Inflation Hedging

A recently discovered this good article discussing inflation hedges.
by Dr. Krassimir Petrov, January 24, 2008:

AS THE MARKETS CONTINUE BUCKING WILDLY, and the fed slashing rates with more cuts to come, we can expect more volatility with our currency. The U.S. will likely spin into a long era of high inflation. The coming years will look like the 1970s. There is also a good risk of hyperinflation, which is a particularly severe bout of high inflation. Thus, the vital question for every investor is how to hedge, or protect, your wealth against inflation. Some, especially realtors, urge to hedge this risk with real estate. So should we really hedge with real estate?
To answer this, we need to consider two closely linked topics. First, what is an inflation hedge? Second, what makes a good inflation hedge? The first answer is simple. An inflation hedge is an asset that loses little value in periods of rising prices. Thus, it holds its value and purchasing power during inflation. This also applies to hyperinflation. An investor expecting inflation will buy this asset to hedge against inflation.

The answer to the second question requires understanding of the two basic types of assets: real assets and financial assets. Real assets have intrinsic value. They have value of their own. People value them for their direct or indirect usefulness. Examples include books, TVs, cars, wheat, gold, real estate, land, etc.

Financial assets, on the other hand, are a claim on the income or wealth of a firm, family or the government. Their typical form is a certificate or a receipt. Examples include paper money, stocks, bonds, mortgages and exchange traded funds. All money market and capital market instruments serve as examples.

In general, real assets hedge better than paper assets. By definition, real assets have a value of their own. Inflation does not erode their value. Thus, any real asset can be an inflation hedge. It follows that real estate is also a hedge, but it’s not the best.

Good hedges have a few key properties. We mention here only four. One key property of a hedge is that it holds its value. It should lose little value over time. Cars and eggs lose value over time. Land, silver and wine do not.

Another key property is marketability. This means that it is easy to sell. Other people will easily take it for payment. Hence, it is good for barter. Chairs and clothes do not sell. Corn and gold do.

A third key property is divisibility. This means that the asset splits into smaller parts without a loss of value. Houses, cars and cows are not divisible. Rice, wine, gas and gold are.

The last key property is financing. It is vital. Experts prefer to fully ignore it. Investors buy assets with either cash or credit. Cash-based hedges are good. Credit-based hedges are bad. History repeatedly shows that assets bought on credit are prone to speculation and bubbles. The hedge might be already overvalued. In this case, investors should avoid it. Credit clearly drives real estate. Moreover, real estate recently went through a wild bubble. It is grossly expensive, so a poor hedge.

The verdict is clear. Real estate is a hedge, but a poor one. It fails all of the above four tests. On the other hand, gold is a far superior hedge. Gold aces all the tests of a good hedge. That is why it is the ultimate inflation hedge. Better yet, now gold is cheap, while real estate is dear. Thus, as a hedge, gold handily beats real estate.

Real estate bought with cash, free and clear of any debt, might be a poor hedge, but it is nevertheless a hedge. It will protect the value of your money. It is not as good a hedge as gold, but it will do the job. However, we emphasize that real estate bought on credit (with a mortgage) creates substantial new risks to the investor. It’s possible to hedge one risk by assuming another, but not recommended.

So what are the risks, or traps, associated with leveraged real estate? We mention here four. First, we could be wrong! What if prices actually fall — or you have what people commonly call a deflation? Deflation kills those who borrowed to hedge with real estate, because it makes those debts more difficult to pay. Even worse, deflation triggers recession, unemployment and falling income. Similarly to what happened during the Great Depression and to Japan during the 1990s, deflation results in massive foreclosures and business failures.

Another trap for leveraged real estate is that the possibility of another credit crunch might spook the market. We saw this in February; we saw it again in August. Real estate was no place to hide then.

