Inflation Investment Ideas

Inflation Investment Ideas

Inflation continues to shock the Global economy and has become a major concern when we discuss investment ideas. This week’s data showed the Consumer Price Index up 9.1% over last year, and the Producer Price Index is up over 11%. These are numbers not seen since 1981.

Today, I’m going to share some thoughts on inflation and get into how we want to respond to this situation. But first, here is an inside look at the government response to inflation.

Federal Reserve Hitting the Brakes

Last week, I attended a breakfast meeting for the Arkansas CFA Society at the Federal Reserve office in Little Rock. Our guest speaker was James Bullard, president of the St. Louis Federal Reserve Bank and voting member of the Open Market Committee which sets interest rates.

Bullard said that we were at a profound regime switching moment today, and that this is not just a blip in inflation but a “stunning amount of inflation”. He stated that the Fed would move aggressively to reduce inflation and that they were committed to their inflation target of 2%. He thinks the Fed will continue to raise rates until policy rates are greater than the inflation rate and may need to hold those high rates for years to come to bring inflation down.

Bullard felt that the current inflation levels are not simply a temporary supply shock from the Ukraine War. Output is actually up. In March 2020, the Fed responded very quickly to support an economy crashing from COVID-19 shutdowns. 60 days later, markets recovered and housing boomed. He wishes that they had reduced their asset purchases sooner. Instead, the Fed is only now ceasing to buy bonds and is allowing their holdings to run-off as they mature. The global stimulus response was correct, but has overheated.

He was less concerned about the possibility of a recession. Bullard said that recessions are difficult to predict and that the Fed is going to focus on getting inflation under control first. Inflation remains a global problem, but the US Federal Reserve will lead the way on fighting inflation, as the European Central Bank has other issues making them slower to respond.

Inflation, Rising Rates, Recession

It’s important to understand that even if inflation remains elevated for a couple of years, the impact of inflation may only be part of the story. Our investment ideas cannot simply assume high inflation as the only factor. We have to also consider the likelihood of rising interest rates and a recession. We’d love it if the Federal Reserve can orchestrate a soft landing as they apply brakes to this runaway economy. But they have not been very good at soft landings in the past.

The Fed policies are starting to work. Since the June inflation numbers, we’ve already seen the price of oil down by 20%. Mortgage applications are down and we should start to see housing inventories normalize and home prices stop their double digit increases. Interest rates have doubled compared to last year – 5.5% versus 2.75% for a 30-year mortgage – and this will impact how much home buyers can afford to pay. The Bloomberg Commodity Index was at 130 on June 16th and is now at 113, a drop of 13% in one month.

It is hard to imagine additional inflation shocks or surprises at this point. Despite the headlines, markets already know we have inflation. Inflation remains high, but may have peaked and should be starting to come down. The question is what is next? How will the markets respond to the Fed actions? Here are five thoughts about where to go from here.

Five Inflation Investment Ideas

  1. Rising Rates. Bond investors beware. The Fed is going to continue to raise interest rates for an extended period. Keep your duration short on bonds. Consider floating rate bonds, if you don’t have any. Stay high quality – rising rates may cause defaults in weaker credits.
  2. I-Bonds. These are inflation linked US savings bonds. They’ve been in the news this year, but I’ve been writing about them since 2016. Limited to $10,000 in purchases a year. These could do great for a couple of years.
  3. Recession and Stocks. We might already be in a recession today, but won’t know it until later economic data shows a negative GDP for two quarters. Please resist the temptation to try to time the stock market. Recessions are a lagging indicator; stocks are a leading indicator and stocks will bounce back sooner. If you try to get out of stocks, it will be very difficult to get back in successfully. Instead, focus on diversification, with Value and Quality stocks. Avoid the high-flying growth names, we are already seeing those stocks get pummelled.
  4. Roth Conversions. We are in a Bear Market, with the S&P 500 Index down 20%. This could be a good time to look at Roth Conversions, if you believe as I do that stocks will come back at some point in the future. An index fund that used to be $50,000 is now trading for $40,000. Do the Roth Conversion, pay taxes on the $40,000 and then it will grow tax-free from here. This works best if you anticipate being in a similar tax bracket in retirement as today.
  5. Cash is Trash. Inflation is reducing your purchasing power. Thankfully, rising interest rates means we can now earn some money on Bonds and CDs. We can build laddered bond portfolios from 1-5 years with yields of 3-5%. And we have CDs at 3% as short as 13 months. Those are a lot better than earning 0% on cash. If you don’t need 100% liquidity, short-term bonds, CDs, and T-Bills are back.

Perseverance and Planning

I believe in long-term investing. Times like these will challenge investors to have the perseverance to stay the course. Rising rates and a possible recession in the months ahead may pose additional losses to our investment portfolios. If I thought we could successfully avoid the losses and step away from the market, I’d do that in a heartbeat. But all the evidence I have seen on market timing suggest it is unlikely to add any value, and would probably make things worse. We will stay invested, continue to rebalance, tax loss harvest, and carefully consider our options and best course of action.

