Bonds and Gold

David Malpass hit the nail on the head with his editorial Beyond the Gold and Bond Bubbles in the Wall Street Journal today: bonds and gold have done well because people fear both deflation and inflation.

I’ve been surprised to see both gold and bonds do so well over the last decade.  After all, deflation and inflation are opposites: when one performs well the other usually doesn’t.  This makes bonds and gold both doing well a bit of a paradox. 

But in today’s mixed message environment, it makes sense from a certain perspective.  Investors are running scared.  They seek safety in some form–any form. 

They correctly see that bad debt (lending which can’t be repaid) leads to deflation, so they want to own bonds as protection.  Just look at Japan over the last 20 years: bonds performed much better than stocks.  Or, look at America during the Great Depression: bonds did much better than stocks.

But, investors also fear inflation, which is caused by too much currency growth relative to goods and services.  Witness Weimar Germany in the 1920’s or the United States during the 1970’s.  In both cases gold protected wealth better than stocks or bonds.

The problem with this reasoning is that it works…until it doesn’t.  Let’s look at what Paul Harvey called “the rest of the story.” 

Bonds were a lousy investment from the bottom of the Great Depression until the 1970’s.  Bonds will likely be a very poor investment in Japan over the coming 20 years.

Gold was a great investment in Weimar Germany…until hyperinflation ended.  Then it tanked.  Same with 1970’s inflation here in the U.S.: gold was great…until it declined 6% a year for 20 years.

Investing to catch the waves of inflation and deflation require excellent market timing.  It only pays to ride the wave as long as you know exactly when to get off.  Getting the timing wrong–even by a little–will lead to poor results.  But, in case you don’t know, no one is good at consistently timing the market (despite all the time, effort and brainpower devoted to it). 

Warren Buffet doesn’t time the market.  Neither did Peter Lynch.  Look at the Forbes 400 some time and scout out the market timers–you won’t find a single one.  Trying to time the market doesn’t lead to permanent wealth–it leads either to temporary or decreasing wealth.

Which is why most investors shouldn’t focus on bonds and gold.  If you can time the market perfectly–and good luck on that–you can ride bond/deflation or gold/inflation.  If you are a mere mortal, then don’t try juggling nitroglycerin. 

If you want to build permanent wealth, you should do what Warren Buffett and a herd of other smart investors do–buy productive assets at cheap prices, which is when everyone hates them.  Productive assets are things that generate cash.  Gold doesn’t.  Bonds do, but the cash they generate isn’t protected against inflation (except for TIPS, but they have their own problems).  You have to own productive assets to really be protected against both inflation and deflation.

Examples include real estate, stocks, businesses, rental equipment, employment, education, etc.  These are assets you put money into and get back over time.  They can adjust to both inflation and deflation. 

Does that mean they do well in all markets?  NO!  Investing is not about what does well over a week, month, quarter, year, or even 5 years.  You invest for the long term, not for a short term kick-back–that’s speculation!

But, producing assets work like a charm during both inflation and deflation.  Look at the record of stocks, real estate, owning a business, rental equipment, education, or any employment during periods of inflation and deflation.  They do poorly initially, but work very well over time.  That’s because they can adjust to inflation and deflation, whereas bonds and gold cannot (gold will maintain, but not grow, value over the full cycle).

Investors flooding into bonds and gold are likely to look brilliant for a while…until they get slaughtered.  The cycle on bonds and gold tend to turn very quickly.  It will only be obvious in hindsight that the tide has turned–and by then it will be too late.

Investors patient enough to invest in producing assets at cheap prices will do well–over the long run–regardless of whether we experience inflation or deflation.  That’s how I’m betting.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds and Gold

The Fed wants MORE (?!) inflation

I know, everyone is taking pot-shots at the Federal Reserve (the YouTube video is hilarious!).  I, however, feel especially privileged to do so not because I read a lot of finance, investing and economics, but because I’ve always been critical of the Fed.

The Fed was originally created in 1913 after the financial panic of 1907 to prevent banking crises.  Bankers and the government had decided that banking crises could be prevented with a lender of last resort, and many judged that a government agency would be better for this purpose than the ad hoc committee of New York bankers, led by J.P. Morgan, who had previously and successfully dealt with banking crises in the past.  The original goal of the Fed was to be this lender of last resort.

Fast forward to the present, and the Fed’s mandate is to maintain price stability and full employment (never mind that the Fed has a lot of control over the former and none over the latter).  As you may have quickly surmised, this has nothing to do with its original mandate.

