China is looking increasingly desperate

Paper was first invented in China. So was paper money, and thus runaway inflation. It is interesting to see China return to its historical roots this week with the significant devaluation of its currency, the renminbi.  

China's actions make it look desperate. The Chinese economy is slowing down, perhaps more rapidly than the communist party in China would like. They have tried spurring stock market growth, and then propping up the stock market to prevent it from falling. Now, they are devaluing the currency to try to get the economy jump-started.

Real economic growth comes from productivity, not from printing currency, redistributing wealth, spurring stock market speculation, or punishing those profiting from stocks falling. All of China's, or Europe's, or America's, or Japan's attempts to get growth from someplace other than productivity (which isn't in the government's wheelhouse) are doomed to failure.

Devaluing the renminbi is an attempt to make Chinese goods cheaper for foreigners to buy. That "works" as long as no other country decides to devalue their currency, too. And, it assumes that market participants are too stupid to adjust prices based on currency manipulation, which history and academic research has been shown not to be the case.

It should come as little surprise that communist dictators misunderstand how a free market works. China is running the risk of not only disrupting the world economy with its actions, but also definitely proving to Chinese people that they don't know what they are doing. The risks and the results are real, and will be felt worldwide.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What if inflation isn't low?

Provocative article in CFA Institute Magazine questioning if inflation isn't really low. What if inflation stats are misreporting actual inflation? What if central banks are keeping rates low and that is causing the income inequality that so many commentators are braying about?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Inflation Path

To most people, inflation seems quite mysterious.  This is not without good reason.  

First of all, it's an abstract concept.  Inflation is not when the price of some things go up.  Just because the price of gasoline or wheat increases doesn't mean inflation is happening.  Inflation is when the price of everything, on average, goes up.  This concept isn't just abstract, it's almost impossible to measure over the short run.  Inflation isn't usually obvious until it's really climbing.

Another reason inflation seems so mysterious is because so many misunderstand when it is or isn't happening.  Politicians and economists are notorious for saying inflation isn't happening when it is, and saying inflation is happening when it isn't.  Anyone paying attention would think inflation is completely inexplicable.

It's not.  Inflation is simply when the money supply increases faster than production of goods and services.  That doesn't mean it's easy to measure, but we do know what it is.

Inflation is also terribly destructive.  As Keynes said, it is a very easy way for governments to confiscate tremendous amounts of wealth without the populous seeming to notice.  That is, until inflation gets very high.  Then it rips an economy and government apart (starting with the poorest, I might add).  

A quick look at history will reveal that few governments collapse because they have bad policies or default on debt, per se.  The thing that will destroy a country more easily than anything (besides war) is inflation.  The record is quite clear.

The path to inflation is also easily understood.  Many writers have described the process accurately, usually after an exhaustive study of history.  Peter Bernholz perhaps describes it best in Monetary Regimes and Inflation: History, Economic and Political Relationships.  

To start, you have a government conservatively financed with low taxes and limited power.  As the government extends its power over time, it gets to the point where it cannot raise taxes enough to further grow its power (people eventually refuse to pay the higher taxes either direct protest, or indirectly by violating the law).  At that point, a government starts to borrow.  The borrowing starts low and gets higher as time progresses.  At a certain point, the borrowing becomes high enough that those lending to the government demand higher interest rates.  That's when things start to come apart, and that's when the government starts creating money much faster than economic growth.  And, that's when inflation goes ballistic and things finally come apart.

This path is not followed precisely each time, but that's generally the path to high inflation.  

For example, some governments realize they are creating money too quickly and reign things in.  This is possible not solely because the people or government decide to be more rational, but because the size of government debt and spending is not too large relative to the rest of the economy.  It wasn't hard for the U.S. to get inflation back under control after the Revolutionary War, Civil War, World War II, and the 1970's (Vietnam War), because our government debt and spending weren't yet too high relative to the productive capacity of the economy.  But, it's not necessarily the case that cooler heads can prevail if the debt is too great.

The best defense against inflation is a precious metal standard, usually gold or silver (and gold has been far superior to silver, historically).  

The next best thing is a paper money standard with an independent central bank (independent of political authorities--particularly elected officials).  Unfortunately, this "next best thing" has always and everywhere been an intermediate step on the way to high inflation, usually by way of making the central bank beholden to elected officials.

I mention this because Barney Frank, a Congressman more responsible for the housing crisis than Wall Street and all the banks in the U.S. put together, is currently suggesting we make our central bank, the Federal Reserve, beholden to elected officials.  Like F.D. Roosevelt tried to stack the Supreme Court to force his policies through, Barney Frank wants to make the Federal Reserve more directly swayed by the Congress.

Now, I'd like to step back to put my above comment into context.  The U.S. government has gone from being conservatively financed (we've had an income tax for less than half our history), to grabbing more and more power (economically, militarily, socially, etc.).  That power has been expensive, so much so that we had to start issuing larger and larger amounts of debt to finance that growth in power.  As that occurred, the U.S. went off its domestic gold standard in 1933 and off the international gold standard in 1971.  Since then, we've had higher and lower inflation (to the degree our independent central bank kept things in check--almost always against the will of politicians!).  With the growth of our welfare state, particularly in the form of Social Security and Medicare, our government has racked up tremendous financial obligations, far out-weighing our military spending or any other spending (including those dreadful bank bailouts).  

Governments get into trouble when debt grows to exceed 90% of the economy.  That's when the economy slows because of the debt millstone around its neck.  We're either there, now, or very close.  We also know that governments get into trouble when the deficit of spending versus tax revenues grows to over 20% of spending.  We're around 30% now.

So, as our government has grown in power, it has gotten into so much debt that it is close to preventing the economy from growing its way out of the problem.  And, it has abandoned the best thing to prevent high inflation--a precious metal standard.  Added to this, there are elected officials who would like to remove our last line of defense--the independence of our central bank.  

Not good.

High inflation doesn't have to happen here, but we are getting farther and farther out on a limb that can lead us to tumble off into serious trouble.  We can decide to turn around and scramble back toward the tree.  That would require us to keep our central bank independent at a minimum, and then get back on a precious metal standard.  It will also require us to reign in our government's size relative to our economy (that means spending cuts and the restructuring of our tax system).

