My macroeconomic forecast for the next 3 to 5 years which I unveiled in my last blog is for stagflation. This week's blog will be about which investments are the worst for stagflation. As for myself, I don’t tie my whole portfolio to my macroeconomic forecast. I could be wrong, so I tilt some of my portfolio to stagflation investments (10 to 20%) and the rest elsewhere. It helps to hedge so that, if my forecast is wrong, I am not forced to sell assets that have lost value. Today a lot of people are finding themselves in the unfortunate position of needing to sell their houses to raise cash to pay debt and living expenses. You never want to be forced to sell an asset that has lost value. A well-diversified portfolio is key - you never put all your eggs in one basket.
I will review all of my investments against my economic forecast to determine whether any are no-nos for the forecasted economic environment. For example, for stagflation medium and long duration bonds funds are not good investments. If I have investments that are medium or long term bond funds I will decrease or eliminate my investment in that fund.
Also, always understand the tax consequences of your investments, how the investment works and what your exit strategy will be.
Worst investments for stagflation:
Long or medium duration bonds (see blog Bonds - February 27, 2010). For example, if you are invested in Vanguard Long-Term Investment Grade Bond fund (VWESX) with the average duration of 12.1 years and interest rate increases by 2%, your investment will decrease by 24.2%. If you invested $100,000 in the fund, after the 2% increase in interest rate, your investment value would $75,800. The time to invest in long term duration bond funds is when inflation and interest rates are at their highest and will be decreasing in the future. That’s why long term bonds have been very good investments over the last 3 years with declining interest rates. Over the last 3 years Barclays Capital US Aggregate Bond Index has returned 6.14% and the S&P 500 Index has returned -4.17%. This is why you do not want to follow performance. With the economic environment changing to higher interest rates and inflation you would not want to be invested in long or medium duration bond funds.
Long term fixed rate annuities, Guaranteed Investment Contracts (GIC) or anything that pays a fixed income. GICs are like Certificates of Deposit (CDs) but they are not guaranteed by the Feds and FDIC; they are only guaranteed by the company that issues them to pay the fixed interest rate. Today you can buy a GIC that will pay you 3.0% annually for 5 years. That 3% income is locked in for 5 years. If the inflation rate is 7% you lose 4% on you investment every year. GICs work like every other type of fixed income investment that will not protect you against rising inflation. The time to buy long term fixed income investments is when inflation rates are declining.
Investments in cash, for example, CDs, savings accounts, etc. Cash, or cash equivalents, generally provide the worst protection against inflation since it will not keep up with inflation. If inflation is 9% and you are getting paid a 2% interest rate annually for your saving account in 10 years (rule of 72) you would lose almost 50% of the value of your investment to inflation. During periods of inflation you just want only enough cash for emergencies. This might be 6 months of your living expenses. You may want to do CD laddering to get the best return for your emergency cash fund.
Stocks. In the short to medium term stocks have an inverse relationship to the Consumer Price Index (CPI). You will need to be very selective on the stocks that you invest in. Pricing power is very important when you have stagflation. Companies that cannot raise prices faster than their input costs will not do well in this environment. If you are a paint manufacturer and cannot raise your prices for paint faster than your major input oil you are going to experience a decrease in profitability or lose money. This will drive down the stock price. Companies that produce durable goods do not do well in a stagflation environment. (Durable goods are products that are not purchased frequently, for example appliances, home and office furnishings, and jewelry.) Examples of companies which are unlikely to prosper in a stagflation environment:
Whirlpool (WHR)
Boeing (BA)
Tiffany (TIF)
In next week’s blog I will be talking about the best investments for stagflation. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.
© 2010 Paul Cusick
Paul
Tuesday, April 27, 2010
Monday, April 12, 2010
Stagflation and Analysis
This week’s blog is my forecast for the economy for the next 3 to 5 years and my supporting analysis. My forecast is for stagflation which is high unemployment rate with inflation. Remember the Carter administration (1976 to 1980) which is known for stagflation and the misery index (employment rate + inflation rate)? We could be headed for the same economic environment that existed in the Carter years.
Interesting URLs:
Misery index: http://www.miseryindex.us
Money supply definition (M1, M2 and M3): http://en.wikipedia.org/wiki/Money_supply
US Debt Clock: http://www.usdebtclock.org
Analysis of the major causes of inflation:
1. One of the major causes of inflation occurs when the money supply grows faster than the potential output of the economy or real GDP. Over the last two years the M1 money supply has increased by 25.5% and M2 has increased by 11.5%. For the same time period the real GDP has decreased by .5%. This will promote higher inflation rates over the next 3 to 5 years. At the same time, the Feds may decide to keep interest rates low for political reasons. Examples of political reasons why the Feds would keep interest rates low are: to keep mortgage rates down (to help get us out of the housing crisis), to promote higher employment, keep the federal government debt payment level lower, etc. This will bring about more inflation as it leads to unsustainable levels of growth and inflation because cheap money is available. With lower interest rates on treasury bonds the Feds will be the lender of last resort and will need to buy the bonds. The only way they can buy more bonds is by printing more money (just like the last two years) and increasing inflation. The Feds or Congress may also determine the only way to pay off the national debt (over $12.7 Trillion and counting) is to make money cheaper through inflation. This will be the main cause of inflation over the next 3 to 5 years.
