Inflation Protection Securties

Seeing lots of posts about inflation recently. Thought it might be a good idea to review it and some options you have to defend against it. And I will put my personal positions at the bottom.

From Deep Risk by Bernstein

Deep Risk – Young investors series

2 types of Risk
- Shallow Risk – loss of real capital that recovers relatively quickly
- Deep Risk – permanent loss of real capital
Permanent loss of capital (negative real return over a 30-year period)
- Severe, prolonged hyperinflation – hurts stocks and bonds but bonds more
  - Wide diversification among international markets
  - A tilt toward value stocks and commodity producing companies
  - Gold bullion
  - Inflation protected securities and annuities
  - Fixed rate mortgages
- Gold bullion protects poorly against inflation and currency shocks
- Gold bullion does superbly with deflation
- Gold bullion does best when the public loses faith in the financial system
- Gold bullion is great for hyperinflation
- PME do not protect against deflation or certain disaster scenarios like gold bullion does
- You have to make choices as to what and how much you want to defend against
- Stocks in the US have done best when inflation ran between 0-4%.
- Stocks do protect against inflationary deep risk, but not in the short term. But they do protect against inflation in the long term
- To put it another way stocks, protect against deep risk, but exacerbate shallow risk
- Widespread diversification of stocks protects against inflation because it is unlikely that all nations would have massive hyperinflation at once
- Inflation devastates bondholders. Especially when it is a surprise/unexpected.
- Fixed rate mortgage payments are also good for inflation
- A value tilt also provides protection against inflation. This worked in both domestic and international
- Inflation is the most likely of the scenarios to play out. But is the easiest to protect against.
- International diversification
- Value Tilt
- PME
- Natural Resource Stocks
- Retired people should use TIPS

Skating Where the Puck Was

When credit contracts during a crisis, investors reevaluate their risk tolerance, seek the comfort of government secured vehicles, and dump all their risky assets – ALL OF THEM
Short term crashes can be painful, but long-term returns are far more important to wealth creation and destruction
Resign yourself that diversifying among risky assets provides scant shelter from bad days or bad years, but that it does help protect against bad decades and generations. Which can be far more destructive to wealth

Rational Expectations

Stocks that have the potential to have high returns during crises, especially inflationary ones, should consequently have the lowest returns of all among equity classes (Like PME)
William Bernstein believes in 3 different industry groups for consideration into a portfolio
1. REITs
2. Precious Metal Equity (PME)
3. Oil/Natural Resource Equity (NR)
Oil and Natural Resource stocks are a great inflation hedge and under appropriate circumstances, might not be unreasonable to have additional allocation to commodities producers
Don't purchase commodity futures. They are great in theory but not in practice. There used to be “Backwardation” in the futures market when investors were scared on deflation in their products and needed downside protection (IE a farmer selling his wheat crop in 9 months). Now inflation is the primary concern and futures contracts are in a condition known as “contango” which drives up the costs and reduces future returns

4 Pillars

PM funds have low expected return. But they are almost perfectly uncorrelated with the market and during global market meltdown, they are likely to do well. PM are also a hedge against inflation. But be careful with PM. Because you will be going against the market and you need to rebalance during. You will be selling when everyone on TV is saying to BUY and you will be buying when everything is good and people will tell you how dumb that is.

