inflation

A is A

© Can Stock Photo / hurricanehank

At the height of ancient Greek civilization, the philosopher Aristotle taught the Law of Identity. A is A. Everything has a single identity, not two or more, and two different things do not share the same identity. A is A. A dog is not a cat; an orange is not an orangutan, an olive is an olive.

One wonders what has been lost through the centuries, when considering Federal Reserve Bank policy. The Fed, as it is known, is charged with a dual mandate. It is supposed to promote maximum employment and stable prices.

If Aristotle were alive today, he might teach that stable prices are stable prices. This would be in accordance with the Law of Identity. A thing is what it is. Yet the Fed has adopted a 2% inflation target, supposedly in accordance with its mandate of price stability1.

At 2% inflation, a dollar today buys only 98 cents worth of goods next year and about 96 cents the year after. Prices would double every 35 years or so, under this inflation target. Over the course of a century, a dollar would shrink to about 12 cents in purchasing power. In what sense is this ‘price stability?’ It violates the simple precept that Aristotle taught 2,300 years ago.

One error some people make is presuming the things we can measure are important, and the things we cannot measure are unimportant. Higher dollar volumes of activity are presumed to be good. So when productivity or technological improvements reduce prices of things we purchase and use, we are obviously better off—but conventional economic statistics may indicate otherwise.

There are ramifications for us as investors. The threats to our prosperity from inflation may be discounted by the Federal Reserve. The advantages of technological progress are understated. We think this means we need to be more sensitive to the damage that future inflation might do to our wealth, and the opportunities presented by technological progress.

Clients, if you have any questions about this or any other pertinent topic, please email us or call.

1Board of Governors of the Federal Reserve System, https://www.federalreserve.gov/faqs/economy_14400.htm


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The opinions expressed in this material do not necessarily reflect the views of LPL Financial.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

This is a hypothetical example and is not representative of any specific investment. Your results may vary.

Two Robbers Lurk in the Shortcut

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The investment methodology promoted by most financial professionals has a costly shortcut at its core. A mathematical trick is used in place of common sense, one that simply equates volatility with risk.

The shortcut enables people to pretend that statistical models can predict the future risk in any portfolio. The model always works perfectly, until it doesn’t. Three Nobel Prize-winners using these kinds of models blew up a hedge fund with billions of dollars in 1998. The failure of Long Term Capital Management caused an international crisis.

Warren Buffett wrote a wonderful analysis of this issue in his 2014 letter to shareholders. He explained that stock prices will always be more volatile than cash holdings in the short term. But he believes that fixed-dollar investments are far riskier than widely diversified stock portfolios over the long term.

One of the robbers that lurks in the shortcut is inflation. A dollar today will only buy 98 cents worth of goods next year, and 96 cents the year after that. Buffett wrote in 2014 that the dollar had lost 87% of its purchasing power over the previous 50 years. So over the long haul, the stable fixed investment becomes quite risky in terms of the potential to melt your wealth away.

While the high risk in currency-denominated investments did its damage, the same 50 year period saw the S&P 500 advance by 11,196%. Another of the robbers lurking in the shortcut is missed opportunity for long term gains.

Fortunately, you can spot the shortcut fairly easily. Every one of the following situations involves costly confusion about volatility and risk:

1. When every market sector supposedly needs to be owned for proper diversification. Our view: Some sectors are overpriced and should not be owned—tech stocks in 2000, real estate in 2007, commodities in 2011, and so forth.

2. When the presence of declining elements in a portfolio is held as proof of proper investment process—the idea that some things always zig when others zag, and keep the whole bucket more stable. Our view: When a crisis hits, many things decline across the board.

3. When a short-term decline is spoken of as ‘a loss.’ Our view: This is a costly misperception, born of a short-sighted approach.

4. When the future returns of a portfolio are described as a range that will be accurate 95% of the time—this is a hallmark of the statistical model. Our view: The model knows the past. The future will be different than the past. The wheels will come off the model when these differences emerge.