The inflation path is clear, and we keep taking steps down it.  Perhaps it's time to turn around.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds and Gold

David Malpass hit the nail on the head with his editorial Beyond the Gold and Bond Bubbles in the Wall Street Journal today: bonds and gold have done well because people fear both deflation and inflation.

I've been surprised to see both gold and bonds do so well over the last decade.  After all, deflation and inflation are opposites: when one performs well the other usually doesn't.  This makes bonds and gold both doing well a bit of a paradox. 

But in today's mixed message environment, it makes sense from a certain perspective.  Investors are running scared.  They seek safety in some form--any form. 

They correctly see that bad debt (lending which can't be repaid) leads to deflation, so they want to own bonds as protection.  Just look at Japan over the last 20 years: bonds performed much better than stocks.  Or, look at America during the Great Depression: bonds did much better than stocks.

But, investors also fear inflation, which is caused by too much currency growth relative to goods and services.  Witness Weimar Germany in the 1920's or the United States during the 1970's.  In both cases gold protected wealth better than stocks or bonds.

The problem with this reasoning is that it works...until it doesn't.  Let's look at what Paul Harvey called "the rest of the story." 

Bonds were a lousy investment from the bottom of the Great Depression until the 1970's.  Bonds will likely be a very poor investment in Japan over the coming 20 years.

Gold was a great investment in Weimar Germany...until hyperinflation ended.  Then it tanked.  Same with 1970's inflation here in the U.S.: gold was great...until it declined 6% a year for 20 years.

Investing to catch the waves of inflation and deflation require excellent market timing.  It only pays to ride the wave as long as you know exactly when to get off.  Getting the timing wrong--even by a little--will lead to poor results.  But, in case you don't know, no one is good at consistently timing the market (despite all the time, effort and brainpower devoted to it). 

Warren Buffet doesn't time the market.  Neither did Peter Lynch.  Look at the Forbes 400 some time and scout out the market timers--you won't find a single one.  Trying to time the market doesn't lead to permanent wealth--it leads either to temporary or decreasing wealth.

Which is why most investors shouldn't focus on bonds and gold.  If you can time the market perfectly--and good luck on that--you can ride bond/deflation or gold/inflation.  If you are a mere mortal, then don't try juggling nitroglycerin. 

If you want to build permanent wealth, you should do what Warren Buffett and a herd of other smart investors do--buy productive assets at cheap prices, which is when everyone hates them.  Productive assets are things that generate cash.  Gold doesn't.  Bonds do, but the cash they generate isn't protected against inflation (except for TIPS, but they have their own problems).  You have to own productive assets to really be protected against both inflation and deflation.

Examples include real estate, stocks, businesses, rental equipment, employment, education, etc.  These are assets you put money into and get back over time.  They can adjust to both inflation and deflation. 

Does that mean they do well in all markets?  NO!  Investing is not about what does well over a week, month, quarter, year, or even 5 years.  You invest for the long term, not for a short term kick-back--that's speculation!

But, producing assets work like a charm during both inflation and deflation.  Look at the record of stocks, real estate, owning a business, rental equipment, education, or any employment during periods of inflation and deflation.  They do poorly initially, but work very well over time.  That's because they can adjust to inflation and deflation, whereas bonds and gold cannot (gold will maintain, but not grow, value over the full cycle).

Investors flooding into bonds and gold are likely to look brilliant for a while...until they get slaughtered.  The cycle on bonds and gold tend to turn very quickly.  It will only be obvious in hindsight that the tide has turned--and by then it will be too late.

Investors patient enough to invest in producing assets at cheap prices will do well--over the long run--regardless of whether we experience inflation or deflation.  That's how I'm betting.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Gold is money, but that doesn't make it a sound investment

"Gold is money.  Everything else is credit." - John Pierpont Morgan

I must admit, I'm a bit of a gold bug. 

After studying economic and financial history for over 16 years, it's quite clear to me that wealth is not pieces of paper, but economic goods.  And money--as a store of value or medium of exchange--is not pieces of paper, either, but an objective equivalent of wealth freely chosen by economic participants. 

Over thousands of years of human history, economic actors chose first rocks and cattle, then base metals like copper, and finally precious metals like silver and gold as mediums of exchange. 

Governments, starting with Croesus in Greece, started minting coins of precious metal not because they arbitrarily decided what money should be, but because market participants were already using it and they grabbed the market for themselves (not for the first or last time, I might add).

After seizing that market, every government has proceeded to debase money by reducing the amount of precious metal in coins, and every time economic participants have adjusted their actions accordingly, revealing the debasement for what it really is--inflation.

Every time, inflation got out of hand and led to price controls that, as always, caused shortages instead of reducing inflation.  And each and every time, this led to a slowing and contraction in economic growth that eventually led people to demand money backed by specie--metal or metal-backed currency.

Both the Chinese and French boldly tried paper currency only to find it yielded the same disastrous result as metal coin debasement--but faster.  Since the 1930's, U.S. currency has not been redeemable in specie.  Since the early 1970's, U.S. currency has not been backed by specie at all.  Want to guess why the 1970's witnessed a huge spike in inflation?

Look at a dollar bill some time and you'll see written across the top "Federal Reserve Note."  A note, for those of you who don't live on planet economica perpetua (I do!), is a debt instrument--in other words, credit.  As Mr. Morgan put it, gold is money and everything else is credit.

With that overlong introduction, you get an idea of why I believe gold is money.  But, let me be clear, that doesn't necessarily make it a good investment.

I think Warren Buffett put things clearly when asked a question about inflation protected assets at his most recent annual meeting.  He noted that there were three types of assets: 1) assets backed by currency, like dollars, euros, bonds, savings accounts, 2) assets backed by something tangible, like gold, art, antique cars, diamonds, land, and 3) producing assets, like stocks, farm land, rental real estate. 

In an inflationary scenario, you can expect the first type to lose value (perhaps badly), you can expect the second to maintain value, and you can expect the third to grow in value.

I place gold firmly in the second category, which makes sense.  You expect gold to maintain value regardless of inflation, but you don't expect it to grow in value relative to the value of other things.  Gold is money, so it is a store or protector of value, not a grower of value. 

You do, however, expect the third category to continue growing regardless of inflation, because it throws off economic value.  Instead of being debased, like currency denominated assets, or maintaining value, like tangible assets, you would expect producing assets to continue producing. 