The people at the Fed long ago decided that deflation (declining prices) was the bane of human existence after the experience of the Great Depression and watching Japan’s last 20 years.  They seem to have forgotten, however, that both of those experiences were due to bad loans and not an inadequate supply of money. 

With this background, those at the Fed would much rather experience inflation than deflation.  In their infinite wisdom, they are now working hard to create inflation to fight off the boogie-man of deflation  They want to increase inflation to boost employment (never mind that inflation won’t boost employment). 

But, to normal people, declining prices seem like a good thing.  In fact, during a deep recession and recovery with 10% unemployment, most people think declining prices might be a very good thing.

That’s because most people haven’t been lobotomized by a PhD in economics to believe that declining prices (deflation) or stable prices (gold standard) are a bad thing. 

Most people, too, understand that printing money to create inflation won’t create prosperity, but will lead to extremely negative economic consequences (Zimbabwe or Weimar Germany, anyone?). 

Why don’t the people at the Fed possess such common sense?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Fed wants MORE (?!) inflation

Competitive Devaluation

The issue I fear most from an economic, political and geo-political standpoint is the huge debt overhang of the largest developed economies of the world: U.S., Europe, U.K. and Japan.

Solving this nightmare is not just an issue for the developed world, either, because it also greatly impacts the developing world (especially Brazil, Russia, China and India).

In order for the developed economies to pay off their debt, they must either grow their way out of debt or print money to inflate away the debt they owe. 

Growth would be the best and most honorable way to solve the problem, but growth in developed economies is inhibited by high debt loads (which lead to slower growth) and huge social programs (Medicare, Medicaid, Social Security and their equivalents in the other developed economies).

I’m sorry to admit it, but democracies have never successfully voted away social programs, and I don’t think they will this time, either.

That leaves inflation.

But, inflation is a nasty solution to debt problems. 

From an economic standpoint inflation is tough to put back in the bottle once you let it out.  If you think the Federal Reserve or any other central bank has a dial they can turn to 3%, 5%, or any other specific level of inflation, I’m sorry to let you know that smurfs aren’t real, either.

Inflation crimps a whole economy as everyone–from employees to employers, from government bureaucrats to private companies–becomes bogged down in trying to figure out wages, salaries, costs, prices, tax rates, etc.  No high inflation economy runs smoothly and efficiently.

The political and geo-political stage started to ripple this week as the U.S. Congress is trying to pressure China into revaluing their currency and Brazil’s Finance Minister remarked that an “international currency war” is taking place as governments manipulate their currencies to improve their export effectiveness.  Japan recently announced they will be active in currency markets to prevent the price of the yen from rising too much and becoming uncompetitive in global markets.  These trends will result in the beggar thy neighbor problem I highlighted in a previous blog.

This competitive devaluation process is a race to the bottom and has an ugly history.  In the past it’s led to world war and economic collapse.  I wish I could say these were idle fears, but they are not.

The U.S. economy currently has low inflation, and that looks set to last until the private market works down its bad debt problem (which I think will happen over the next 3 – 5 years).  Some believe the U.S. economy will experience the low inflation, deflation and low interest rates of Japan over the last 20 years.  In that environment, cash and bonds will do very well.

Never say never, but I doubt we’ll experience what Japan did.  In that case, inflation is the more likely threat, and that’s not a good scenario for owning a lot of bonds or cash.

The competitive devaluation that’s occurring does not need to continue, so my fears may be unjustified.  Even if they are justified, the end-game is unlikely to play out soon, but over the next decade.  Hope is not a strategy, so I’m hoping for the best while preparing for the worst.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Competitive Devaluation

Is Deflation Really That Bad?

People in the financial world don’t have nightmares about werewolves or falling off a cliff, they wake up in a cold sweat crying out one bone-chilling word: “Deflation!”

Ordinary (or should I say normal?) people don’t suffer from this affliction.  In fact, I’d dare say most people don’t even think of the word deflation, much less dream about it.

However, to those in the financial world, whether investors, economists, accountants, or central bankers, the word deflation conjures up visions of the Great Depression and Japan’s Lost Decade (it’s been 2 decades, actually, but it’s always referred to as 1 for some reason).

Is deflation really that bad?  It all depends on what you mean by the term.  For some odd reason, the term refers to two very different things.

One refers to the end of a credit expansion that ends in debt defaults, bank failures, and tremendous and long-lasting economic collapses.  That’s the nightmare one.

The other thing deflation refers to is when money supply doesn’t keep up with economic growth.  In my opinion, this one isn’t bad at all. 

