Wednesday, May 08, 2013

What Will Tomorrow Bring: Is it a Bubble?

Stock market indexes have broken records multiple times in past weeks. Yes, this is a stock bubble.

It will likely turn into a more general bubble on the price of everything  ... which is another way of describing .... inflation. This is just the mathematical result of the very-very-very low interest rates. 

On the other hand, the Fed (or Congress) can reverse the inflation in a couple of ways, all of which are like hitting the brakes on the Titanic ... the effect takes a long time to be felt, by which time the facts on the ground have largely changed. They can:
  • Threaten to change interest rate policy and people would  immediately change their behavior. People would borrow a lot and buy a few big items in the short term, but would reduce spending in the longer term
  • Increase interest rates or bank reserve requirements. Both would have the effect of reducing new borrowing, which would in turn reduce industrial production as well as family consumption. People don't buy cars as often when car payment interest rates are high.
  • Increase tax rates without increasing spending ... or reduce spending without changing tax rates
  • Toy with the exchange rate of the dollar (for example, through tariffs or WTO complaints)
  • Continue to be unclear about future US taxation and regulation policy. People are more conservative when they don't know what the future holds
  • Impose uncomfortable (or unknown) rules on future taxation and/or regulation of borrowing, buying, selling, and/or profits. 
  • "Prick" the stock market bubble either through taxes/rules or by convincing big investors that the world is scarier than they thought it was
However, all of the above will also reduce GDP and growth, which will increase unemployment.

The tougher question is how can we avoid getting drowned by the inflation if it happens. Options would include:
  • Horde stuff now which will rise in value faster than the coming inflation ... tough to know what this would be. You have to look at supply and demand (SnD) forecasts
    • Gold is one option, but as recent history shows, the SnD situation is sketchy. The majority of the supply is held by basically a cartel of central banks (US, Germany, Italy, France, China, Switzerland, Russia, Japan in descending order ... google "world gold holdings" for details) who keep threatening to dump it. If this happens, then individuals who own gold would get screwed. Recently, the ECB has tried to make countries sell their gold prior to getting a bailout. If Italy or Japan decided to do this, gold value would fall steeply. I prefer to protect my money from politics as much as possible.
    • Other commodities are another option (metals, minerals)
    • Oil is another option, but the recently-found supplies and the alternative energy investments may mess up supply as well as demand, and the mideast can always be annoying. Politics and money again.
    • Real estate is another one. The US SnD situation is pretty predictable, but the possibility of a change to the mortgage-interest-tax-deductibility rules might screw things up. Real estate abroad is often subject to politics.
    • Other limited-supply and high-demand valuables. Fancy cars. Wines. Jewelry. Industrial metals. Bubaru. Whatever.
  • Move money into assets in a foreign currency which is not going to have as much inflation. For example, if it's $1 per 1 EUR today ... and you think that USD will inflate faster than EUR for the next 10 years ... then you might want to convert your money to EUR today. Then, in 10 years, when it's $2 per 1 EUR, you could convert it back to dollars and buy stuff here. The key to this is finding assets in that foreign currency which will appreciate at an acceptable rate vs. what you could get in $.
    For example, assume you have $1000. You can:
    • keep it in dollars and buy something like IBM stock which will increase in value. Assume USD inflation is 10% and IBM stock increases at 15% per year. This would mean that over time you would neutralize inflation PLUS gain an extra +5% of appreciation each year. The net impact on your purchasing power (=what you can buy with your money) would be an increase of+5% per year. At the end of the first year you'd have $1050
    • OR you could convert it to EUR1000 and buy something like BNPP stock.  Assume that the USD/EUR exchange rate depreciates by 5% per year due to the US inflation situation. Also assume BNPP stock increases  7% per year. This would mean that over time your total appreciation in USD terms would be 5%+7% = 12%. This would neutralize USD inflation plus an extra +2% per year. At the end of the first year, you'd have $1020 if you converted back to USD, so it wouldn't be worth all the trouble. There's also the possibility of paying double-taxes on foreign income once you bring it back to the US.
  • Which brings us to inflation-proof profit-generating assets. Owning companies (or investment properties) creates a cash flow. Some companies/properties will "float" like a boat meaning that they can increase their prices at the same rate their costs increase (at least). These "inflation proof" companies would be good investments assuming they:
    • Have an innovation/growth/improvement/efficiency plan which will allow them to expand their market share and/or charge higher prices than competitors, 
    • Are in good financial health
    • Are not vulnerable to other inflation-related issues like floating interest rates on loans (or short-term loans that they have to frequently roll over)
  • Or you can just ignore it and hope that Social Security increases with inflation ... which it historically hasn't
As always, a "portfolio" approach is probably best, rather than putting all your eggs in one basket. 

An alternative is to outsource the decision to somebody you think is super smart. Obviously, an investment advisor is one way to do this, but another way is to invest in a company that you think will be smart about maximizing value in the face of inflation. For example, Warren Buffett has survived several periods of inflation and is very watchful of inflation. His Berkshire Hathaway would ... probably ... maybe ... figure out the smartest  way to preserve value. Buying shares in that company lets you ride his coattails.