With higher inflation, the cost of living in retirement increases, and so we have to aim for equity-like returns to make plans work. For our clients who are in retirement or close to retirement, we typically have a bucket with 5-years of expenses set aside in short-term bonds. And that bucket is still there and we won’t need to touch their equities for five years. In many cases, we have bonds which will mature in 2023, 2024, etc. in place to fund your spending or RMD needs. So, I am happy we have the bucket strategy in place, it is working as we had planned.

We have shared some inflation investment ideas, but I think the risks to investors may be greater from the Fed. Rising rates and recession are likely in the cards as they look to slow the economy. In spite of the headlines, this will undoubtedly be different than 1981, so I’m not sure we have an exact road map of what will happen. But, I will be your guide to continue to monitor, evaluate, and recommend what steps we want to take with our investments.

Bear Market Has Arrived

Bear Market Has Arrived

Stocks continued their slide for an eighth week. Friday’s drop now brings the S&P 500 Index down 20% from its recent peak. We are officially in a Bear Market. Tech stocks, in the Nasdaq Index, are down over 30% and have already been in a Bear Market.

Investors have questions and want to know what to do next. I’m going to share five thoughts.

One. Predictions are a waste of time. I’ve spent too much time this past week, reading, listening, and watching “experts” suggest what will happen next. No one knows. Some say the bottom is in, others call for another 20% drop. Some say inflation is here to stay, some say we are already in a recession, other say stagflation. The challenge is Confirmation Bias. Are we really evaluating evidence with an open mind? Or are we only looking for evidence which confirms our point of view? Unfortunately, certainty is one thing which we do not get to have as investors. Luckily, we don’t need a crystal ball to be successful. We know what has worked over time: diversification, index strategies, and focusing on keeping costs and taxes low.

Two. Our Investment Themes for 2022 have been helpful. Year to Date: Value stocks are doing better than growth stocks. International stocks are doing better than US Stocks. Short-Term bonds and Floating Rate bonds have held up better than the Aggregate Bond Index. We are still down an uncomfortable amount, and that is to be expected. However, we are down less than our benchmarks across all our portfolio models. I am not ever happy about Bear Markets, but our asset allocation has been a positive factor.

Three. We are at a 52-week low in many stocks and indices. Look back over the last 10, 20, or 30 years of stock market history and find those 52-week low points. Going forward, were you better off selling those lows or buying those lows? Obviously, you would have done very well by buying historic 52-week lows and selling would have been a mistake eventually. Could the market go lower from here? Of course. We don’t know what will happen next, but market timing via selling 52-week lows has been a poor strategy historically.

Read more: Are We Headed For a Bear Market? (2015)

Four. We have made a few moves in our portfolio that I wanted to share. We sold some of our convertible bonds and replaced them with a Vanguard Commodities fund. This should help us reduce equity-like exposure and add an inflation hedge. We sold one emerging markets bond fund and replaced it with a newer fund (also from Vanguard) with a much lower expense ratio. We sold bond funds and replaced them with individual bonds, laddered from 1-5 years. Although interest rates may rise, we can hold bonds to maturity and receive back our par value. Overall, these trades do not drastically change our asset allocation. But we are always looking for ways to improve our holdings, even in modest, incremental ways. We are not ignoring the market, portfolios, or clients at this time.

Five. Patience. If you are a ways off from retirement, this is a great time to dollar cost average and be buying shares in your IRA, 401(k), or brokerage account. You make money in Bear Markets, you just don’t realize it until later. For those who are close to retirement, or in retirement, we are already diversified and have a withdrawal strategy that anticipates market volatility such as this. We are planning for the next 20-30 years. There will be multiple Bear Markets over your retirement. Although each Bear Market feels like a surprise, they are bound to happen. And like in 2020, we are using the current drop as an opportunity to rebalance portfolios and do tax loss harvesting.

Read more: Stock Crash Pattern (March 2020)

We’ve seen this before. We’ve been here before. Bear Markets are an unfortunate reality of being an investor. They stink and we would all prefer if markets only went up. When times are good, we need to invest with the knowledge that Bear Markets are inevitable. And then when Bear Markets do arrive, like Winter, we need to wait out the storms knowing that Spring will eventually return.

Ignore predictions. Our investment themes are on the right track. Don’t sell a 52-week low. Look for opportunities to make small improvements. Be patient and persevere. That is how we are responding to the Bear.

5 Ways to Buy The Dip

5 Ways to Buy The Dip

Right now, we are talking to investors about ways to buy the dip. From the highs of December, it is pretty remarkable how quickly markets have reversed. Stocks were already down in January as fears of inflation and rising interest rates took hold. The war in Ukraine has shocked the world and we are seeing tragic consequences of this inexcusable aggression. Inflation was reported at 7.9% for February and that was before we saw gas prices surge in March following the Russia sanctions.

This past Tuesday, we saw 52-week lows in international stock funds, such as the Vanguard Developed Markets Index (VEA) and the Vanguard Emerging Markets Index (VWO). Here at home, the tech-heavy NASDAQ is down 20%, the threshold used to describe a Bear Market. It’s ugly and there’s not a lot of good news to report.