2. Rise in production cost of goods, for example, increases in raw materials and / or labor cost. There will be very little or no increase in labor cost over the next 3 to 5 years. Instead there will be downward pressure on labor cost during this period with jobs moving overseas and high unemployment. Cost of goods increases will stem from increases in the cost of raw materials, for example, corn, wheat, oil, natural gas, etc. There will continue to be increased demand for commodities in the emerging countries (for example, China and India) which will increase the cost of raw materials. Since commodities are one of the best investments when there is inflation, hedge fund managers and other investors will increase their investments in commodities, which will further drive up the price of raw materials.
3. Change in availability of supplies. The Arab Oil embargo of the mid 1970’s is a classic example of change in availability of supplies. The embargo caused an increase in the price of gas, paint, and other oil-based products. Inflation can also arise from speculation and increased demand from emerging countries. Of all the causes of inflation, this will be the wild card over the next 3 to 5 years. Oil is currently going up because of speculation. A major political event in the Middle East, Russia, etc. could drive up the price of oil to $150 a barrel or higher. For example, Iran is bombed by the US or another country seeking to destroy their nuclear power plants.
4. The consumer demands more goods and services than are available. This can lead to the seller increasing the price of the good or service and driving up the rate of inflation. I don’t see this being a factor driving inflation over the next 3 to 5 years.
5. Inflation can be artificially created through a circular demand by workers to increase wages (for example, because a change in supply increases cost of goods) which causes an increase in production costs which increases prices and leads to further demands for higher wages. This will not occur in the current economic environment. With the high unemployment rate and with the ability of companies to move jobs overseas, workers simply do not have the power to demand wage increases.
Employment analysis:
The total number of unemployed US workers is 15 million (this is the U3 number – see definition below) out of the total work force of 154 million (unemployment rate is 9.7%). If you want to decrease the unemployment rate to 5%, there would need to be more than 7.3 million new jobs created. If the US increases new jobs by 300,000 per month (factoring in 100,000 new employees entering the work force every month) it would take 36 months to get back to 5%. U6 unemployment rate is around 20%. That is another 15 million workers over and above the U3 number. If only 50% of these workers enter the work force, that is still 7.5 million workers. Including the U6 workers it will take 72 months (6 years) to get back to a 5% unemployment rate. If the job growth is 200,000, it will take 144 months (12 years) to achieve 5% unemployment. At no period in US history have we been able to generate job growth at 300,000 for a sustained period of time. It is going to be very difficult to grow jobs at this rate with so many jobs going overseas because of lower labor cost. The unemployment rate will decrease slowly over the next 3 to 5 years.
• U1: Percentage of labor force unemployed 15 weeks or longer.
• U2: Percentage of labor force who lost jobs or completed temporary work assignments.
• U3: Official unemployment rate per ILO definition.
• U4: U3 + "discouraged workers", or those who have stopped looking for work because current economic conditions make them believe that no work is available for them.
• U5: U4 + other "marginally attached workers", or "loosely attached workers", or those who "would like" and are able to work, but have not looked for work recently.
• U6: U5 + Part time workers who want to work full time, but cannot due to economic reasons
Summary:
Over the next 3 to 5 year period there will be an increase in the inflation rate driven by the money supply increasing faster than the real GDP, increases in commodities prices driven by increasing demand of emerging countries and speculation, and the US government wanting higher inflation to pay off the debt of the US government. The unemployment rate will slowly decrease over the next 3 to 5 years. For the next 3 to 5 years, we will be in a period of stagflation.
In next week’s blog I will be talking about best investments for stagflation. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.