The only guide to alternative investments

REIT's are a great choice. But do not invest in mortgage REIT's as they are bonds and not equity
REIT's have a low correlation to both stocks and bonds. This is true of domestic and international
International REIT's can provide a benefit but their expenses tend to be higher so be careful. A 50/50 domestic and international REIT AA is a good starting place
Do not treat your personal home as a financial asset. It is a place to live. It should not be included in your overall AA plan
Investors who are not real estate professionals should gain exposure to REIT's though low-cost mutual funds and not directly buy properties as a way to achieve broad diversification
REIT's provide a reasonably good long-term hedge against inflation
5-15% is a good AA for REIT's in your portfolio
TIPS provide a guaranteed rate of return and are less volatile than nominal return bonds
TIPS have a lower correlation to equities than nominal return bonds
Commodities (Hard Assets) have negative correlation to stocks and bonds and act as a hedge against event risk (wars, disruptions, political instability, etc.) and inflation. Usually made up of Energy, Industrial Metals, PM, Ag, Livestock
CCF's do will during times of rising or unexpected inflation. But do poorly during times low or falling inflation
Larry Swedroe likes Collateralized commodity futures (CCF) and not the actual producers
William Bernstein likes commodities, but not CCF's. He likes the actual commodity producers(Example – Oil and Materials). They won't provide protection from Shallow Risk like the CCF will, but they will provide protection from deep risk.
PME's have a low correlation to both stocks and bonds both domestic and international
Excellent hedge against inflation. Especially good for retired persons who need a hedge against inflation
There is a large rebalancing bonus (as much as 5%)
PME are HIGHLY volatile so be careful and rebalance
PME tend to experience long periods of very low returns during periods of economic and political stability and short periods of high returns in times of crisis

Global investing

There is a weak negative correlation between inflation rates and stock returns
The short-term relation between equity returns and inflation is weak, but over the long term equity returns impound inflation rates
- In 1920's Germany Hyperinflation, stocks hedged inflation well, but investors would have been better off if inflation didn't take place
The negative relation between stocks and inflation is a short to intermediate term phenomenon. Over the longer terms, stocks behave as claims to real economics assets
Inflation is likely to remain a factor in society, primarily because governments spend more than they receive in taxes, forcing the governments to borrow. Monetization of this debt causes inflation.
Over the long term, real estate should provide returns competitive with those on stocks and bonds, and its low correlation with other assets makes it valuable for diversification. Real estate has also been a superior inflation hedge
Commodities futures have low correlations with other assets.
- Commodities and bonds tend to act opposite each other
- Why? Commodity futures are claims to real assets, while bonds are claims to money payments
Gold was more volatile than commodity futures but had a better return.
Commodity futures tracked inflation fairly well, but underperformed it

The delusions of crowds

Market Bubbles require 4 necessary conditions
- Technological and financial displacement
- Credit loosening
- Amnesia of the past
- Abandonment of time-honored valuation principles
Under most circumstances, the Federal Reserve cares about 2 things
- Overall state of the economy (as measured by GDP growth and unemployment)
- Keeping inflation under control
- Stock prices are of lesser concern and often wind up a bystander of the other 2 policies
The Fed primary operates via the federal funds rate (interest rate at which member banks lend to each other overnight)
- When interest rates on these are high, they attract investors. Which pulls investment from risk assets (stocks) and lowers their prices. The opposite is true

Asset Allocation

No liquid investment alternative with stable guaranteed principal exist that can provide real returns by consistently beating the combined impact of inflation and taxes
Governments are the primary beneficiaries of inflation, in part because of tax structures that tax nominal rather than real incomes
Common stocks do much better in a low inflation environment. They have performed poorly during deflation or high inflation, especially if the inflation is unexpected.
- Over the longer run, the companies can make adjustments to inflation, but in the short run those adjustments are difficult to accomplish

A Random Walk Down Wall Street

Exercise 6 – Buy a house. Real estate is a great inflation hedge. REIT's are a good choice to own commercial real estate
Exercise 8 – Gold can have a place in your portfolio (5%). It is a good diversifier and is an excellent inflation hedge. Don't invest in diamonds or Collectibles. Buy diamonds and collectibles because you like them. Not as an investment. Do NOT invest in commodities futures contracts. You will get burned. Stay away from hedge funds, private equity, and venture capital funds. They are great for the managers, not for you

