (GLD), which, by its prospectus, actually buys and holds gold at its custodian in London.

Other ETFs or mutual funds investing in precious metals or commodities may simply be putting together a basket of futures contracts on the commodity in question.  That’s fine if you have faith in the ETF or fund provider, but how exactly those contracts will perform in volatile markets is a bit of a question mark.

The Wall Street Journal continues:

…Though long heralded as a hedge against inflation, gold hasn’t always gone along for the ride when U.S. consumer prices are rising. Consider data from Morningstar Inc.’s Ibbotson Associates research and consulting unit: The correlation of spot gold prices to an Ibbotson-tracked inflation benchmark is just 0.096. (Correlation is perfect at 1; the closer to 0, the less the correlation.)

Certainly, gold has done well in some inflationary periods, like the late 1970s, when the metal spiked above $800 an ounce. Still, investors would do better to view gold as an international currency that hedges against weakening paper currencies, particularly the dollar. For instance, the U.S. dollar index, tracking the greenback’s performance against a basket of currencies, has slipped more than 13% since March, when the index hit its peak so far for this year. Gold prices, meanwhile, are up more about 14% so far this year.

…But there’s another issue: What does your gold fund own?

Exchange-traded funds such as SPDR Gold Shares and related trust products such as Canada’s Central GoldTrust own physical bullion, held in secure bank vaults and regularly audited.

Others don’t own physical gold and instead seek gold exposure through derivatives. PowerShares DB Gold, for instance, tracks an index of gold-futures contracts…

In mutual funds or ETFs that invest through futures contracts on gold or silver, there are a number of risks.  The obvious one is that spot prices for a given precious metal and futures contracts for that metal have very different prices as we saw from the examples above.  In a rising market, the fund would often underperform spot prices.  That can be very disappointing if you bought a fund and the precious metal followed the trajectory you anticipated, yet the fund lagged far behind.

So, there is the issue of the internal structure and strategy of the fund or ETF.  But, there are also other issues.  The Wall Street Journal continues:

…Many commodity-based securities are exchange-traded notes, or ETNs, which pose a different risk. Unlike ETFs, which generally own a pool of hard assets or securities, ETNs own nothing. They are promissory notes issued by a bank, meaning they’re unsecured debt; the return you earn is calculated based on the movement of an underlying commodity index.

“You’re loaning money to a bank, and the bank pays you the return of the underlying index,” Morningstar’s Mr. Burns says…

Hmmm.  Loaning money to a bank.  What could go wrong?

Going beyond precious metals or commodity funds, here are some thoughts on different asset classes of funds and how they might fare during inflationary times:

Money market mutual funds: One very good investment in times of high inflation is cash in a money market funds.  Assuming interest rates go up due to inflation, the return on the money market fund should go up too.  In a money market fund, interest rates are variable, so your money will begin earning higher interest as soon as rates go up.

Short-term & intermediate-term bond funds:  If you have some fixed income investments, as a first step for an inflation conscious investor, I would shorten the maturity of any bonds or bond funds you own and use short-term and intermediate-term bond funds primarily.  You could also put some assets in a fund that invests in Treasury Inflation Protection securities as mentioned above.

U.S. stock mutual funds: Stocks can do quite well in a moderate inflationary environment, in particular stocks of companies that have pricing power.  However, if inflation really takes off, eventually the Federal Reserve would have to raise interest rates and that would result in a recession in all likelihood.  Recessions are not generally good for stocks.

International stock mutual funds:  The points made above about U.S. stock funds apply generally to international stock funds too.  In addition, there is the currency issues.  That is, most international funds hold stocks in currencies other than the U.S. dollar.  As such, if inflation has a negative impact on the dollar, then those funds should benefit.  The flip side is true also though.  That is, if the dollar strengthens, then most international funds would suffer a bit due to their non-dollar exposure.  Right now, international stock funds are benefiting from higher share prices plus currency gains from the falling dollar.

Real estate mutual funds:  Real estate has been struggling for a couple of years now.  Residential real estate started falling first and now commercial real estate is taking a big hit.  Assuming you are a long-term investor and assuming you are worried about inflation, real estate funds are worth a look.  It may be premature at this point because real estate is still weak, but historically real estate has done pretty well during inflationary times.  I would wait a bit on this though.

In closing, I’ll make a couple of points.  First, there is no guarantee that we will go through a high inflationary period.  There is pretty solid evidence that inflation will be moving up at some point, but that does not mean we will get back to the type of inflation we saw in the 1970s.  Also, as you know, disinflation, not to mention, deflation, is still a possibility although probably a much lower one than inflation.  But, if the economy fails to re-ignite, we could drift into another recession in a year or two and that would mean most inflation-centric investments might suffer.

When it comes to investing, I believe a diversified portfolio works best because the future is not knowable.  That is, do not bet all your assets on one specific scenario such as high inflation.  You can certainly do things to lessen the impact of inflation on your portfolio, but do not put all your assets in one narrow strategy.