© 2010 Paul Cusick
Paul
Interesting URLs:
Misery index: http://www.miseryindex.us
Money supply definition (M1, M2 and M3): http://en.wikipedia.org/wiki/Money_supply
US Debt Clock: http://www.usdebtclock.org
Analysis of the major causes of inflation:
1. One of the major causes of inflation occurs when the money supply grows faster than the potential output of the economy or real GDP. Over the last two years the M1 money supply has increased by 25.5% and M2 has increased by 11.5%. For the same time period the real GDP has decreased by .5%. This will promote higher inflation rates over the next 3 to 5 years. At the same time, the Feds may decide to keep interest rates low for political reasons. Examples of political reasons why the Feds would keep interest rates low are: to keep mortgage rates down (to help get us out of the housing crisis), to promote higher employment, keep the federal government debt payment level lower, etc. This will bring about more inflation as it leads to unsustainable levels of growth and inflation because cheap money is available. With lower interest rates on treasury bonds the Feds will be the lender of last resort and will need to buy the bonds. The only way they can buy more bonds is by printing more money (just like the last two years) and increasing inflation. The Feds or Congress may also determine the only way to pay off the national debt (over $12.7 Trillion and counting) is to make money cheaper through inflation. This will be the main cause of inflation over the next 3 to 5 years.
2. Rise in production cost of goods, for example, increases in raw materials and / or labor cost. There will be very little or no increase in labor cost over the next 3 to 5 years. Instead there will be downward pressure on labor cost during this period with jobs moving overseas and high unemployment. Cost of goods increases will stem from increases in the cost of raw materials, for example, corn, wheat, oil, natural gas, etc. There will continue to be increased demand for commodities in the emerging countries (for example, China and India) which will increase the cost of raw materials. Since commodities are one of the best investments when there is inflation, hedge fund managers and other investors will increase their investments in commodities, which will further drive up the price of raw materials.
3. Change in availability of supplies. The Arab Oil embargo of the mid 1970’s is a classic example of change in availability of supplies. The embargo caused an increase in the price of gas, paint, and other oil-based products. Inflation can also arise from speculation and increased demand from emerging countries. Of all the causes of inflation, this will be the wild card over the next 3 to 5 years. Oil is currently going up because of speculation. A major political event in the Middle East, Russia, etc. could drive up the price of oil to $150 a barrel or higher. For example, Iran is bombed by the US or another country seeking to destroy their nuclear power plants.
4. The consumer demands more goods and services than are available. This can lead to the seller increasing the price of the good or service and driving up the rate of inflation. I don’t see this being a factor driving inflation over the next 3 to 5 years.
5. Inflation can be artificially created through a circular demand by workers to increase wages (for example, because a change in supply increases cost of goods) which causes an increase in production costs which increases prices and leads to further demands for higher wages. This will not occur in the current economic environment. With the high unemployment rate and with the ability of companies to move jobs overseas, workers simply do not have the power to demand wage increases.
Employment analysis:
The total number of unemployed US workers is 15 million (this is the U3 number – see definition below) out of the total work force of 154 million (unemployment rate is 9.7%). If you want to decrease the unemployment rate to 5%, there would need to be more than 7.3 million new jobs created. If the US increases new jobs by 300,000 per month (factoring in 100,000 new employees entering the work force every month) it would take 36 months to get back to 5%. U6 unemployment rate is around 20%. That is another 15 million workers over and above the U3 number. If only 50% of these workers enter the work force, that is still 7.5 million workers. Including the U6 workers it will take 72 months (6 years) to get back to a 5% unemployment rate. If the job growth is 200,000, it will take 144 months (12 years) to achieve 5% unemployment. At no period in US history have we been able to generate job growth at 300,000 for a sustained period of time. It is going to be very difficult to grow jobs at this rate with so many jobs going overseas because of lower labor cost. The unemployment rate will decrease slowly over the next 3 to 5 years.
• U1: Percentage of labor force unemployed 15 weeks or longer.
• U2: Percentage of labor force who lost jobs or completed temporary work assignments.
• U3: Official unemployment rate per ILO definition.
• U4: U3 + "discouraged workers", or those who have stopped looking for work because current economic conditions make them believe that no work is available for them.
• U5: U4 + other "marginally attached workers", or "loosely attached workers", or those who "would like" and are able to work, but have not looked for work recently.
• U6: U5 + Part time workers who want to work full time, but cannot due to economic reasons
Summary:
Over the next 3 to 5 year period there will be an increase in the inflation rate driven by the money supply increasing faster than the real GDP, increases in commodities prices driven by increasing demand of emerging countries and speculation, and the US government wanting higher inflation to pay off the debt of the US government. The unemployment rate will slowly decrease over the next 3 to 5 years. For the next 3 to 5 years, we will be in a period of stagflation.
In next week’s blog I will be talking about best investments for stagflation. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.