A farm continues producing corn, regardless of how corn is priced.  Stocks are priced in terms of earnings, where revenues and costs adjust to changing prices over time.  Rental real estate rates adjust to underlying currency, whether dollars, dinars, or drachma.  You get the idea. 

I know gold is money, but that doesn't make it a great investment.  Gold may preserve value, it may provide insurance against negative outcomes, but gold is not a producing asset.  You may speculate in gold prices, but that's not investing.  For my money, I want growth, not standing still or speculation.

Gold is money, no doubt, but that doesn't make it a sound investment.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Capital preservation

Investing is not as complex as most in the field like to make it out to be.  Economists, financial planners, market strategists, professors of finance and economics, etc. like to make the field seem more difficult to grasp than it is.  Not surprisingly, this serves their interests.

In the Middle Ages, when hardly anyone could read or understand Latin, men of the church had a stranglehold on religious doctrine.  If you wanted to understand or get guidance on the most important issues of the time, you had to go through the men of the church.  This served the church's interests well.

And, so it is now with investing.  Today's clergymen of finance work hard to cloak the simplicity of investing in higher math, floating abstractions, mindless charts, confusing terms.  Their efforts are not to clarify, but to obfuscate; for, if you're completely confused, then you'll need their help! 

(As an amusing aside: a former investing boss of mine, in criticizing my writing ability, complained that I wasn't writing in a sufficiently high-minded way.  He told me that magazines and newspapers were written at an 8th grade level, and so was my writing, but he wanted it at an 11th or 12th grade level.  When I commented that it might make the writing unintelligible to many of his clients, he said that was okay because his clients would prefer someone who sounded smart over actually understanding!) 

So, why do I claim that investing is simple?  I read a description of investing 16 years ago that made perfect sense and was simple, and I've used it ever since.  This description, from Benjamin Graham and David Dodd's Security Analysis, 1934:

"An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.  Operations not meeting these requirements are speculative."

No mention of alpha, beta, standard deviation, diversification, macro-economic forecasting, the efficient frontier, small cap blend, negative correlation, optimized portfolios.  You're investing if you 1) do thorough analysis, and 2) invest in securities that promise a) safety of principal and b) a satisfactory return. 

If you don't do thorough analysis or hire someone who doesn't, it's not investing, it's speculation.  No stock tips, no hunches, no astrology, no gut feel, no "I just know...", no buying lots of everything--just thorough analysis.

If you invest in securities that don't promise--first--safety of principal and--second--a  satisfactory return, then you're not investing, you're speculating.  A lot of investors focus on that second part, the satisfactory return part, but few put the emphasis necessary on the first part (which Graham and Dodd correctly made primary).

Many financial planners and investment advisors give lip service to safety of principal, or capital preservation, but few give it the attention it needs.  This lip service to capital preservation is frequently waved away with the magic of diversification.  If you put your eggs in many baskets, they say, then there's no way all your eggs will break at once.

2008, or any other financial crisis in history for that matter, should put that notion to rest.  Unfortunately, it hasn't.  Putting your eggs in poorly built baskets, no matter how many of them, is unwise.

Capital preservation is also framed in terms of volatility.  If the basket goes up and down a lot, they say, you'll get scared.  Fear is a relevant issue, but it's not the same as capital preservation.  Capital preservation is whether the eggs break or remain whole, not whether they are jostled or swung about.

Capital preservation means you get back what you put in.  Not volatility, not fear, but whether you get back what you put in.  The price of an investment may go up and down and all over, but it's still capital preservation if you get back what you put in. 

Risk, as Graham defined it, is the permanent loss of capital.  Not the temporary loss of capital, not the fear of the loss of capital, but the permanent loss of capital.  Not eggs jostled or raised and lowered, but eggs BROKEN.

If your investment returns the capital you put in, then capital has been preserved.  If not, or if the safety of that capital, upon thorough analysis, is suspect, then it's not investing.

This raises an important issue which many overlook: capital preservation is preservation of the spending power of the capital.  Not the capital quoted in dollars, drachma, cows, or shells, but the real, sustainable purchasing power of that capital.  If you put in 6 large eggs and get back 6 small ones, or if even 1 is missing, then it's not capital preservation. 

Many incorrectly think of cash or bonds as being the soundest means of capital preservation.  In most cases it is, but not if inflation occurs.  If inflation is a real threat over the time-frame that capital must be used, then capital preservation must necessarily include inflation protection.  Cash and bonds, by themselves, don't cut it.

Most investing experts focus too much on secondary, tertiary, etc., issues.  They focus on diversification, statistical "guarantees," unexamined impressions, recent history.  But, investing just isn't that complex. 

You need to do thorough analysis (examine that basket in-depth), you need to preserve capital primarily (will I get back the same number of actual eggs I put in the basket, unbroken), and you'd like to get a satisfactory return secondarily (given that the number and size of eggs is safe, can I get back more eggs than I put in). 

It's not rocket science or brain surgery--it's quite simple.

But, as Warren Buffett put it, investing is simple, but not easy.  Which means: knowing how to invest is not complex, but doing it well is difficult.  Losing weight requires you to consumer more calories than you put in--that's simple.  But doing it isn't easy--it's very difficult (especially around Christmas!).

Perhaps Buffett's investment success should lead investors to focus on his methodology (including very little of what financial clergymen sell), which starts with: capital preservation.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Fed wants MORE (?!) inflation

I know, everyone is taking pot-shots at the Federal Reserve (the YouTube video is hilarious!).  I, however, feel especially privileged to do so not because I read a lot of finance, investing and economics, but because I've always been critical of the Fed.

The Fed was originally created in 1913 after the financial panic of 1907 to prevent banking crises.  Bankers and the government had decided that banking crises could be prevented with a lender of last resort, and many judged that a government agency would be better for this purpose than the ad hoc committee of New York bankers, led by J.P. Morgan, who had previously and successfully dealt with banking crises in the past.  The original goal of the Fed was to be this lender of last resort.

Fast forward to the present, and the Fed's mandate is to maintain price stability and full employment (never mind that the Fed has a lot of control over the former and none over the latter).  As you may have quickly surmised, this has nothing to do with its original mandate.

