Tuesday, August 23, 2011

Equity Strategies for Inflationary Periods

I'm not going to speculate on which way inflation is going. These days it's very difficult to forecast anything. But if you think we are in for some high inflation, then I want to offer some strategies for protecting your wealth. I've been studying up on inflation hedges and I have found that, over the long-run, stocks offer about the best protection there is. But not all stocks are equally good hedges, and they also are not a good short-term strategy. Probably gold, silver, and commodities are better short-term strategies.But for investors, here are some tips.

1) Think long-run. Not a month, a quarter or a year. More like 5-year horizons. You might find that on the next CPI announcement day, if it is unexpectedly high, your stocks will move down. Fight the urge to sell! You will make it up over time. It's not a one-to-one hedge, though. For every 1% increase in inflation, you get about 0.5% more returns on your stocks over a 5-year window.

2) Allocate assets to non-cyclical companies. Hold more of your wealth in consumer stables. Industries like Apparel and Food and Beverage hold up better against inflation than producer goods industries.

3) Hold lower-beta stocks. No sense in doubling up on risk. If you are worried about maintaining your wealth in inflationary periods, you are better off holding less volatile stocks.

4) Diversify internationally. In the U.S. the equities don't have as much inflation hedge as in countries where people are accustomed to high inflation. Holdings in Israel can be particularly advantageous since everything there is in real terms, so by definition you keep up to inflation. Emerging markets also appear to cover for inflation spillover from the U.S., so you get a double-hedge.

5) Hold net debtors. In periods of unexpected inflation, the real value of debt goes down, leaving more of the firm for the equity holders. This isn't that big of a deal, though.

Do all of these things and you'll have a better chance to maintain your wealth in inflationary times. Above all, though, do not settle for risk-free returns that are below inflation. Then your real returns are negative, and that's bad news all 'round.


  1. Thanks for posting this. Good stuff. I became frustrated with mutual funds after realizing the S&P 500 hasn't gone anywhere in a decade, and I expect inflation to increase rather than decrease in the medium term. Although Mark Perry had a post that showed investor's expectations about inflation weren't cause for alarm.

    I don't know what a "net debtor" is, please clarify. Another difficulty is scattering such a small pittance of money between stocks you suggest. I guess I'm saying it's seems more difficult to diversify (with stocks) when the nest egg is young (small).

    I recently purchased the Motley Fool Stock Advisor. Heard of it? They publish a newsletter once a month and recommend two stocks. I've followed some of their suggestions, and it will take some time to see if they pan out. Motley also has a core they recommend, but again, it's hard to own them all unless you have a fairly large nest egg.

  2. The way I screen for net debtors is to find companies that have a long-term debt/equity ratio of higher than 1.0. So, if the firm has $500 million in equity, it also has at least $500 million in long-term debt. Don't count short-term debt like accounts payable here.

    I used to follow Motley Fool pretty regularly. My understanding is their recommendations are among the better ones out there.

    You might try looking at some ETFs. I think you can find some that concentrate on different industries. I have some mutuals that are in emerging markets, which can help too.