A Portfolio Against War, Inflation and Bubbles

April 3rd, 2014
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Investing Daily Article of the Week

by Richard Stavros

Whereas in the 1970s there were limited ways to hedge against inflation, now there is a cornucopia of currency and international commodities instruments that can not only hedge against inflation but other global shocks, such as market bubbles and even war.


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And it is these very scenarios that investors have been worried about. Since the beginning of the year, stocks, bonds and just about any investment you can think of have gyrated wildly at various times amid concerns of war, inflation and the possibility that the U.S. equity market is overvalued and headed for a correction.

In response, some market analysts in Bloomberg news reports have offered any number of wildly unsubstantiated statements for why investors should ignore today's perils. They dismiss the danger posed by Russia's annexation of Ukraine's Crimea region ("Putin will stop short of other countries or war with the West"). They also argue that the Federal Reserve chairwoman misspoke ("Janet Yellen really didn't mean a rate hike is coming soon. Inflation is under control. It was a rookie mistake.").

For my money, here's the most outrageous: The Shiller Cyclically adjusted P/E metric which has predicted the 1929, 2000 and 2007 downturns doesn't apply ("Suggests only a slightly expensive market with low to moderate returns going forward on average").

With new records being set by the S&P 500 in the last few months, it stands to reason that some investors have not needed much convincing to stay all in and buying. This mindset has prevailed, even as the impact of a Russian war or conflict, runaway inflation or a market correction could be devastating to investor portfolios, taking years to recover.

If you've never thought of certain investments as "insurance," it's time to start now. Protecting wealth is as important as building wealth. And as previously mentioned, we have found that the Inflation Survival Letter's Thrive and Survive Portfolios can be effective at providing protection for a number of potential wealth destroying events in addition to inflation.

Below we examine various types of investments that should be in every portfolio.

Gold: The Ultimate Safety

Market prognosticators have as of late been bearish on gold, convinced that the U.S. recovery is so real that investors won't need the insurance or value preservation that the yellow metal has provided for centuries. This attitude exists despite the potential economic shocks that could come from in an escalation in tensions with Russia, a major oil producer (recall the oil price shocks of the 1970s that caused stocks to crash and pushed the U.S. into a pronounced recession).

Moreover, the fact that the Federal Reserve is beginning to think about rate hikes means it does believe inflation will be on the increase in the coming years. This is no secret, because the central bank has actually been encouraging inflation though its stimulus program and accommodative policy.

If the market does suffer some sort of correction - as the Shiller Cyclically adjusted P/E metric suggests could happen - there are only a few investments by which investors will be able to preserve their wealth. That's why we believe investors should view any drops in the price of gold as an opportunity to buy cheap insurance.

Gold has offered protection and value creation during the latest period of high volatility in the market over news on Russia and potential rate hikes (See Chart A). The chart compares the performance of Thrive Portfolio gold miner Goldcorp (NYSE: GG), and gold prices viewed against changes in the VIX, a key measure of market expectations of near-term volatility.

Chart A: Gold Has Been the Calm in the Storm of Volatility
Created with Y Charts

Chart A

Agricultural Commodities Are the Place to Be

There's been a lot of talk about the commodities sell-off in the last few months, particularly in emerging markets. But anyone who understands that the Federal Reserve is willfully attempting to create inflation through stimulus, and also understands history, knows that central banks are terrible at timing rates.

Beyond gold, there are several commodities that offer diversification away from what is happening in U.S. equity markets, the U.S price level and geopolitical situations in far off lands. The next geopolitical struggle could be over food, notwithstanding Mr. Putin's machinations in Crimea and the Ukraine. Many experts predict that there won't be enough food to feed growing populations and agricultural commodities will double in price over the next 20 years.

For the sixth time in 11 years, up to 2012, the world consumed more food than it produced, largely because of extreme weather in the U.S. and other major food-exporting countries. Poverty fighting organizations such as Oxfam predict that the price of key staples, including wheat and rice, could double over the next two decades, threatening disastrous consequences for human populations.

The value of equal weighting the index between energy and agricultural as opposed to heavily weighting toward just energy allowed top picks GreenHaven Continuous Commodity Index (NYSE:GCC) andPowerShares DB Agriculture (NYSE: DBA) to outperform the once vaunted Jeffries TR/J CRB Commodity indices (NYSE: CRBQ), one of the oldest in the country. DBA and GCC have also beaten the S&P 500 year-to-date.

Chart B: Agricultural Commodities Have Trumped the S&P and Other Indexes
Created with Y Charts.

Chart B

Don't Forget Your TIPS

Since the beginning of the year, a steady stream of economic news has sharpened investor concerns about the threat of inflation. This data includes increased wage growth, a rebound in the labor market and higher energy prices. These economic metrics indicate growth; they also mean that as the economy improves companies will more easily pass on increased costs.

In fact, investor expectations for inflation over the next five years, as measured by comparing yields on Treasury Inflation-Protected Securities (TIPS) and nominal Treasury bonds, known as the break-even, have hit a new high in their long-term average, at 1.97, and a daily market high on March 27 of 3.55 (See Chart C), up from 1.86 on March 14, levels not seen in a year.

C: Inflation Protection and Expectations on the Rise
Created with Y Charts.
Chart C

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