The people at the Fed long ago decided that deflation (declining prices) was the bane of human existence after the experience of the Great Depression and watching Japan's last 20 years.  They seem to have forgotten, however, that both of those experiences were due to bad loans and not an inadequate supply of money. 

With this background, those at the Fed would much rather experience inflation than deflation.  In their infinite wisdom, they are now working hard to create inflation to fight off the boogie-man of deflation  They want to increase inflation to boost employment (never mind that inflation won't boost employment). 

But, to normal people, declining prices seem like a good thing.  In fact, during a deep recession and recovery with 10% unemployment, most people think declining prices might be a very good thing.

That's because most people haven't been lobotomized by a PhD in economics to believe that declining prices (deflation) or stable prices (gold standard) are a bad thing. 

Most people, too, understand that printing money to create inflation won't create prosperity, but will lead to extremely negative economic consequences (Zimbabwe or Weimar Germany, anyone?). 

Why don't the people at the Fed possess such common sense?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

QE2 launched to much fanfare

This was no buy the rumor, sell the news week.  This week, it was buy the rumor, buy the news...whatever you do, just buy, buy, BUY!

The Federal Reserve will create dollars out of thin air and use them to buy debt issued by our Treasury Department, and this was good news to markets.  Everything, except the U.S. dollar, rallied. 

Happy days are here again.  A chicken in every pot, a car in every garage, prosperity for all.  Print away, dear Fed!

Okay, I'm just bitter because I thought  more than 3 people might see election outcomes, quantitative easing part 2, and 9.6% unemployment as less than good news.  I was wrong.

But, the little voice of reason in my head is screaming in protest, "How can printing money with no backing create prosperity?!  I know, for a fact, it can't!!!" 

A lower dollar means a little extra business for a couple of U.S. exporters.  But, the U.S. imports vastly more than it exports, so it means higher costs for the majority of us. 

If you don't believe me, look at commodity prices--they're up 19% since August.  The rocketing price of cotton is jacking up clothing costs.  Oil at over $86 a barrel will translate into high gasoline and heating oil prices.  Copper closing in on $4 means higher prices for electronics.  Et cetera, et cetera, et cetera.

Soon, this will translate into higher costs and lower profits for U.S. companies.  It will also mean higher prices for all U.S. consumers.

Quantitative easing will not create jobs in the U.S. or increase lending to U.S. businesses (although both of those things are occurring completely separate from and despite federal action).  The Fed's printed dollars are going to find their way into emerging markets, commodities and government bonds.  In the short run, it means "party on, Wayne"; in the long run, it means more inflation.

Oh, by the way, the last 2 times the Fed tried to create prosperity with the printing press (and the economy was not on the brink of financial collapse) ended in the dot-com crash and the housing crash. 

While the party is going, it will seem great, just like the NASDAQ and housing bubbles back in 1999 and 2006.  But, when it ends, and few will see it coming or be prepared, it's going to hurt like no hangover we've ever experienced.

In the meantime, the markets will rally and the prudent will look foolish.  And, yes, I'm looking like a fool.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Competitive Devaluation

The issue I fear most from an economic, political and geo-political standpoint is the huge debt overhang of the largest developed economies of the world: U.S., Europe, U.K. and Japan.

Solving this nightmare is not just an issue for the developed world, either, because it also greatly impacts the developing world (especially Brazil, Russia, China and India).

In order for the developed economies to pay off their debt, they must either grow their way out of debt or print money to inflate away the debt they owe. 

Growth would be the best and most honorable way to solve the problem, but growth in developed economies is inhibited by high debt loads (which lead to slower growth) and huge social programs (Medicare, Medicaid, Social Security and their equivalents in the other developed economies).

I'm sorry to admit it, but democracies have never successfully voted away social programs, and I don't think they will this time, either.

That leaves inflation.

But, inflation is a nasty solution to debt problems. 

From an economic standpoint inflation is tough to put back in the bottle once you let it out.  If you think the Federal Reserve or any other central bank has a dial they can turn to 3%, 5%, or any other specific level of inflation, I'm sorry to let you know that smurfs aren't real, either.

Inflation crimps a whole economy as everyone--from employees to employers, from government bureaucrats to private companies--becomes bogged down in trying to figure out wages, salaries, costs, prices, tax rates, etc.  No high inflation economy runs smoothly and efficiently.

The political and geo-political stage started to ripple this week as the U.S. Congress is trying to pressure China into revaluing their currency and Brazil's Finance Minister remarked that an "international currency war" is taking place as governments manipulate their currencies to improve their export effectiveness.  Japan recently announced they will be active in currency markets to prevent the price of the yen from rising too much and becoming uncompetitive in global markets.  These trends will result in the beggar thy neighbor problem I highlighted in a previous blog.

This competitive devaluation process is a race to the bottom and has an ugly history.  In the past it's led to world war and economic collapse.  I wish I could say these were idle fears, but they are not.

The U.S. economy currently has low inflation, and that looks set to last until the private market works down its bad debt problem (which I think will happen over the next 3 - 5 years).  Some believe the U.S. economy will experience the low inflation, deflation and low interest rates of Japan over the last 20 years.  In that environment, cash and bonds will do very well.

Never say never, but I doubt we'll experience what Japan did.  In that case, inflation is the more likely threat, and that's not a good scenario for owning a lot of bonds or cash.

The competitive devaluation that's occurring does not need to continue, so my fears may be unjustified.  Even if they are justified, the end-game is unlikely to play out soon, but over the next decade.  Hope is not a strategy, so I'm hoping for the best while preparing for the worst.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Raging debate.

The investing world has divided itself into two camps: those fearing inflation and those fearing deflation. A debate is raging about what we'll face going forward and the appropriate way to invest under each scenario.

This debate is not between dummies. I'm not referring to the talking heads on TV or the perma-bulls of Wall Street who perpetually advise buying stocks NOW! Nor am a talking about the perma-bears and gold bugs that advise canned food and fall-out shelters.

I'm talking about the smart investors who saw the 2000 tech bubble and the 2008 housing bubble popping years in advance. They made money when almost everyone else lost it.

They were in complete agreement back in 2000 and 2008, but now they aren't. Now, they hold diametrically opposed views about the economy and where to invest.

If we face deflation, you should hold cash and buy high quality fixed income instruments. If we face inflation, you should buy commodities and stocks that will thrive in a rising price environment.