The third trap concerns how investors finance real estate. An ARM, or adjustable rate mortgage, can be a risky way to finance. Rising prices drive interest rates higher. Mortgage rates may rise from a modest 3-4% to 12-15%. This actually happened during the 1970s. Thus, monthly payments could easily triple. Obvious, yet millions of Americans fell for it once again in the early 2000s. Sure, they fell driven by greed. Still, many hedgers are oblivious to this.

The last trap is by far the most insidious, for it is the hardest to see. Inflation overwhelms the borrower; it eats him alive. Before long, food prices double, gas doubles, electricity doubles; prices of all the basic needs double in short order. Yet salaries do not; they lag far behind prices. Oftentimes, as in the 1970s, salaries lag many years behind. Similarly, prices of basic goods, such as food and energy, have more than doubled since 2002. Eventually, there comes the time that after paying for your basic needs, there’s not enough left to pay the mortgage. Let’s further clarify this point with an example.

Say the borrower makes $2,000 — $1,000 goes to pay the mortgage; the other $1,000 goes to pay the bills. Rising food and gasoline prices squeeze the borrower. To pay the bills, he cuts down on consumption, but the bills overwhelm him — they cost him now $1,600. He got a raise and his salary is now $2,300, but he must still borrow some more, maybe on his credit cards, to pay the bills and keep up with the mortgage. He falls deeper and deeper into debt. The higher interest on the credit drains more and more of his income, leaving less for living expenses and the mortgage. Eventually, the consumer buckles. Only now it becomes apparent that he erred — he knew all along that he was paying off his mortgage with cheaper dollars, but he didn’t realize that the same cheap dollars made up his monthly salary. Even a mortgage with a fixed interest rate and fixed monthly payments did not help. Many fell for this in the 1970s, but few saw it coming. Worse, many seem to fall for this today, yet no one warns them. Forewarned is forearmed!
Thus, leveraged real estate is not only a poor hedge against inflation, but also a very risky one. However, if you must hedge, then hedge with gold, not with real estate.

Source: http://whiskeyandgunpowder.com/is-real-estate-a-good-hedge-against-hyperinflation/

Navigating The Rapids

On our recent vacation in the Carolina mountains, we embarked on a day of whitewater rafting. My raft, filled with my sister's family, was led by our veteran river guide named Pappy. Throughout the trip down the river, Pappy spoke of his 29 years of experience on the river. For most of the trip, we were lulled to sleep by his solid navigation skills that took us through each Class II rapid with relative ease.

As the trip was coming to an end, Pappy prepared us for the finale, the Class III rapid called Nantahalla Falls. Our group consisted of 12 rafts and Pappy chose for us to go last so that we could pick up any "pieces" that might have not successfully navigated this more challenging rapid. Two other rafts with guides went first to set their ropes out into the water for catching those that might take an unplanned swim.

As we approached the rapid, my sister asked Pappy if it would be best for her two young boys to move to the center of the raft. Pappy, with confidence, said "no, they'll be fine". Throughout the day, we had grown confident in Pappy's navigation skills. That proved to be a fatal error.

I'm always amazed at how much confidence people have in their financial advisor. These advisors, in many cases, started their careers in some other discipline, and at some point decided to shift toward the field of financial advisement. They typically work for a large firm and provide a bunch of pretty charts that serve the purpose of convincing you to always be in the stock market. They'll say things like "you can't time the market" and coincidentally they'll propose to you the purchase of mutual funds that their company represents versus those that have better outperformed the market. They typically enter your profile into their "black box" and spit out a nice presentation portraying your customized portfolio.

I often ask these planners questions about market cycles and other non-equity investments, and typically they can't speak very intelligently about them. They only know stocks and only those stocks that some guru in their company has defined as a "buy". My conclusion is that one should be careful how much confidence and responsibility they place in the hands of these planners. As Gerald Celente has said "why are we listening to the people that didn't warn us about the crisis that has occurred?".