© 2010 Paul Cusick
Paul
Saturday, April 3, 2010
Financial Reading Recommendations & Next Blog
This week I am doing research for the next blog in which I'll discuss the most likely future economic environment for the US: deflation, inflation or stagflation (high unemployment rate with inflation) and what the best investments for that economic environment might be. The US may be headed for sustained high unemployment and inflation. Readers who are old enough may remember the aptly named misery index from the 1970s which equaled the unemployment rate plus the inflation rate. If you are interested in the misery index and the historical and current data for the misery index you can check the following website: http://www.miseryindex.us
I read some very interesting documents and websites during the last week:
A.K. Barnett-Hart's Harvard undergraduate thesis about the market for subprime mortgage backed Collator Debt Obligations (CDOs) is a must read. This may be the best, most clearly written and most interesting document about subprime mortgage backed CDOs out there. If you want to understand CDOs and all the problems/issues that caused the financial meltdown this is required reading. Better yet, it should be required reading for every US congress person and financial regulator. President Obama should invite Ms. Barnett-Hart over to the White House for lunch to get a better understanding of the financial regulations needed by the US. URL for the thesis: http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf
The Yale 2009 Endowment Investments report (thanks Barry) is a very interesting document with a lot of good financial and investment information: http://www.yale.edu/investments/Yale_Endowment_09.pdf. David Swensen, Chief Investment Officer of Yale’s endowment for the last 25 years, is one the top money managers in the world. His return on investment has been 13.4% per year over the last 20 years. He has increased his allocation goal in real assets (real estate, oil and gas and timberland) to 37% for inflation protection and to capitalize on pricing inefficiencies in the asset class (from 29% in 2008). His allocations in domestic and foreign equities have decreased by 8% from last year. After reviewing the changes he is making in the endowment’s allocations it looks like he is protecting the endowment from inflation vulnerability in the future. Thus it would seem that Mr. Swensen is betting that an inflation environment looms in our economic future.
I reviewed the Feds website on the money supply of the US: http://www.federalreserve.gov/releases/h6/Current. This site lets you check out what is happening with the US money supply. There is a lot of interesting information on this site, for example: the increase of money in saving accounts and the overall increase in US money supply since 2008. It is interesting that the Feds ceased publishing the M3 numbers in March 2006 with the result that it is now harder to track the money supply growth. M3 includes the following: M2 + all other certificate of deposits (large time deposits, institutional money market mutual fund balances, deposits of euro dollars and repurchase agreements). The Feds did this, they say, to save money and because the data was not needed. I will start checking this website once a month for economic information.
The following 3 financial books are ones that I have read over the last 3 months and recommend. If you are interested, you can select the link and get a review of the books from the Amazon website:
The Ascent of Money: A Financial History of the World
The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
The Big Short: Inside the Doomsday Machine
© 2010 Paul Cusick
Paul
I read some very interesting documents and websites during the last week:
A.K. Barnett-Hart's Harvard undergraduate thesis about the market for subprime mortgage backed Collator Debt Obligations (CDOs) is a must read. This may be the best, most clearly written and most interesting document about subprime mortgage backed CDOs out there. If you want to understand CDOs and all the problems/issues that caused the financial meltdown this is required reading. Better yet, it should be required reading for every US congress person and financial regulator. President Obama should invite Ms. Barnett-Hart over to the White House for lunch to get a better understanding of the financial regulations needed by the US. URL for the thesis: http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf
The Yale 2009 Endowment Investments report (thanks Barry) is a very interesting document with a lot of good financial and investment information: http://www.yale.edu/investments/Yale_Endowment_09.pdf. David Swensen, Chief Investment Officer of Yale’s endowment for the last 25 years, is one the top money managers in the world. His return on investment has been 13.4% per year over the last 20 years. He has increased his allocation goal in real assets (real estate, oil and gas and timberland) to 37% for inflation protection and to capitalize on pricing inefficiencies in the asset class (from 29% in 2008). His allocations in domestic and foreign equities have decreased by 8% from last year. After reviewing the changes he is making in the endowment’s allocations it looks like he is protecting the endowment from inflation vulnerability in the future. Thus it would seem that Mr. Swensen is betting that an inflation environment looms in our economic future.
I reviewed the Feds website on the money supply of the US: http://www.federalreserve.gov/releases/h6/Current. This site lets you check out what is happening with the US money supply. There is a lot of interesting information on this site, for example: the increase of money in saving accounts and the overall increase in US money supply since 2008. It is interesting that the Feds ceased publishing the M3 numbers in March 2006 with the result that it is now harder to track the money supply growth. M3 includes the following: M2 + all other certificate of deposits (large time deposits, institutional money market mutual fund balances, deposits of euro dollars and repurchase agreements). The Feds did this, they say, to save money and because the data was not needed. I will start checking this website once a month for economic information.
The following 3 financial books are ones that I have read over the last 3 months and recommend. If you are interested, you can select the link and get a review of the books from the Amazon website:
The Ascent of Money: A Financial History of the World
The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
The Big Short: Inside the Doomsday Machine
© 2010 Paul Cusick
Paul
Subscribe to:
Posts (Atom)
Posts