They are in total disagreement about which one we face and are ripping each other to shreds in articles and interviews. I've never seen such strong disagreement between the smartest in the field.

The outcome really matters. If you invest in cash and bonds and inflation occurs, you'll get killed; if you invest in commodities and stocks and deflation occurs, you'll get killed. This is no mere academic debate. This will impact the lives of millions of investors.

Like many, I don't know how this story ends. It's my opinion we'll experience deflation until bad debt is squeezed from the system and then inflation from there. The problem is getting the timing right of when we go from deflation to inflation (and correctly guessing ahead of the herd when the crowd will recognize that shift).

And, to further confuse things, the outcome depends more on the decisions of government officials than economic analysis. If they print lots of money, we'll get inflation. If they don't, we'll have deflation. We're in an uncomfortable position.

I don't think it's possible to get the timing right, so I'm not trying. Instead, I want to own instruments that can do well in either inflation or deflation. For me, that's investing in businesses with pricing power and competitive advantages that can cut costs in deflation or raise prices in inflation.

I prefer businesses with cash on hand and that pay a meaningful dividend. That's the same as owning cash and a fixed income instrument, but it has the benefit of adapting to inflationary conditions in ways that cash and bonds can't.

I'm also favoring strong management teams that own a significant chunk of the business and are focused on building shareholder wealth. A smart management team can adapt and exploit a changing environment in ways that cash, fixed income, canned goods and commodities can't.

In other words, I'm looking for the best of both worlds. I don't want to guess whether we'll experience inflation or deflation or when one or the other will kick in. Instead, I'm investing for either environment.

Such investments are likely to feel short term pain if either strong inflation or deflation occurs. But, in the long run they will survive and grow in ways the other alternatives can't.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Tipping Point?

The next crisis we face may be much worse than the housing crisis. It's what I've talked about in the space before: sovereign subprime or too much government debt.

This may seem like a problem facing far-off Greece or Hungary, but it's bigger and more problematic in the developed economies. Here, I'm talking about the big economies we typically associate with stability: Japan, Germany, France, Britain and the United States.

The issue is that such developed economies have borrowed too much money, like subprime borrowers, to live high on the hog today. This borrowing is going and has gone to generous social programs, defense, and, most insidiously, growing interest payments.

When the burden of paying debt, both interest and principal payments, get too high relative to incoming money (taxes) or an economy's size (GDP), you get to a tipping point where there's no where to go but down.

This problem is exacerbated by two additional issues: who did you borrow from and when do you owe them principal.

If you borrow from your own citizens, you're in a better situation than when you borrow from foreigners, especially when those foreigners aren't your best friend (hello, China).

If you borrow the money short instead of long term, you face the same problem as paying off a credit card versus a home loan--no credit card will give you wiggle room while you get your financial house in order.

Japan and Britain borrowed mostly from their own citizens. The U.S. borrowed mostly from Japan and China. Japan and Britain predominantly borrowed long term, the U.S. borrowed short term and must roll over most of its debt over the next several years.

The U.S. has an advantage over Japan, Britain, France and Germany, though: our economy grows faster and so does our population (both organically and from immigration). This gives us some wiggle room they don't have.

Back to the tipping point issue. When interest payments get too high relative to economic production or tax revenues, those who lent you money want a higher interest rate. Guess what a higher interest rate does to those interest payments? Yep, higher and higher.

You can see why there's a tipping point--once you reach a certain threshold, people start to doubt you can pay and want higher interest payments (or won't lend you money), which creates a vicious cycle.

The developed economies of the world are entering that vicious cycle over the coming years. We stand on a knife's edge and can chose, now, to stay on the good side or go to the dark side. And, we don't have much time to chose.

If you tip to the dark side, what do you have to do? Theoretically, you can grow your way out of trouble, lower your interest payments, get bailed out by someone else, cut spending and jack up taxes, print money (inflation) to pay back loans, or default (also known as restructuring, repudiation, rescheduling, etc.).

The U.S. has been growing its way out of trouble for over 200 years. Unfortunately, when government spending grows to a certain percentage of the economy, your growth rate slows dramatically. We're reaching that point, so we need to allow a lot of immigration, cut government spending, and reduce taxes to increase growth. I'm guessing the chance of any of those three happening is as great as finding a snowball near the sun's core.

Is there any way we could lower the interest rate on our debt? You'll have to ask Japan and China on that one, but don't count on it.

Is it possible that any country in the world is capable of bailing out the U.S.? Please see snowball reference above.

Can we cut our spending and raise additional taxes? We could, but in a populist environment like we're in, that will probably work as well as it has in Greece (please see riot footage as reference).

Can we inflate? This is the most likely outcome, and it won't be a lot of fun for those who lent us money or for those on a fixed income here in the U.S.--and, by the way, that's a lot of people!

Can we default? Like inflation, we can do it, but it won't be pretty and will likely be a disaster for many.

Standing on the knife's edge and looking at those six options, I would chose to knuckle down now, so we don't have to go down the path of the six. I'm not optimistic that will happen in a democracy, so I'm planning on inflation.

So should you.

(I think we'll still experience slight inflation/deflation over the next couple of years, but the turning point is hard to predict because our lenders will get to chose the timing).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds and cash just aren't that safe

Bonds are seen as safe. So is cash. But, that's not necessarily true.

For starters, bonds and cash are susceptible to higher tax rates than stocks. Whether anyone likes it or not, interest on bonds and cash are taxed at much higher rates than dividends and capital gains on stocks. That differential may change with new tax laws, but even then, stocks are likely to be taxed at lower rates.

Most significantly, bonds and cash are more prone to suffer from the impacts of inflation. That may not seem as dangerous as a 50% stock market plunge, but 4.14% inflation over 10 years will do the same thing (and is much more likely to be a permanent 50% loss versus a temporary one for stocks). Does anyone really want to bet that inflation won't be above 4% over the next 10 years considering huge government debt and budget deficits?

Finally, bonds and cash can be defaulted on. This is probably the risk most people dismiss as too unlikely, but a low likelihood is not the same as no likelihood. Bonds are more likely to default than cash, and stocks are more likely to go to zero than bonds, but bonds are not without default risk. If you hold government bonds and think they can't default, a re-reading of the history of Germany, Argentina, Russia and the Confederate States of America is in order. Think cash is default free? Check again. History has many examples including Weimar Germany, France after the South Seas Bubble, or any other example of cash not backed by specie (not yet and never aren't the same thing).