These planners remind my of our raft guide Pappy. He lulled us to sleep with his stories and successful ride down the easiest part of the river. When the big rapid came, Pappy proved that he didn't know everything. Don't let your portfolio end up like us in the photos below.

Footnote: Note that Pappy is dry and didn't dive in to save us from the 48 degree water!!

Finally! A Correct Prediction

I've finally made a correct prediction!!!

http://randomroving.blogspot.com/2008/12/happy-new-years.html

Brett Favre has retired again. I'm one that felt that he would have been best to retire as a Packer, but it's hard to retire the mindset of a competitor, champion, and legend.....ask Lance Armstrong about that. LA might have just destroyed the whole concept of retiring before you get past your prime. Hopefully Brett will find peace hanging out on his ranch in Kiln, MS. Weekend touch football games in his Levis should keep the spirit alive.

The Camel Ride

"My father rode a camel. I drive a car. My son flies a jet airplane. His son will ride a camel." Saudi Arabian saying

Beware of The Boogeyman!

I've made several posts in the past regarding mass social mood. I continue to sense a rise in the "fear factor".

During a watch of "Cronkite Remembers" on the Discovery Channel, I was struck by the similarities today with the McCarthyism era of the late 40's and 50's. The boogeyman then was the Communist regime. The period was deemed the "2nd Red Scare". The "1st Red Scare" occurred from 1917-20.

Wikipedia summarizes the era as this:
"During the post–World War II era of McCarthyism, many thousands of Americans were accused of being Communists or communist sympathizers and became the subject of aggressive investigations and questioning before government or private-industry panels, committees and agencies. The primary targets of such suspicions were government employees, those in the entertainment industry, educators and union activists. Suspicions were often given credence despite inconclusive or questionable evidence, and the level of threat posed by a person's real or supposed leftist associations or beliefs was often greatly exaggerated. Many people suffered loss of employment, destruction of their careers, and even imprisonment. Most of these punishments came about through trial verdicts later overturned,laws that would be declared unconstitutional, dismissals for reasons later declared illegal or extra-legal procedures that would come into general disrepute."

Today's boogeyman appears to be Muslims. We've deemed them all jihadists that want to kill all Americans. We've deemed ourselves experts of the Koran and have confirmed that they are enemy #1.

A few weeks ago I was invited via email to the showing of a film about how Muslims are secretly taking over our country. The most alarming thing to me was that it came from a sane person that I respect and more striking was that a Baptist church was hosting the event.

I continue to state that we can learn a lot from history. The McCarthyism era proved to be a boogeyman hunt. This one will likely play out the same.

A Legend vs A Pop Icon

Back from ten days in the beautiful Carolina mountains. What a great part of the country.

It's been quite a few weeks of famous people deaths. I was saddened to hear of Walter Cronkite's death. He definitely falls in that category of greatest generation "gentlemen". He did his job with class and was a true legend in evening news. Unfortunately our media only gave us two days of Cronkite coverage and we're guaranteed additional months of Michael Jackson coverage. Why we give so much coverage to the bizarre and so little to the classy.

I had a chance to watch a few segments of the 8 part series "Cronkite Remembers" today on Discovery Channel. It's a great span of history through Cronkite's eyes. Check it out.
http://www.youtube.com/watch?v=PcoXV5nlsNU

Hyperinflation Nation

This is "must see" TV on the risks of hyperinflation:
http://www.youtube.com/watch?v=SzmYI_4XCbM

If Deflation, Then...............

If you buy into the argument for deflation then checkout Robert Prechter's 10 tips and strategies:
http://www.financialsense.com/Experts/ewave/2009/0619.html

Perspective From The Past

"Money is power, and in that government which pays all the public officers of the states will all political power be substantially concentrated.”
Andrew Jackson

“Debt is the fatal disease of republics, the first thing and the mightiest to undermine governments and corrupt the people.”
Wendell Phillips

Coin Surge

The Wall Street Journal reports:

Sales of gold and silver bullion coins were up sharply in the first half of 2009, when dealers were citing strong physical demand amid worries about other investments.