No one knows what the future holds. Our approach is to avoid stampedes, seek the best bargains, and strive to own the orchard for the fruit crop. These principles help us pick our spots, so to speak, rather than think we need to own a little bit of everything no matter what. The principles are no guarantee against loss.

The key advantage in our method, we believe, is avoiding the robbers who lurk in the shortcut. No systematic wealth melting from unneeded stagnant fixed investments, no missed opportunities for long term gains. We have no guarantees that our approach will be superior.

Clients, you know that one thing is required of you in order to have a chance to be successful with our methods. The understanding that volatility is NOT risk is key. Please call us or email if you would like to discuss this at greater length.


The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

The Medicine is Worse than the Disease

© Can Stock Photo Inc. / nebari

Monetary authorities took extreme measures during and after the financial crisis. These policies failed in their stated goal. More importantly, they have the potential for much mischief in the portfolios of the unwary in the months and years ahead.

Fed Chairman Ben Bernanke made it clear that the role of zero interest rates and Quantitative Easing was to push money into productive investments (or “risk assets”) that would help the economy grow. Instead, the biggest tidal wave of money ever flooded into supposedly safe assets, like Treasury bonds. Money flows into US stocks disappeared in the crisis, and basically have never come back. Zero interest worked exactly opposite the way it was supposed to. This obvious reality is totally ignored by the central bankers.

Current Federal Reserve Chair Janet Yellen continues to parrot the party line. Progress toward undoing the mistaken crisis policies has been excruciatingly slow. And the potential for damage to safety-seeking investors continues to mount. Similar policies, or worse, are in effect around the world.

Standard & Poor’s recently issued a report stating that corporate debt would grow from a little over $50 trillion now to $75 trillion by 2021, globally. Bonds are the largest single form of corporate debt, which is how investors are affected. This isn’t happening because corporations are investing so much money in new plants and equipment and research. It is merely meeting the demand of safety-seeking investors for places to put money. We think of this as “the safety bubble.” It appears to be the biggest bubble in history.

Standard & Poor’s is warning of future defaults from companies that borrowed too much money at these artificially low interest rates. Our concern is that when interest rates inevitably rise, people locked into low interest investments will see large market value losses even if their bonds are ultimately repaid.

We’ve written about the impact of higher inflation on today’s supposedly safe investments. Now the warning from S&P highlights another risk. The distortions created by counter-productive monetary policy are growing.

Of course, we believe our portfolios are constructed to defend against these risks, and to profit from the artificially low interest rates. We will continue to monitor these and other developments. If you have questions or comments, please email or call us.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Deflated Inflation Expectations

© Can Stock Photo Inc. / NataliyaShirokova

We’ve written before about inflation and its corrosive effect over time. The topic has become much more timely because of two developments:

1. The prospects for inflation have gone up with the large increase in the price of oil and other forms of energy. We could potentially see annual inflation indicators top 3% within the next six months.

2. Money continues to flood into long-term low rate fixed income, as safety-seekers buy bonds yielding in the 1 and 2 percent range.

It appears these trends are in for quite a collision. Our first principle is ‘Avoid stampedes in the markets.’ So we suspect that the safety-seekers may not end up with what they were seeking. If today’s 2% bond is repriced in a 3% world, capital losses may result.

Human tendency is to expect current conditions and trends to continue. So the prospects for inflation are pretty much ‘out of sight, out of mind,’ since we have not had much inflation for quite a while. But the large increases in the price of oil and other raw materials could potentially generate annual inflation rates in excess of 3% over the next few months. Crude oil, for example, bottomed at $28 per barrel in February 2016. Current prices in the $40’s, if they persist until February 2017, will exert a lot of upward pressure on inflation.1

One would expect that investors locked in at 2% yields when inflation is running at 3% will not sit still for it. The mystery is, will the stampede of money into bonds come stampeding back out if safety-seekers find losses on their supposedly safe investments?

The potential for profit lives in the gap between expectations and unfolding reality. We believe inflation expectations and corresponding investment yields are off the mark. We have no guarantees, but our opinion is inflation will be up and bond prices will be down in the months and years ahead. If you would like to talk about the ramifications on our portfolios or yours, write or call.