Bonds and cash can be safer than stocks, but not always. Bonds are a promise to pay, but that promise can be broken. Cash is a note (debt) issued by the Federal Reserve as legal tender, and that promise too can be broken. Bonds and cash are much more impacted by inflation and have higher tax rates than stocks. They are not without risk.

I was reminded of this recently when I read that individual investors were generally selling stocks to buy bonds over the last year. They are rushing for a safe haven to avoid the pain of another downdraft. In the meantime, they have missed the market rally and are hoping to time the market. The history of individual investors, especially as a herd, being right on something like this is extremely poor.

The very fact that so many retail investors are racing to bonds together as a herd is enough to remind me of how badly bonds and cash can do. The next couple of years are likely to remind investors that not even bonds or cash are completely safe.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

How to invest with deflation/inflation

Last week, I talked about why I thought we'd be experiencing deflation over the short term and inflation over the long run. This week, I'll discuss how to invest in both scenarios.

A deflationary environment is the harder of the two.

The thing that does best is U.S. government bills, notes and bonds. This was clear late last year as U.S. Treasuries were the best performing asset class. Cash and gold did okay as well, but U.S. Treasuries were the all-star.

Not much else does well in deflation. Some people think other bonds like corporates or municipals or mortgage backed do well, but I beg to differ. The problem is that deflation usually leads corporations to collect less revenue, thus increasing default and bankruptcy risk. Municipalities suffer from less tax revenue and, unlike the Federal government, can't print money or run huge budget deficits. Mortgage backed bonds do poorly for the same reason as corporations--people default on their loans under deflation.

Gold tends to hold its value, but it doesn't produce any cash flow and it is very expensive to store, insure, etc. Cash is a great thing to have, especially if you can deploy that cash as deflation is bottoming and before inflation has taken off.

Stocks tend to get clobbered during deflation. Some companies do better than other, though. High quality companies do better than low quality companies. Companies with pricing power--that can raise and lower their prices easily--tend to do well. Companies with low or no debt do well.

Another problem with investing during deflation is timing. If deflation increases or decreases, it can dramatically impact returns. If you are sitting in U.S. Treasuries when deflation bottoms, you can get clobbered (and many have since January). Nobody can time the market, so trying to go to Treasuries and jump back into stocks or other risky assets is very tough. I don't know anyone who can consistently do it.

Inflation is an easier environment to invest in.

Most people instantly think of gold, but I don't believe gold is the best investment in inflation. Once again, gold is expensive to invest in and it doesn't throw off cash. It will maintain its value over the long run, and that's important, but other investments do better.

Commodities do well under inflation. Resource and mining companies tend to do even better. Land and real estate--as long as it's not bought with debt--can hold up well in an inflationary environment. The things that do well in inflation tend to be tangible.

Stocks tend to do poorly in the initial stages of inflation, but then do outstandingly when inflation is brought under control. Once again, companies with pricing power do better. Companies with debt can do well as long as their debt isn't floating (variable rate).

The problem, like with deflation, is getting the timing right. It's not easy or even possible to do.

For that reason, I have a different approach than most to investing in a deflationary and then inflationary environment, especially because I know I can't get the timing right on when deflation will turn into inflation.

First, I am buying high qualities companies with pricing power. They should fall less during deflation and should recover more quickly when inflation kicks in.

Second, I am buying companies with resource exposure as the market goes down. I can lock in better and better prices on the way down, and then really do well as inflation kicks in.

Third, I'm investing in foreign companies. When the dollar goes down for U.S. macro-economic reasons, that doesn't mean other country's currency will go down, too. High quality companies with pricing power in countries with more solid economics than the U.S. fit the bill here.

Finally, I'm caring more cash than usual going into this deflationary scenario. I will have cash as the market goes down and will be able to buy great companies, resource companies and foreign companies on the way down. It's hard to buy low if you don't have cash because you have to pick something that will probably have gone down a lot to buy something else cheap.

Deflationary and inflationary environments are tough to invest in, but there are smart options. Timing things perfectly can't be done, so don't try it. Investing to benefit from such an environment, however, can allow you to build tremendous wealth over the long run, and having a disciplined plan in place helps. Happy investing!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Inflation or deflation?

One of the big arguments raging in markets is whether we face inflation or deflation going forward. This is an extremely complex subject, and I don't believe anyone really knows, with certainty, which will happen. I certainly don't. My educated guess is that we'll experience deflation in the short run and then inflation in the long run.

I believe this issue is clouded because the terms "inflation" and "deflation" are used to refer to two entirely different, but related, things in reality.

One is what I'll refer to as monetary inflation and deflation. Monetary inflation and deflation is caused when the supply of money grows faster or slower than the economy. When money is created faster than the economy grows, all things equal, then inflation results. When money is created slower than the economy grows, all things equal, then deflation results.

The second kind is what I'll refer to as credit based inflation and deflation. Credit based inflation or deflation is caused by the creation or retraction of credit. This is very similar to monetary inflation in that banks can create money equivalents when they advance credit to borrowers using the money they gather from demand depositors (that's your checking account--it's lent out to borrowers). When credit money is created faster than the economy grows, you get credit based inflation, and when credit money is destroyed through bad loans or banking regulation, you get credit based deflation.

Credit inflation and deflation require more explanation, so stick with me for a little bit. Credit inflation creates an artificial demand that flows into whatever sector is popular--housing in the mid 2000's. Credit deflation occurs when the credit expansion collapses because asset prices collapse without an ever-increasing supply of more credit--welcome to the 2007 and 2008 residential real estate bust. Credit deflation is very ugly because using borrowed money to buy a product and then finding out you can't pay back what you borrowed creates a real decline in growth. Borrowing $100 and paying back $90, when done in the aggregate, leads to negative economic growth. No fun.

If you're lost at this point, you're not alone. Like I said before, this subject is complex and it doesn't seem like anyone has a firm grasp on this overly abstract subject.

I don't think you'll find any conventional economists or investors using the terms I've used above. It's my nomenclature and it's based on my extensive reading and experience on the subject.