Sales remained strong but abated somewhat in late spring and early summer, but there are at least some signs it might be on the rise again, said one dealer. “Over the last 30 days, business has picked up again mostly because, I believe, there is a lot of skepticism still in the market about which way the economy is heading,” said Scott Thomas, president and chief executive of American Precious Metals Exchange in Edmond, Okla.

Bullion coins are meant to provide investors with a convenient and cost-effective way to add small amounts of precious metals to their portfolios. It is valued by the weight and the type of precious metal.

This is different from numismatic coins, which are valued on the basis of factors such as limited mintage, rarity, condition and age. The only coin in this category sold by the Mint in the first half is the 2009 Ultra High Relief Double Eagle Gold Coin that was launched in January. Sales hit 68,445 in the first half, the Mint reported.

The outlook for bullion-coin sales may hinge on whether inflation begins to rear its head or whether there are more credit-market problems, said James Cook, president of Investment Rarities in Minneapolis.

The U.S. Mint said it sold 680,500 one-ounce American Eagle gold bullion coins in the first six months of the year.

By contrast, in the first half of 2008, the Mint sold 180,000 one-ounce Eagle coins and 67,000 American Buffalo coins. (Release of 2009 Buffalo bullion coins is planned for later in the year, the Mint said.)

For all of 2008, sales of one-ounce American Eagle bullion coins totaled 794,000 and sales of one-ounce Buffalo coins totaled 172,500.

Any comparison to year-ago totals must take into account Mint sales of half-, quarter- and tenth-ounce American Eagle bullion coins that have been suspended this year due to a shortage of blanks. When including these, the combined weight of all Eagle gold coins sold in the first half of 2008 amounted to 197,500 ounces, still far short of the 2009 total of 680,500.

For all of 2008, a total of 1,172,000 Eagle coins were sold totaling 860,500 ounces, which, in turn, was a sharp increase from 409,500 coins totaling 198,500 ounces in 2007.

Source:
http://online.wsj.com/article/SB10001424052970203577304574274450380620612.html?mod=googlenews_wsj

The Chinese Gold Rush

In this interview, it is revealed that China is pursuing an $80 billion gold acquisition (two Fort Knoxes).

http://www.youtube.com/watch?v=PUl9DedlQJw

The Pope On The Financial Crisis

"Above all, the intention to do good must not be considered incompatible with the effective capacity to produce goods. Financiers must rediscover the genuinely ethical foundation of their activity, so as not to abuse the sophisticated instruments which can serve to betray the interests of savers." Pope Benedict XVI

Source: CNN

Kissing The Sheeple

The sheeple appear to adhere to the K.I.S.S. Principle (Keep It Simple Stupid):
-viewers of Michael Jackson's memorial service: 3 billion (estimated)
-viewers of Princess Diana's funeral: 2.5 billion
-viewers of Pope John Paul II's funeral: 2 billion
-viewers of Princess Diana's wedding: 700 million
-viewers of 2005 season of American Idol: 500 million
-voters in 2008 presidential election: 125 million
-voters in 2004 presidential election: 122 million
-viewers of last episode of MASH: 106 million
-viewers of Barack Obama's inauguration: 50 million
-viewers of Ronald Reagan's inauguration: 42 million
-viewers of Ronald Reagan memorial service: 35 million

Betting On The Black Swan: The Mountain Or The Ocean?

In mid-May, I made a post regarding Nassim Taleb.

Bloomberg reports:
' "Policy makers have no control over the outcome of their actions,” Taleb said. “The plane they are flying will either hit the mountain, which is hyperinflation, or crash in the ocean, which is deflation. There is a chance of the pilot hitting the runway. But if he’s not skilled, it’s less than he thinks.” '

"Universa is buying options on about 20 products that move according to expectations about inflation, Taleb said."