Stocks For the Long Run

Under a paper money standard, bad economic times are more likely to be associated with inflation, not deflation like the 1930's. Under these circumstances, stock and bond prices tend to be more correlated. Thereby reducing the diversifying qualities of government bonds
Because of this it is unlikely that bonds will remain a good long-term diversifier, especially if inflation looms once again
Bonds are bad during inflation as they are fixed income investments whose cash flows are not adjusted for inflation.
- It is also bad for the stock market. Stocks have proved to be poor hedges against inflation in the short run. But are great in the long run
Although fascinating to observe and understand a market's reaction, investing on the basis of data releases (CPI, unemployment, etc.) is a tricky game and best left to speculators. Most investors will do well to watch from the sidelines and stick to a long-term investment strategy.
Inflation and Deflation have characterized history as far back as economists have gathered data. But since 1955, there has never been a single year in which the US consumer price index declined
Why the shift, because instead of Gold having control, now the government does and they always provide liquidity to prevent prices from declining
The market used to react more to fed policy. But investors have become so geared to watching and anticipating Fed policy that the effect of its tightening or easing is already in the market.
Stocks have an inflation hedge or an ability to maintain its purchasing power during periods of inflation
Since stocks are claims on the earnings of real assets, assets whose value is intrinsically related to the price of the goods and services they produce, one should expect that their long-term returns will not be harmed by inflation
Stock are not good hedges against inflation in the short term, but no financial asset is. In the long run however, stocks are very good hedges against inflation, while bonds are not
Smith's Common Stocks and Long-Term Investments showed that stocks outperform bonds in times of falling and well as rising prices.
Fisher found that in theory, stocks will be an ideal inflation hedge
If inflation rears its head again, investors will do much better in stocks than bonds

Safe Havens

Gold
- Hedge against the banking system.
- No counter party risk.
- Historically thought of as a hedge against inflation. But, is a very noisy hedge against inflation.
  - It is mostly tied to movements in real interest rates (When inflation goes up faster than nominal interest rates, real rates go down, pushing up gold prices).
- Mildly explosive crash (market down 15%) payoff on average (30% in the 1970's and 7% since) but, it has had a very wide range of returns since the 1970's.
- Gold is all about investors' expectations of value, it has no yield and has no intrinsic value.
  - It is for that reason impossible to fundamentally value. Its payoff profile is largely statistical as expected.
- During the 1970's, golds payoff profile made it very cost effective as a safe haven, outside of that, gold has been much less cost effective.
  - Gold has required a tactical call regarding inflation or real interest rates in order to be a cost-effective safe haven.
  - This means we need certain things to go right for gold to be an effective safe haven in mitigating systemic risk (of a crash), much less cost-effective.
  - The amount of gold needed to fully hedge our portfolio is very high adding to its carry costs.

IAA

REIT's and Precious Metals stocks can have a place in a portfolio even if they have lower expected returns
- They are inflation hedges and likely to do well in an inflationary environment in which other stocks and bonds would be adversely affected

All About Asset Allocation

Real estate is a separate asset class from stocks and bond
REITs have low correlation with stocks and bonds
Nearly all commercial lease contracts have a built-in inflation hedge. Therefore, REITs are a good inflation hedge

Below are the full posts on books by Friedman and Dalio. Deals more with central bank policy positions and how they think and act.

https://old.reddit.com/r/Bogleheads/comments/obcr4m/ray_dalio_principles_of_navigating_big_debt/

https://old.reddit.com/r/Bogleheads/comments/rh5nyu/milton_friedman_money_mischief_book_summary/

Golden Constant Book Summary

https://reddit.com/r/stocks/comments/q4p6sg/the_golden_constant_book_summary/

Permanent Portfolio article. You also have Golden Butterfly and All Weather. All versions of the same idea.

http://www.efficientfrontier.com/ef/0adhoc/harry.htm

And this is why I don't own CCF for inflation protection personally. I do own an energy ETF

http://www.efficientfrontier.com/ef/0adhoc/stuff.htm

Book Summaries and FAQ

https://reddit.com/r/u_captmorgan50/comments/rnftyk/book_summaries/

My positions