Disclosure:  Kurt Brouwer owns shares of Pimco Commodity RealReturn Fund (PCRDX)

GDP Turns Positive (Sort of)

Kurt Brouwer October 29th, 2009

U.S. GDP rises 3.5% as stimulus kicks in (MarketWatch, October 29, 2020, Rex Nutting)

The U.S. economy expanded at a 3.5% annual pace in the third quarter, as massive government stimulus helped drag the economy out of the longest and deepest recession since the 1930s, the Commerce Department estimated Thursday.

This is an estimate and will almost certainly get revised.

Along with improvements in key monthly figures on output and sales, the rise in real gross domestic product means the Great Recession is likely over in a technical sense, even as further job losses occur. A formal call on the end of the recession isn’t expected for months

…It was the first increase in real gross domestic product in a year and it was the strongest growth in two years, the government said. Before growing in the June-to-September quarter, the U.S. economy had shrunk for four straight quarters for the first time since the Great Depression.

…In the past year, the economy has contracted 2.3%. The economy shrank 0.7% annualized in the second quarter and 6.4% in the first quarter. The figures are seasonally adjusted and adjusted for price changes.

…Third-quarter growth was due to higher consumer spending, a slowdown in the reduction of inventories, an increase in residential investments, and robust government spending…

How much of the growth was due to stimulus and other forms of robust government spending? The Bureau of Economic Analysis report referenced above can be found here.  It gives us a bit more detail on the elements of GDP growth:

…Motor vehicle output added 1.66 percentage points to the third-quarter change in real GDP after adding 0.19 percentage point to the second-quarter change…

Yikes.  That is, of the 3.5% growth, fully 1.66% came from motor vehicle output and that, of course, was goosed mightily by Cash for Clunkers.  If vehicle output had come in at the same level as the second quarter, then GDP growth would have been only been 2.03% (3.5 - 1.66 + .19 = 2.03).

This chart illustrates what I meant by vehicle sales were goosed by Cash for Clunkers:

Source: Clusterstock

The little sign in the chart indicating a car going off a cliff presumably is suggestive of a likely decline in vehicle sales now that Cash for Clunkers is over.  I would be shocked if we did not see a big dropoff in vehicle sales.

So, the good news is that the economy has sped up and we are seeing modest economic growth.  The bad news is that growth is still heavily dependent on various government spending programs which are unsustainable.

Cash for Carts (golf carts that is)

Kurt Brouwer October 19th, 2009

In a post on the Cash for Clunkers program, I joked about a similar program for appliances.  But, I should not have joked because such a program was included in the economic stimulus program passed earlier this year.  CNBC reports [emphasis added]:

Dollars for Dishwashers? Appliance Rebates on the Way (CNBC, August 20, 2020, Christina Cheddar Berk)

…The government’s so-called “Cash for Clunkers” program has been grabbing headlines, but it’s not the only federal program putting money back into consumers’ pockets. A new government program is poised to help appliance manufacturers the same way “Clunkers” gave a jump start to auto manufacturers.

As part of the Obama Administration’s economic stimulus bill, nearly $300 million was set aside to fund a state-run rebate program for consumers purchases of Energy Star-qualified home appliances.

Like the “Clunkers” program, the plan takes aim at energy guzzlers. However, unlike in the popular auto program, consumers will not have to turn in their old appliances in order to buy a more efficient one and qualify for the rebate. However, the exact criteria remain unclear because states are still drafting their individual plans, with the hope of having the programs up and running by the end of this year…

Great line that says so much, ‘…the exact criteria remain unclear…’  It really is impossible to parody Congress anymore.  And, of course, the fact that Cash for Clunkers has been a fiasco will not stop implementation of Dollars for Dishwashers.

Now, we find that even Dollars for Dishwashers was not the end of the government’s effort to subsidize our purchases.  We also have Cash for Golf Carts.

Cash for Golf Carts 

As part of the American Recovery & Reinvestment Act of 2009 (ARRA), there is a stimulating program that is helping golfers buy electric golf carts.  I am not knocking golfers with this post, in fact, I play golf from time to time.  I even spent several years of my wayward youth caddying at a tony country club.

However, I really don’t see why we need to borrow money — that’s what economic stimulus really means at this point — to subsidize golfers who want to buy a cart, do you?

One problem with very large government programs is that there are always unintended consequences.  I suspect the legislators who worked on this program did not really intend to give electric golf cart sales a boost, but who knows what evil lurks in the heart of the vast golf cart lobby? This editorial from the Wall Street Journal describes  program [emphasis added]:

Cash for Clubbers (Wall Street Journal, October 17, 2020)

…Uncle Sam is now paying Americans to buy that great necessity of modern life, the golf cart.

The federal credit provides from $4,200 to $5,500 for the purchase of an electric vehicle, and when it is combined with similar incentive plans in many states the tax credits can pay for nearly the entire cost of a golf cart...which is typically in the range of $8,000 to $10,000. “The purchase of some models could be absolutely free,” Roger Gaddis of Ada Electric Cars in Oklahoma said…

Free.  When it comes to almost any consumer product, if you make it free, you can in fact stimulate demand. That’s not exactly news though.