1Oil prices retrieved via Federal Reserve Bank of St. Louis


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield.

The economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Inflated Expectations

© Can Stock Photo Inc. / smuay

Back in 1970, gas was 25 cents a gallon and you could buy a liter of Coca-Cola for 15 cents. We all know that money is not what it used to be. When planning for the future, we need to remember that our money is not always going to be what it is now, either.

Conventional monetary policy aims for “normal” levels of inflation in the low 2-3% range per year. That may not sound like much, but it adds up. At this level of inflation, prices double approximately every 30 years. If you bury a dollar in the ground and dig it back up in 30 years, you can expect it to only buy half of what it could buy today.

For some people, this is fantastic news. If you take out a mortgage to buy a house, it gradually becomes easier for you to pay it off over the lifetime of the loan. At the end of a 30 year mortgage you’ll still be paying off the same amount, but the prices of everything else (including your wages) will have doubled. A small amount of inflation gives people incentives to invest and take risks with their money, helping make the economy more productive.

If you’re planning to retire on fixed assets, however, inflation poses a serious threat to you. With advances in healthcare it’s not unreasonable to expect new retirees to live another 30 years. After thirty years of inflation your retirement assets will only buy half as much in groceries and rent. Retirement funds that seem generous when you’re 65 may leave you in dire straits when you’re 95.

The simplest way to fix this is just to have more money than you’ll ever need—it doesn’t matter if your money loses spending power if you have even more money to spend. Of course, this is easier said than done! Saving diligently and spending wisely will only take you so far. If your retirement bucket isn’t big enough to weather inflation, you need to be able to grow your bucket. A balanced growth and income portfolio can potentially give you retirement income while still having some growth possibilities.

There are no guarantees; the future is full of uncertainty. Growth-oriented holdings can be volatile, and it takes steady nerves to watch the value of your retirement holdings going up and down. If you can tolerate it, though, including growth holdings as part of your retirement portfolio can give you a chance to stay ahead of inflation.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Not All That Glitters is Gold

© www.canstockphoto.com / scanrail

The gold standard is a seductive idea that tends to emerge in times of economic confusion. We see this today with the anxiety surrounding the Federal Reserve’s long-anticipated rate increase. Gold is synonymous with wealth, and a gold-based currency represents stability in a world of economic uncertainty… or so we think.

Unfortunately the reality is more complex. The value of a currency is based on two things: the amount of that currency, and the amount of economic wealth it represents. If our supply of currency increases at the same rate as the supply of “stuff” for it to buy, prices remain stable.

If the supply of currency grows faster than the supply of “stuff”, it takes more currency to buy the same amount. Prices rise, and then we have inflation. The gold standard is not a guarantee against this: sudden increases in the gold supply (such as from a mining boom) can create spikes of inflation in a gold-based economy. This risk decreases as we accumulate more gold stockpiles, but gold supplies can still be manipulated by currency speculators in the open market, doing serious damage to gold-based economies.

Worse, even if we could keep the supply of gold stable, the supply of “stuff” is not. If a large amount of wealth is wiped out (by wars, natural disasters, or economic collapse) then we have inflation again as there is now too much currency for the shrinking amount of stuff, creating a “double whammy” of inflation on top of economic hardship.

If the currency supply fails to keep up with the “stuff” supply (as is likely when mineral gold reserves become depleted), it’s just as bad. In this case, the currency becomes more valuable and prices decrease. We have deflation, the opposite of inflation. This sounds fantastic at first: all our money becomes more valuable! But then we have a problem, because who wants to spend money today if they know it will be more valuable tomorrow? Everyone begins hoarding money instead of spending or investing it, creating an economic slowdown.

We don’t always agree with the Fed’s policies. However, we believe that having someone influencing the money supply on purpose is a better way to stabilize prices than crossing our fingers and hoping that our supply of shiny metals just happens to expand and contract itself as needed.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Investing involves risk including loss of principal. No strategy assures success or protects against loss.