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Next Stop: Inflation

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The greatest monetary and fiscal stimulus in history has saved the world from deflation. Next stop: inflation.

The Fed's heroic success at making money "free" for the past year--with short-term interest rates near zero--has saved the planet from another Depression. The money supply has exploded; the steepened yield curve has recapitalized the banking sector. There's always a cost to the printing of money. That cost is inflation.

We don't know when it will return. Inflation tends to lag behind money supply creation by several quarters. The deflationary forces of unemployment and the lingering credit crisis are muting any major price appreciation: prices were up 0.4% in August but declined 1.5% over the past year. Any attempt to time the return of inflation will be futile, since price spikes are only visible in the rearview mirror. Predicting economic cycles is also impossible since economic predictions make weather forecasts look respectable.

How then to position a portfolio?

There are several protective measures for impending inflation:

1) Keep bond duration short to minimize interest rate sensitivity. Average bond duration should be kept below 8 years, preferably closer to 5. Long-term bonds will lose lots of value in an inflationary environment. We're keeping all clients in short-term or medium-term bond funds with low average durations.

2) Avoid staying in cash for long periods of time. The 3.5 trillion dollars in money market funds earning less than 1% will be the main loser, since inflation is likely to run above the long-term average of 3%. Cash deposits will hemorrhage value on an inflation-adjusted basis. The damage will be invisible but real. We're raising some cash in conservative accounts due to the massive run-up in equity prices (especially in Asian and tech allocations) but plan to redeploy it into bonds or stocks.

3) Invest in equities. Equities are a decent place to be during periods of inflation. When the Fed raises rates, it can hurt the value of stocks by making cash flow yields less attractive on a relative basis; however, equities perform better than bonds and cash during inflationary periods. The earnings of companies are priced in inflated dollars. For this reason alone, stocks do better than bonds (which are saddled with their fixed interest rates). For example, the average equity return over the four major inflationary cycles of the past 100 years (1914-19, 1945-47, 1949-51, and 1971-81) was a surprising 12.1%. The consumer price index averaged 8.3% over the same periods, meaning that the real return of equities over inflation was only 3.7%. But this was better than being in bonds which returned 3.1%, and therefore lost 5.2% in real terms. We're keeping equity allocations high enough to provide an inflation hedge in all portfolios.

4) Invest in gold. Gold is a very poor long-term investment, with a real return of zero over the past century; however, gold prices spike during periods of inflationary crisis, given gold's history as a store of value. You shouldn't overdo it with gold. Gold has no yield, no cash flows, and no intrinsic value -- beyond that which is determined by market prices. But a small gold position as a hedge makes sense in this environment. We purchased the GDX (the exchange-traded fund that purchases gold mining stocks) in December in every suitable account.

One asset class we'll avoid for now is TIPS (Treasury Inflation Protected Securities) which are overvalued and yield next to nothing due to the rush into these securities. Should a sell-off in these bonds create more value, we won't hesitate to invest. TIPS are only appropriate in tax-deferred accounts, however, due to the imputed interest of the CPI price adjustment.

The market has had the biggest six month rally since the 1930s and stocks cannot go up forever. Equities will take one step back for every two steps forward. We can't time the sell-off, but we can prepare for one of its likely causes: inflation.