The entire article:
http://www.bloomberg.com/apps/news?pid=20601087&sid=aDVgqxiT9RSg

The Wall Street Journal also reported on the story:
"Unlike last year's sudden market implosion, inflation isn't an unimaginable event that few currently anticipate. In fact, many fear inflation right now amid government efforts to goose the economy. Universa's bet, however, is that inflation will reach levels few expect."

"By opening the inflation fund, Universa is trying to capitalize on a wave of investor demand for its products, which when they're right can protect investors from extreme market moves.
The new strategy, designed by Mr. Spitznagel, aims to post big gains if inflation and interest rates take off as they did in the 1970s. Universa will invest in options tied to commodities such as corn, crude oil and copper, as well as options on stocks such as oil drillers and gold miners."

' "We think these things are going to see massive volatility," Mr. Taleb said in an interview.
The fund will also bet against Treasury bonds, which tend to weaken in inflationary environments. Last week, Treasury yields shot to their highest level since November as prices fell on inflation concerns. Oil topped $66 a barrel. Gold is creeping nearing $1,000 an ounce."

The entire WSJ story:
http://online.wsj.com/article/SB124380234786770027.html

Taleb's Ten Principles For a Black Swan-Proof World
1. What is fragile should break early while it is still small. Nothing should ever become too big
to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and
hence the most fragile – become the biggest.
2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out
should be nationalised; whatever does not need a bail-out should be free, small and riskbearing.
We have managed to combine the worst of capitalism and socialism. In France in the
1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the
government. This is surreal.
3. People who were driving a school bus blindfolded (and crashed it) should never be given a
new bus. The economics establishment (universities, regulators, central bankers, government
officials, various organisations staffed with economists) lost its legitimacy with the failure of the
system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out
of this mess. Instead, find the smart people whose hands are clean.
4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial
risks. Odds are he would cut every corner on safety to show “profits” while claiming to be
“conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry
of the bonus system that got us here. No incentives without disincentives: capitalism is about
rewards and punishments, not just rewards.
5. Counter-balance complexity with simplicity. Complexity from globalisation and highly
networked economic life needs to be countered by simplicity in financial products. The complex
economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks
to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no
room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have
proved to be mild; debt bubbles are vicious.
6. Do not give children sticks of dynamite, even if they come with a warning . Complex
derivatives need to be banned because nobody understands them and few are rational enough
to know it. Citizens must be protected from themselves, from bankers selling them “hedging”
products, and from gullible regulators who listen to economic theorists.
7. Only Ponzi schemes should depend on confidence. Governments should never need to
“restore confidence”. Cascading rumours are a product of complex systems. Governments
cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust
in the face of them.
8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the
problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a
temporary problem, it is a structural one. We need rehab.
9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement.
Economic life should be definancialised. We should learn not to use markets as storehouses of
value: they do not harbour the certainties that normal citizens require. Citizens should
experience anxiety about their own businesses (which they control), not their investments
(which they do not control).
10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift
repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to
rebuild the hull with new (stronger) materials; we will have to remake the system before it does
so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break
on its own, converting debt into equity, marginalising the economics and business school
establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting
bankers where they belong, clawing back the bonuses of those who got us here, and teaching
people to navigate a world with fewer certainties.

Then we will see an economic life closer to our biological environment: smaller companies,
richer ecology, no leverage. A world in which entrepreneurs, not bankers, take the risks and
companies are born and die every day without making the news.

In other words, a place more resistant to black swans.

Cataracts & The Green Shoots

"I had a cataract operation on my left eye about a month ago and I thought that maybe now I'll be able to see some green shoots. We're not seeing them. Whether it's retail or manufacturing or where ever. Industrial demand is down like we've never seen it."
Warren Buffet on CNBC

Happy 4th of July

Happy 4th of July to all!!

