Two Inflation Hedges
Thursday, December 12, 2013
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

TIPS and Inflation Protection
TIPS are influenced by past and expected future inflation.

Inflation-Indexed Annuities
These annuities adjust to an inflation benchmark.

AAII Discussion Boards
How do you hedge against future inflation?

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 41.3%, down 1.4 points
  Neutral: 33.7%, up 3.9 points
  Bearish: 25.0%, down 2.5 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

How do you protect your ability to buy goods and services if you think inflation will be higher in the future than it is now? Even if you agree with current monetary policy, what should you own now to guard against losing purchasing power in the future?

On a shorter-term basis, the answer requires correctly guessing which asset class will deliver the highest returns over the next couple of years. Given the prevalence of cracked crystal balls, you are better off trying to protect the cash you will need rather than risking a loss in absolute dollars. Over the long term, however, you have two options, according to James Montier of asset management company GMO: stocks and Treasury inflation-protected securities (TIPS).

In a recent report, Montier looked at the return characteristics of various assets to see how they fared on a real (inflation-adjusted) basis. He concluded that some perceived inflation hedges have not worked over the long term. Rather, a mix of stocks and TIPS is actually an investor’s best defense against inflation

Montier calls stocks “an underappreciated inflation hedge.” He cites two reasons why. First, stocks are claims on real assets. Second, some corporations have pricing power, which increases their cash flows in response to inflation. Data from the Ibbotson SBBI Classic Yearbook backs Montier up. Stocks consistently beat inflation during most rolling 10-year periods since 1926. The notable exceptions were the majority of 10-year periods ending between 1974 and 1982. Extend the time frame to rolling 20-year periods and stocks have a perfect track record of beating inflation.

TIPS adjust their principal amount, and thereby their yield, in response to reported inflation. As inflation rises, TIPS pay a higher yield. They are bonds, however, and will fluctuate in price between the time they are issued and the time they mature. Both bond market fluctuations and changes in expectations for inflation will cause the value of TIPS to rise or fall. Thus, if your goal is to use them as a long-term inflation hedge, you should consider buying directly from the Treasury Department and holding them until maturity.

What about other assets? Montier attributes commodities’ reputation as an inflation hedge to the 1970s as well as the creation of OPEC and the heavy weighting of energy in most commodity indexes. Otherwise, he views them as being risky bets. To successfully invest in commodities, Montier says investors must determine not only which specific commodities to buy, but also when prices are attractive and how long the commodities should be held. As far as gold, he doesn’t see a good historical relationship between gold and inflation beyond the 1970s. Plus, investors who buy gold when it’s expensive have tended to experience negative real returns. I’ll add that it is very difficult to determine what a fair price for gold is since the metal just sits there and does not produce any cash flow until it is sold.

Real estate is a good “very long-term inflation hedge,” according to Montier, but valuation is of extreme importance. Those who bought real estate at the height of a bubble likely have not realized enough gains to offset the expenses of owning the asset.

One of the biggest things to remember about hedging against inflation is to avoid making big bets on uncertain outcomes. There are various books, newsletters and, likely, advisers pitching strategies on how to protect your portfolio against future high inflation and dollar devaluation. The truth of the matter is that nobody knows with any certainty what will happen in the future. It is far more likely that the next big bear market (and bull market) will be caused by factors hardly anyone is currently talking or thinking about. Given this probability, it makes more sense to follow the historical odds then to bet against them.

More on

The Week Ahead

We will get an early glance on at fourth-quarter earnings as 15 S&P 500 member companies are scheduled to report. Included in this group are FedEx Corp. (FDX) and Oracle Corp. (ORCL) on Wednesday; Accenture (ACN) and Dow component Nike (NKE) on Thursday; and Walgreen Co. (WAG) on Friday.

The Federal Open Market Committee Meeting will hold a two-day meeting, starting on Tuesday. The meeting statement and committee member forecasts will be released around 2:00 p.m. ET on Wednesday. Ben Bernanke will hold his last quarterly press conference as Fed chairman at 2:30 p.m. ET on Wednesday. It is uncertain if the committee will vote to begin tapering the Fed’s bond purchases.

Three economic reports of note will be released on Monday morning: November industrial production and capacity utilization, the December Empire State Index and revised third-quarter productivity. The November Consumer Price Index (CPI) and the National Association of Home Builders’ December housing market index will be released on Tuesday. Wednesday will feature November housing starts and building permits. The November Philadelphia Fed Survey and November existing home sales will be released on Thursday. Friday will feature the final estimate of third-quarter GDP.

Friday is a quadruple witching day, meaning futures and options contracts will expire.

The Treasury Department will auction $32 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

AAII Sentiment Survey

Neutral sentiment rose back above average as pessimism fell to its lowest level in five weeks, according to the latest AAII Sentiment Survey. Optimism declined modestly.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 1.4 percentage points to 41.3%. This is the eighth time in the past 10 weeks that optimism is above 40%. The historical average is 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, rose 3.9 percentage points to 33.7%. Since falling to 24.4% two weeks ago, neutral sentiment has rebounded by a cumulative 9.3 percentage points. The historical average is 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 2.5 percentage points to 25.0%. This is a five-week low. It is also the ninth consecutive week and the 11th out of the past 13 weeks with a bearish sentiment reading below the historical average of 30.5%.

The market’s lackluster start to December has dampened optimism a bit as shown by bullish sentiment falling by a cumulative 6.0 percentage points since Thanksgiving. Nonetheless, the level of optimism remains above its historical average as many individual investors continue to be encouraged by the new record highs established by the large-cap indexes along with earnings growth and economic growth. Tempering the level of optimism are concerns about the pace of economic growth, elevated stock valuations and the lack of a long-term fiscal solution.

This week’s special question asked AAII members if they are holding onto stocks they consider to be overvalued or overbought. Responses were split with 45% of respondents saying no, they are not, and 38% saying yes, they are. Among the reasons given for holding onto a stock considered to be pricey are that it is a long-term investment, expectations for the price to continue rising, the dividend yield and a desire to avoid or defer capital gains taxes.
Here is a sampling of the responses:

  • “No. If I thought they were overvalued, I would sell.”
  • “No. I sold the stocks two weeks ago that I thought were overvalued.”
  • “I like to let my winners run.”
  • “Yes. Because overbought conditions can last for a long time.”
  • “I think the market will continue upward and I don’t want to pay capital gains taxes.”

» Take the AAII Sentiment Survey