The golf-cart boom has followed an IRS ruling that golf carts qualify for the electric-car credit as long as they are also road worthy. These qualifying golf carts are essentially the same as normal golf carts save for adding some safety features, such as side and rearview mirrors and three-point seat belts. They typically can go 15 to 25 miles per hour.

…The IRS has also ruled that there’s no limit to how many electric cars an individual can buy, so some enterprising profiteers are stocking up on multiple carts while the federal credit lasts, in order to resell them at a profit later…

Great.

This golf-cart fiasco perfectly illustrates tax policy…politicians dole out credits and loopholes for everything from plug-in cars to fuel efficient appliances, home insulation and vitamins…then insist that to pay for these absurdities they have no choice but to raise tax rates… 

This is kind of funny in a way.  We don’t generally think of golfers who tootle around in golf carts as needy, but they are just responding to incentives, so you can’t really blame them.

However, if you think of this as a wasted and misguided use of our money, then it’s not so funny.  And, if you multiply this sort of idiocy thousands of times in many different industries, then it starts to get infuriating.

Congress & the vast golf cart industrial complex

I doubt if anyone in Congress is in thrall to the vast golf cart industrial complex, but the American Recovery & Reinvestment Act is now funding well-to-do golfers who want a FREE personal golf cart.  I shudder to think of what’s next.

See also:

50 Ways the Feds Waste Our Money

CRASH for Clunkers

Clunking toward health reform

Convicts Cash In On Fed Stimulus

We’re in the best of hands

Clunk

Collateral Damage From Cash for Clunkers

$1.4 Trillion Federal Budget Deficit

Kurt Brouwer October 17th, 2009

Source: Washington Post

As you can see, the red ink is flowing in Washington DC.

In a way though, this record budget deficit is a little less bad than it could have been.  As you can see from the next chart, also from the Washington Post, earlier this year the deficit was projected to be even larger, more in the range of $1.75 - 1.85 trillion.


wapoobamabudget1.jpg

Source: Washington Post

But, where do we go from here?  As I read through this piece from the Washington Post, I was not reassured that anyone in Washington DC actually has a handle on this.  Or, at least, the WaPo reporters could not find anyone who really has a plan [emphasis added]:

Record-High Deficit May Dash Big Plans (Washington Post, October 17, 2020, Lori Montgomery and Neil Irwin)

The federal budget deficit soared to a record $1.4 trillion in the fiscal year that ended in September, a chasm of red ink unequaled in the postwar era that threatens to complicate the most ambitious goals of the Obama administration…

…At about 10 percent of the overall economy, the gap between federal spending and tax collections is the largest on record since the end of World War II, and bigger in nominal terms than the past four years of deficits combined. Next year is unlikely to be much better, budget analysts say. And Obama’s current policies would drive the budget gap into the trillion-dollar range for much of the next decade.

This is the type of record we really don’t want.  And, I think we need to get past the partisan sniping.  Neither the Republicans nor the Democrats can claim any glory when it comes to spending control.  Politicians seldom get criticized for spending our money, so they keep right on doing it.  We can assign blame to different players and parties, but that still begs the question: ‘What the heck do we do?’

The WaPo article continues:

…A combination of factors combined to produce the $1.4 trillion gap. A deep recession caused tax revenue to plummet by more than $400 billion this year, while the government’s economic rescue efforts swelled federal spending. In all, the government spent $3.5 trillion in fiscal 2009, while taking in only $2.1 trillion in taxes, the Treasury Department said. Among the outlays: $113 billion in stimulus cash, $154 billion for the bank bailout and nearly $96 billion in capital payments to Fannie Mae and Freddie Mac, the troubled mortgage insurance giants that the government took over last year.

…”In the short term the deficit is not our primary problem,” said Heather Boushey, a senior economist at the left-leaning Center for American Progress. “The unemployment rate is near 10 percent, and the key thing is to get the economy growing, which will increase tax revenues. But in the long term we do need to think about the deficit problem and do something about it.”

Economists universally agree that the nation cannot run such massive deficits indefinitely. The question now facing Obama, budget experts said, is how to bring spending and revenue more closely into balance in the years ahead, after the economy fully recovers…

We cannot run such massive deficits indefinitely on that much there is agreement.  But, where is the plan for how we bring spending and revenues more closely into balance?  If there is one, I have not seen it.

Bonds Outperform Stocks: What’s Next?

Kurt Brouwer October 13th, 2009

So far, 2009 has been a great year for bonds and an even better year for stocks.  However, the long-term numbers are quite different.  For the past 20 years, bonds have done better than stocks on average.

This chart from Steve Leuthold illustrates this fact and also points to an interesting historical comparison.  First, let’s check out the chart:

Source: Leuthold Group

The top line (black) is the S&P 500 and the lower line (blue) shows time periods when stocks are outperforming bonds (above the 0% line) or underperforming bonds (below the 0% line).

Right now is a very rare time period in which bonds have outperformed stocks on average for 20 years.  As you can see from the chart, stocks have generally done very well after one of these periods in which stocks struggled.

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