Can you imagine what life would look like if the cost of goods went down by 3% a year instead of up 3% a year?  Would you really have nightmares if the cost of computers, cars, TV’s, food, clothing, etc. went down each year?  I don’t think so–everyone loves a sale!

And yet, this is why people get so confused, because deflation refers to two entirely different things.  Can you imagine going to the grocery store and seeing hamburgers labeled “Rat Poison”?  You know hamburgers aren’t poisonous, but the label would definitely throw you off.  The same is true with the word “deflation.”  It refers to something yummy like a hamburger, and at the same time something terrible like rat poison.  No wonder people fear deflation.

Historically, deflation (the good kind) got a bad name in late 1800’s United States.  After the Civil War, the U.S. experienced years of declining prices as the government worked to get its finances back in order and U.S. currency back on the gold standard.

It was great as long as you hadn’t borrowed lots of money.  This was a boom time for railroads and manufacturing industry like Carnegie Steel.  If you owned stock in James J. Hill’s railroad, the Great Northern, you received 8% dividends that bought more and more stuff each year, plus you benefited from the railroad’s growth! 

The cost of things were going down because the U.S. economy was becoming more productive.  It was great unless you owed debt.  Debtholders hate deflation because it means they must pay back loans with dollars worth more each year.

This was especially painful for marginally profitable farmers.  Industrialization had made farming more productive, which meant marginal farmers couldn’t break even.  They borrowed to try to keep up with productive farmers, but this just created new problems.  You can’t pay back loans or farm profitably if the value of the corn you produce is going down faster than the debt you owe. 

So it is with every technological advance.  I’m sure caveman Ug was put out of the hunting business by caveman Thug who invented a new, more effective spear.  Such is the way of the world.

This industrial/technological/economic shift led to the populist movement and William Jennings Bryant’s “cross of gold.”  But, none of that helped the poor farmers who needed to find economical work.  Eventually, they went to work in factories and a new boom occurred.

But, the legacy of deflation as a bad thing lived on.  The very vocal minority of unprofitable farmers (and especially their political demagogues) made enough of a ruckus that deflation has a bad name to this day.

Next time you wake up in a cold sweat dreading deflation (not very likely, huh?), just reflect on which type you dreamed about–the hamburger, or the rat poison?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Is Deflation Really That Bad?

Raging debate.

The investing world has divided itself into two camps: those fearing inflation and those fearing deflation. A debate is raging about what we’ll face going forward and the appropriate way to invest under each scenario.

This debate is not between dummies. I’m not referring to the talking heads on TV or the perma-bulls of Wall Street who perpetually advise buying stocks NOW! Nor am a talking about the perma-bears and gold bugs that advise canned food and fall-out shelters.

I’m talking about the smart investors who saw the 2000 tech bubble and the 2008 housing bubble popping years in advance. They made money when almost everyone else lost it.

They were in complete agreement back in 2000 and 2008, but now they aren’t. Now, they hold diametrically opposed views about the economy and where to invest.

If we face deflation, you should hold cash and buy high quality fixed income instruments. If we face inflation, you should buy commodities and stocks that will thrive in a rising price environment.

They are in total disagreement about which one we face and are ripping each other to shreds in articles and interviews. I’ve never seen such strong disagreement between the smartest in the field.

The outcome really matters. If you invest in cash and bonds and inflation occurs, you’ll get killed; if you invest in commodities and stocks and deflation occurs, you’ll get killed. This is no mere academic debate. This will impact the lives of millions of investors.

Like many, I don’t know how this story ends. It’s my opinion we’ll experience deflation until bad debt is squeezed from the system and then inflation from there. The problem is getting the timing right of when we go from deflation to inflation (and correctly guessing ahead of the herd when the crowd will recognize that shift).

And, to further confuse things, the outcome depends more on the decisions of government officials than economic analysis. If they print lots of money, we’ll get inflation. If they don’t, we’ll have deflation. We’re in an uncomfortable position.

I don’t think it’s possible to get the timing right, so I’m not trying. Instead, I want to own instruments that can do well in either inflation or deflation. For me, that’s investing in businesses with pricing power and competitive advantages that can cut costs in deflation or raise prices in inflation.

I prefer businesses with cash on hand and that pay a meaningful dividend. That’s the same as owning cash and a fixed income instrument, but it has the benefit of adapting to inflationary conditions in ways that cash and bonds can’t.