Things get very difficult to grasp because when the Fed creates money in the monetary inflation sense, it also causes banks to create credit based inflation as well. This was easy to see in the Dot Com bubble of the late 1990's and the housing bubble of the early and mid 2000's. In both cases, inflation didn't show up in the conventional measures (like the consumer price index), but it was easy to see in assets prices--technology stocks in the first case and residential real estate in the second.

With that framework in mind, let me explain where I think we are now and where I think things will go. I think the monetary inflation that was unleashed to fight the Dot Com collapse created a credit inflation that went, predominantly, into residential real estate in the early and mid 2000's. Because these loans went bad, meaning people in aggregate borrowed $100 only to find out they invested in something that was worth less than $100, we are experiencing credit based deflation.

The Federal Reserve is trying to fight that credit based deflation by using monetary inflation. This keeps prices from spiraling down, in theory, but it doesn't make the original credit based borrowing justified. What you see, in the short term, is a credit based deflation in relative equilibrium with monetary inflation, keeping prices, as a whole, from falling.

The problem is that printing money--monetary inflation--doesn't really solve the problem. When someone invests money and doesn't get all their money back, then you have insolvency instead of a lack of liquidity (a lack of money to lend or spend). What needs to happen is people need to spend less than they make to replenish the capital that was lost in bad investments made with credit based money. That takes time.

When that capital is replenished and growth continues, the Fed will have to use monetary deflation--taking money out of the system--to prevent inflation. I'm not sure if you can see where this is going, but the Fed has an almost impossible task. It has to print just the right amount of money to make up for credit based deflation--and no one knows exactly what that number is--and then they have to take the exact right amount of money back out of the system when the credit based deflation ends and becomes inflation again. I think that's a super-human task that no mere mortal can perform (not even Ben "Helicopter" Bernanke).

Perhaps a simpler way of putting it is this: the banks made a bunch of bad loans at the behest of politicians trying to bring prosperity through collusion, and then those loans went bad. Now the Fed is printing money to make up for the bad loans, but the banks aren't lending that money out, yet, because they need to rebuild their money to make up for loan losses. When those losses are made up for and the banks start lending again, the Fed has to bring all that printed money back out of the system.

In the short run, I think the Fed isn't printing enough money to make up for loan losses because it's under-estimating how many bad loans were made. That's why I think we will be experiencing deflation over the short term.

Eventually, though, due to higher saving rates (consumers have gone from saving less than 0% of their income 2 years ago to saving almost 6% of their income now), capital will be rebuilt and banks will start lending. This will not be entirely clear at the time, and the Fed (facing a lot of political pressure from the President and Congress) will not want to pull money from the system until they are sure the economy is going again. The Fed will almost certainly wait too long and not pull the money out fast enough, which will lead to inflation.

In my opinion, this will be the highest inflation we will have seen since the 1970's. The Fed will get on the ball, eventually (like it did in the early 1980's), and that will probably cause another nasty recession (like it did in the early 1980's).

The result, in my humble opinion, will be deflation over the next few years and then high inflation.

Next week, I'll address how to invest under these scenarios and why this could be an unbelievably good time to make money when everyone else is losing theirs.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What could go wrong?

The economy seems to be getting back on its feet. New unemployment claims seem to be turning the corner. Manufacturing seems to be turning up. The housing market even seems to be stabilizing.

There are very good reasons to believe the U.S. economy may be growing again before year end.

That's the good news.

But, what could go wrong? When things look rosy, I begin to wonder what would happen if most people are wrong. There are good reasons to worry.

This is not a normal post World War II recession. This is a credit induced recession, and credit induced recessions take longer to work out. It's possible we are out of the woods, but I don't think it's likely.

For starters, the thing that got us into this recession, a credit induced binge to buy real estate, doesn't seem to have worked its way out, yet. Housing may be stabilizing, but option ARM, jumbo, Alt A and prime loans will be reseting to higher rates over the next couple of years. That could put us right back into a 2007-2008 scenario.

On the other hand, the governments of the world have done everything they can, both monetary and fiscal stimulus, to get the world economy going again. There's no such thing as a free lunch, so such stimulus will have consequences. Those consequences could include much higher inflation and perhaps even a dollar crisis.

More credit defaults would be deflationary. If the economy improves, then government stimulus will be highly inflationary. We are stuck between a rock and a hard place. If everything happens perfectly, then we'll be okay and we won't experience inflation or deflation. But, that doesn't seem to be the odds-on bet.

More likely than not, investors will want to be prepared for both contingencies. If deflation happens, then you'll want to be in solid companies with strong balance sheets and earnings power. If inflation happens, you'll want to be invested in companies that benefit disproportionally from inflation, like resource companies or companies with strong pricing power.

It's possible for us to reach a Goldilocks economy again with low inflation and good growth, but it doesn't seem likely considering the dynamics currently at play.

Be prepared for either inflation or deflation. Keep some dry powder in case great opportunities come up. Don't invest in marginal or junky companies--this is not the time to gamble.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bond market in focus

Most stock investors, myself included, tend to focus solely on how the stock market is doing. I own almost entirely stocks and so do my clients, so why focus on bond markets?

For starters, bonds are alternatives to stocks. If bond yields rise high enough, some people will sell stocks to buy bonds. If bond yields are climbing, like they have been lately, then it may lead investors to sell stocks and buy bonds.

Bonds are also a strong indicator of inflation. If bond yields are climbing, it means bond investors are probably worried about inflation. With governments around the world printing money to get the world economy going again, this worry is not unjustified. Inflation is bad for stocks in the short run, so increasing bond yields are a bad sign for stocks in the short run. If you remember the 20% stock market crash that happened in one day in 1987, you might also like to know that bond yields had been rising and the dollar sinking for months beforehand. Sounds like today in some ways...

Bond markets are good indicators of financial stress, too. When investors become worried about credit issues, they frequently flood into U.S. Treasuries, which leads to declining interest rates. Lately, interest rates have been going the other direction, indicating that worries about credit issues are declining and the economy may be recovering. This could be signaling the end of the credit crisis, and/or the beginning of a dollar crisis.

Bond markets are as vital to understanding the economy and investing as stock markets. They frequently signal economic, credit, and inflation changes long before stock markets do. It's important to pay attention to bond markets for this reason.