I wish everyone a great day with family and friends. As we celebrate the 233rd anniversary of our independence, I encourage and challenge everyone to be proud of our great nation from a truly patriotic perspective versus from a nationalistic one. Be proud of our technological achievements and our history of being a worldwide provider and protector.

I'll repeat this quote from my 6/23 post because I believe that it speaks accurately of the current state of affairs.

"I am patriotic. These days I like to draw the line between patriotism and nationalism. Patriotism is love of country. Nationalism is breast beating 'we are number one and kick your butt'." Peggy Noonan

Halftime Gameplan

A few years ago, a friend recommended the book "Halftime" to me. It was a very good read. The premise of the book is that we spend the first half of our lives focused more on "self" and that at mid-life, the opportunity exists to make a transformation to "giving" during the second half. The author, Bob Buford, uses the metaphor of the football halftime to illustrate how the first and second halves can be very different. He emphasizes that the 2nd half can be a time of transformation toward a more satisfying and significant life.

Checkout the book:
http://www.amazon.com/Halftime-Changing-Your-Success-Significance/dp/0310215323/ref=sr_1_1?ie=UTF8&s=books&qid=1246537866&sr=8-1

Sign up for their email communication:
http://www.halftime.org/register.aspx

The website:
http://www.halftime.org/register.aspx

Check's In The Mail

As posted prior, our individual states are one level of Sierpinski's Triangle. California IOU's mean that "the check's in the mail".

The BBC reports:
"It is the latest sign of the fiscal crisis that is spreading across the nation as the recession has had a dramatic effect on state spending. The state of California, with a GDP larger than most countries, has been among the hardest hit. On Wednesday, it said it would start issuing IOUs rather than cash payments to its creditors after the state legislature failed to agree a budget deal."

"The 50 US states play a much more important role in the US system than local authorities do in a European context. Together they make up about one-third of all public spending, or 10% of US GDP. Detroit is to close 23 schools and lay off 600 teachers. Most spending on schools, roads and welfare support is made at the state level. And the states also have an important constraint that the Federal government does not - they have nearly all passed laws in the past 20 years requiring them to have a balanced budget, and forbidding them to borrow money to pay for current spending."

"This has hit them very hard as the US recession starts to bite. States rely on sales taxes and property taxes at the local level to fund much of their spending. These revenues have plunged as the economy has gone into freefall. At the same time, they have faced higher bills to pay for the casualties of the recession. California dreaming California, the biggest and richest state in the US, has been particularly hard-hit. It has an unemployment rate of 11.5%, well above the US average, and has been at the centre of the sub-prime mortgage crisis, with more properties foreclosed than in any other state."

"Several of its biggest banks, including IndyMac, have been taken over by the federal government, and its manufacturing sector has been hard-hit by the crisis. It also has more poor people and immigrants than other states. So California faces a $26bn (£15bn) deficit on its general budget of $96bn. But it is not alone."

"According to the Center for Budget and Policy Priorities (CBPP), a Washington think tank, 48 of the 50 states are facing budget deficits this year, with a total deficit of $166bn, or 24% of their budgets. And it projects an aggregate deficit of $311bn by 2011."

The Shiny Coin

Mankind's long term stable currency (gold) took a nice dip yesterday below $930/ounce. It seemed like another invitation to purchase for the following reasons:

1) Fundamental: All of the world's major powers continue to print enormous amounts of paper money. Big Ben and Barack are printing at a record pace that can only lead to the debasement of our currency. Most believe that gold is the ultimate inflation safety net.

2) Technical: The gold price chart reveals a pattern recently that some describe as an "inverse" or "reverse" head and shoulders. It is believed to lead to a breakout upward in price.

Gold Chart ($/ounce) - My Recent Buy Points In Blue

Gold Chart ($/ounce) - Reverse Head & Shoulders Pattern

Reverse/Inverse Head & Shoulder Examples

Chart Source: Investopedia

$1000/ounce appears to be the major psychological barrier. I believe that a breaking of this barrier will lead to much higher prices in a short period of time.