I’m also favoring strong management teams that own a significant chunk of the business and are focused on building shareholder wealth. A smart management team can adapt and exploit a changing environment in ways that cash, fixed income, canned goods and commodities can’t.

In other words, I’m looking for the best of both worlds. I don’t want to guess whether we’ll experience inflation or deflation or when one or the other will kick in. Instead, I’m investing for either environment.

Such investments are likely to feel short term pain if either strong inflation or deflation occurs. But, in the long run they will survive and grow in ways the other alternatives can’t.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

How to invest with deflation/inflation

Last week, I talked about why I thought we’d be experiencing deflation over the short term and inflation over the long run. This week, I’ll discuss how to invest in both scenarios.

A deflationary environment is the harder of the two.

The thing that does best is U.S. government bills, notes and bonds. This was clear late last year as U.S. Treasuries were the best performing asset class. Cash and gold did okay as well, but U.S. Treasuries were the all-star.

Not much else does well in deflation. Some people think other bonds like corporates or municipals or mortgage backed do well, but I beg to differ. The problem is that deflation usually leads corporations to collect less revenue, thus increasing default and bankruptcy risk. Municipalities suffer from less tax revenue and, unlike the Federal government, can’t print money or run huge budget deficits. Mortgage backed bonds do poorly for the same reason as corporations–people default on their loans under deflation.

Gold tends to hold its value, but it doesn’t produce any cash flow and it is very expensive to store, insure, etc. Cash is a great thing to have, especially if you can deploy that cash as deflation is bottoming and before inflation has taken off.

Stocks tend to get clobbered during deflation. Some companies do better than other, though. High quality companies do better than low quality companies. Companies with pricing power–that can raise and lower their prices easily–tend to do well. Companies with low or no debt do well.

Another problem with investing during deflation is timing. If deflation increases or decreases, it can dramatically impact returns. If you are sitting in U.S. Treasuries when deflation bottoms, you can get clobbered (and many have since January). Nobody can time the market, so trying to go to Treasuries and jump back into stocks or other risky assets is very tough. I don’t know anyone who can consistently do it.

Inflation is an easier environment to invest in.

Most people instantly think of gold, but I don’t believe gold is the best investment in inflation. Once again, gold is expensive to invest in and it doesn’t throw off cash. It will maintain its value over the long run, and that’s important, but other investments do better.

Commodities do well under inflation. Resource and mining companies tend to do even better. Land and real estate–as long as it’s not bought with debt–can hold up well in an inflationary environment. The things that do well in inflation tend to be tangible.

Stocks tend to do poorly in the initial stages of inflation, but then do outstandingly when inflation is brought under control. Once again, companies with pricing power do better. Companies with debt can do well as long as their debt isn’t floating (variable rate).

The problem, like with deflation, is getting the timing right. It’s not easy or even possible to do.

For that reason, I have a different approach than most to investing in a deflationary and then inflationary environment, especially because I know I can’t get the timing right on when deflation will turn into inflation.

First, I am buying high qualities companies with pricing power. They should fall less during deflation and should recover more quickly when inflation kicks in.

Second, I am buying companies with resource exposure as the market goes down. I can lock in better and better prices on the way down, and then really do well as inflation kicks in.

Third, I’m investing in foreign companies. When the dollar goes down for U.S. macro-economic reasons, that doesn’t mean other country’s currency will go down, too. High quality companies with pricing power in countries with more solid economics than the U.S. fit the bill here.

Finally, I’m caring more cash than usual going into this deflationary scenario. I will have cash as the market goes down and will be able to buy great companies, resource companies and foreign companies on the way down. It’s hard to buy low if you don’t have cash because you have to pick something that will probably have gone down a lot to buy something else cheap.

Deflationary and inflationary environments are tough to invest in, but there are smart options. Timing things perfectly can’t be done, so don’t try it. Investing to benefit from such an environment, however, can allow you to build tremendous wealth over the long run, and having a disciplined plan in place helps. Happy investing!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Inflation or deflation?

One of the big arguments raging in markets is whether we face inflation or deflation going forward. This is an extremely complex subject, and I don’t believe anyone really knows, with certainty, which will happen. I certainly don’t. My educated guess is that we’ll experience deflation in the short run and then inflation in the long run.

I believe this issue is clouded because the terms “inflation” and “deflation” are used to refer to two entirely different, but related, things in reality.

One is what I’ll refer to as monetary inflation and deflation. Monetary inflation and deflation is caused when the supply of money grows faster or slower than the economy. When money is created faster than the economy grows, all things equal, then inflation results. When money is created slower than the economy grows, all things equal, then deflation results.