As I've highlighted above, interest rates have been climbing recently. Interest rates climb when bond prices go down, and are an indication that stock markets may decline because of competition with bonds or worries about inflation. Increasing interest rates can also mean the credit crisis may be ending, the economy may be improving, and investors may becoming increasingly concerned about the value of the U.S. dollar.

These are important things to consider.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The peril of bonds

Long term bonds have beaten stocks for decades.

As reported by Rob Arnott (chairman of Research Affiliates), 20 year bonds have provided better returns than the S&P 500 starting any time from the 1979 through 2008.

That's a startling fact to many investors who've been told, ad nauseam, that stocks always do better than bonds over the long run.

This out-performance by bonds has not gone unnoticed by investors, who are selling stock mutual funds and buying bond funds.

Is it time to abandon stocks and buy bonds?

No.

You shouldn't drive your car by looking in the rear view mirror, and you shouldn't invest your money that way, either. The past can be a wonderful guide to the future, if and only if situations are sufficiently similar.

But, the situation over the next 30 years is highly unlikely to be the same as it was over the last 30 years.

For starters, inflation was in double digits 30 years ago. When inflation is high, bonds sell at super-cheap prices. When high inflation is tackled, as it was by Paul Volcker in the 1980's, and continues to decline for another 20 years, as it did, then bonds have remarkable performance.

That is not the situation today. In fact, reported inflation is at an all time low, showing its first annual decline since the mid 1950's. Bond yields reflect this low inflation with record low yields.

Bonds will not perform as they did over the last 30 years because inflation isn't starting high and going to record lows. Count on it.

In addition, the threat of growing inflation is as high now as it was the last time bond rates were this low, in the 1960's.

At that point in time, government spending was going through the roof to fund new social programs like Medicare and to fight an on-going war in Vietnam. If that sounds familiar to you, it should.

The U.S. government is running record high deficits as a percentage of the economy in an attempt to jump start an economic recovery, fight on-going wars in Iraq and Afghanistan, fund social programs like universal health care, and reduce carbon emissions to prevent global warming. If you think that won't sooner or later lead to high inflation, I've got a few bridges I'd like to sell you.

Just because long bonds have done well in the past doesn't mean they will do well in the future. If deflation continues for some time, as many smart people think it will, long bonds will do well. But, I believe that situation will only be temporary.

When inflation kicks up, as I think it will, long bonds will be gutted.

Stocks may not do well in the short run, but they offer excellent long term protection against inflation. Stocks are also selling at historically low prices relative to bonds. Bonds are now priced for perfection (low or declining inflation) whereas stocks are priced for a sustained recession.

Stocks may under-perform bonds over the short run, but over the long run, I don't think its even a contest--stocks will almost certainly out-perform over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds aren't as safe as they may seem

When stock markets tank, most people think, "boy do I wish I owned bonds."

Let me make this clear--bonds are NOT riskless. Although people perceive them as riskless, they are not! Bonds face risks from default and inflation.

Many people wish they owned bonds because U.S. Treasury bonds have done so well over the last year and a half. That doesn't mean all bonds have done well. Junk bonds, corporate bonds, investment grade corporate bonds, municipal bonds, mortgage backed bonds, etc. have all been decimated.

To have done well with bonds during this downturn, you'd have needed to be prescient enough to know exactly which bonds to buy and no others. Very few people are that good at forecasting beforehand. Everyone is afterward--but those are profits you can't eat.

So, what are the risks for bonds. The first risk is the same as for stocks--what you buy can become worthless. Government bonds rarely default, but rarely is not never. The second risk is inflation. Government bonds are very vulnerable to inflation risk (the exception being inflation protected bonds, but even they face inflation risk if the consumer price index differs from your cost of living increases).

How can a bond become worthless? A bond has a senior claim on a business's assets. That means bondholders get paid before equity holders. But, that claim comes after customers and after the tax man. If a company goes bankrupt, bond holders can still be wiped out. They get paid before equity holders based on what's left, but that doesn't mean they will get paid back in full, and it doesn't mean they will get paid back with certainty.

The bigger threat to bondholders is inflation. And, here, I believe stockholders are actually better off than bondholders.

Suppose you buy a 3% bond and inflation goes up. If you own a short term bond, your impact is smaller than if you own a long term bond. A short term bond can be rolled over into a higher yields as inflation goes up. A long term bond doesn't have this luxury.

How much of an impact am I talking about? Pretty big. Suppose inflation goes up by 3% more than the market expects: the value of a 10 year bond would decline by around 20% (all things equal). A 30 year bond would decline by almost 40%! If inflation went up 6% more than people expected, then a 10 year bond would decline by 40% and a 30 year bond would decline by over 60%! If you believe bonds can't go down like stocks, think again!

The price declines I referred to above would happen quickly, but you'd still get back your full principal at maturity, right? The problem is that those dollars will be worth a lot less than they are now. Whether you sold right away or held to maturity, higher than expected inflation will hammer long term bond holders.

That's true for government bonds as much as any other bond. In fact, I believe government bonds are much more risky than usual now. Almost every other type of bond is trading at record high relative yields, so they are safer from inflation risk than government bonds that are at record low yields. Government bonds are extremely unlikely to default, but the dollars you'd receive may not be worth much.

Most people seem to under-estimate the risks of bonds. Default risk and inflation risk make them risky, whether people recognize it or not. Talk to anyone who owned bonds in the 1970's, and they'll tell you what owning bonds felt like in an inflationary and recessionary environment.

Stocks may have a lower priority claim on a business's assets, but they do adapt to inflation better. The revenues and costs of most businesses tend to keep up with inflation over time and so do their earnings. This protects them, over the long run, from the ravages of inflation. Stocks may not do well when inflation increases, but they do very well when inflation levels off or decreases. In the long run, they protect shareholders from inflation better than bonds.

Is unexpected inflation likely? Perhaps not in the short term, but over the next 3 to 5 years, I believe high inflation is very likely, and perhaps more than the 3% or 6% I referred to above.

Stocks aren't riskless, but neither are bonds. Stocks face more risk from default, but less risk from inflation. When government spending is expanding like never before and the Federal Reserve is printing money at a rapid pace, it's a good time to consider inflation protection and the fact that stocks may turn out to be less risky than bonds over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.