The second kind is what I’ll refer to as credit based inflation and deflation. Credit based inflation or deflation is caused by the creation or retraction of credit. This is very similar to monetary inflation in that banks can create money equivalents when they advance credit to borrowers using the money they gather from demand depositors (that’s your checking account–it’s lent out to borrowers). When credit money is created faster than the economy grows, you get credit based inflation, and when credit money is destroyed through bad loans or banking regulation, you get credit based deflation.

Credit inflation and deflation require more explanation, so stick with me for a little bit. Credit inflation creates an artificial demand that flows into whatever sector is popular–housing in the mid 2000’s. Credit deflation occurs when the credit expansion collapses because asset prices collapse without an ever-increasing supply of more credit–welcome to the 2007 and 2008 residential real estate bust. Credit deflation is very ugly because using borrowed money to buy a product and then finding out you can’t pay back what you borrowed creates a real decline in growth. Borrowing $100 and paying back $90, when done in the aggregate, leads to negative economic growth. No fun.

If you’re lost at this point, you’re not alone. Like I said before, this subject is complex and it doesn’t seem like anyone has a firm grasp on this overly abstract subject.

I don’t think you’ll find any conventional economists or investors using the terms I’ve used above. It’s my nomenclature and it’s based on my extensive reading and experience on the subject.

Things get very difficult to grasp because when the Fed creates money in the monetary inflation sense, it also causes banks to create credit based inflation as well. This was easy to see in the Dot Com bubble of the late 1990’s and the housing bubble of the early and mid 2000’s. In both cases, inflation didn’t show up in the conventional measures (like the consumer price index), but it was easy to see in assets prices–technology stocks in the first case and residential real estate in the second.

With that framework in mind, let me explain where I think we are now and where I think things will go. I think the monetary inflation that was unleashed to fight the Dot Com collapse created a credit inflation that went, predominantly, into residential real estate in the early and mid 2000’s. Because these loans went bad, meaning people in aggregate borrowed $100 only to find out they invested in something that was worth less than $100, we are experiencing credit based deflation.

The Federal Reserve is trying to fight that credit based deflation by using monetary inflation. This keeps prices from spiraling down, in theory, but it doesn’t make the original credit based borrowing justified. What you see, in the short term, is a credit based deflation in relative equilibrium with monetary inflation, keeping prices, as a whole, from falling.

The problem is that printing money–monetary inflation–doesn’t really solve the problem. When someone invests money and doesn’t get all their money back, then you have insolvency instead of a lack of liquidity (a lack of money to lend or spend). What needs to happen is people need to spend less than they make to replenish the capital that was lost in bad investments made with credit based money. That takes time.

When that capital is replenished and growth continues, the Fed will have to use monetary deflation–taking money out of the system–to prevent inflation. I’m not sure if you can see where this is going, but the Fed has an almost impossible task. It has to print just the right amount of money to make up for credit based deflation–and no one knows exactly what that number is–and then they have to take the exact right amount of money back out of the system when the credit based deflation ends and becomes inflation again. I think that’s a super-human task that no mere mortal can perform (not even Ben “Helicopter” Bernanke).

Perhaps a simpler way of putting it is this: the banks made a bunch of bad loans at the behest of politicians trying to bring prosperity through collusion, and then those loans went bad. Now the Fed is printing money to make up for the bad loans, but the banks aren’t lending that money out, yet, because they need to rebuild their money to make up for loan losses. When those losses are made up for and the banks start lending again, the Fed has to bring all that printed money back out of the system.

In the short run, I think the Fed isn’t printing enough money to make up for loan losses because it’s under-estimating how many bad loans were made. That’s why I think we will be experiencing deflation over the short term.

Eventually, though, due to higher saving rates (consumers have gone from saving less than 0% of their income 2 years ago to saving almost 6% of their income now), capital will be rebuilt and banks will start lending. This will not be entirely clear at the time, and the Fed (facing a lot of political pressure from the President and Congress) will not want to pull money from the system until they are sure the economy is going again. The Fed will almost certainly wait too long and not pull the money out fast enough, which will lead to inflation.

In my opinion, this will be the highest inflation we will have seen since the 1970’s. The Fed will get on the ball, eventually (like it did in the early 1980’s), and that will probably cause another nasty recession (like it did in the early 1980’s).

The result, in my humble opinion, will be deflation over the next few years and then high inflation.

Next week, I’ll address how to invest under these scenarios and why this could be an unbelievably good time to make money when everyone else is losing theirs.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.