Ah, but volatility is the fundamental reality of investing. Volatility is inevitable and profits are never guaranteed. In December, when the market was at or near all-time highs, everyone was piling into stocks. And now that many ETFs are near their 52-week lows, investors are wondering if they should sell.

Market timing doesn’t work

Unfortunately, our natural instinct is to do what is wrong and want sell the 52-week low rather than buy. Back in December, there were a lot of people hoping for a correction to make purchases. Now that a correction is here, it’s not so easy to pull the trigger on making purchases. The risks seem heightened today and nobody wants to try to catch a falling knife. Unfortunately, the market isn’t going to tell us when the bottom is in place and it is “safe” to invest.

Last week was the 13-year anniversary of the 2009 Lows. Most reporters say that the low was on March 9, 2009, because that was the lowest close. But I remember being at my desk when we saw the Intraday low of 666 on the S&P 500 Index on 3/06/09. Today, the S&P 500 is at 4,200 (down from a recent 4,800). Even with the 2022 drop, we have had a tremendous run for 13 years, up 530%.

A prospective client asked me this week what I had learned from being an Advisor back in 2008-2009. And I told her: First, you can’t time the market. Clients who decided to ride out the bear market did better than those who changed course. Second, individual companies can go out of business. You are better off in diversified funds or ETFs rather than trying to pick stocks.

Buying The Dip

While you shouldn’t try to time the market, we do know that “buying the dip” has worked well in the past. Since 1960, if you had bought the S&P 500 Index each time it had a 10% dip, you would have been up 12 months later 81% of the time. And you would have had an average gain of 12%. That’s a pretty good track record.

I feel especially confident about buying index funds on a dip. While some companies will inevitably become smaller or go out of business, an index like the S&P 500 holds hundreds of stocks. Over time, an index adds emerging leaders and drops companies on their way down. That turnover and diversification are an important part of managing an investment portfolio.

So with the caveat of buying funds, what are ways to buy the dip today? What if you don’t have a lot of cash on the sidelines? After all, if we don’t time the market, we are likely fully invested at all times already.

5 Purchase Strategies

  1. Continue to Dollar Cost Average. If you participate in a 401(k), keep making your contributions and buying shares of high quality, low cost funds. If you are a young investor, you should love these market drops. You can accumulate shares while they are on sale!
  2. Make your IRA contributions now. If you make annual contributions to an Traditional IRA, Roth IRA, 529 Plan, or other investment account, I would not hesitate to proceed. Make your contribution when the market is down.
  3. Rebalance your portfolio. Do you have a target allocation, such as 70% stocks and 30% bonds? With the recent volatility, you may have shifted away from your desired allocation. If your stocks are down from 70% to 65%, sell some bonds and bring your stock level back to 70%. Rebalancing is a process of buying low and selling high.
  4. Limit orders. If you do have cash, you could dollar cost average. Or, with your ETFs you can use limit orders to buy at specific prices.
  5. Sell Puts. Rather than just use limit orders, I prefer to sell Puts for my clients. This is an options strategy where you get paid for your willingness to buy an ETF at a lower price. We have been doing this for larger accounts with cash to deploy, but this not something most investors would want to try on their own.

Uncertainty, Risk, and Sticking to the Plan

There is always risk as an investor. Whenever you buy, there is a possibility that you will be down and have a loss in a week, a month, or a year from now. Luckily, history has shown us that the longer we wait, the better chance of a positive return in a market allocation. We have to learn to accept volatility and be okay with holding during drops.

We can go one step further and seek ways to buy the dip. To me, Risk means opportunity, not just danger. So, which is riskier, buying at a 52-week high or at a 52-week low? Well, neither is a guarantee of success, but given a choice, I would rather buy at a low. And that is where we are today.

I think back to March of 2020, when the market crashed from the COVID shut-downs. And I recall the horrible markets in March of 2009. In both cases, we stuck to the plan. We held our funds and didn’t sell. We rebalanced and made new purchases with available funds. That is what I have been doing with my own portfolio this month and it’s what I have been recommending to clients. We don’t have a crystal ball to predict the future. But we do know what behavior was beneficial in the past. And that is the playbook I think we should follow.

Amazingly, I have had only a couple of calls and emails from clients concerned about the market. None have bailed. We are in it for the long-haul. Market dips are inevitable. It is smarter to ignore them than to panic and sell. And if we can make additional purchases during market dips, even better.

Past performance is no guarantee of future results. Investing includes risk of loss of principal and Dollar Cost Averaging may not protect you from declining prices or risk of loss.

Bonds in 2022

Bonds in 2022

Resuming last week’s Investment Themes, today we consider Bonds in 2022. It is a challenging environment for bond investors. We are coming off record low yields and the yield on the 10-year Treasury is still only 1.5%. At the same time, yields are starting to move up. And since prices move inversely to yields, the US Aggregate Bond index ETF (AGG) is actually down 1.74% year to date. Even including the yield, you’ve lost money in bonds this year. With stocks having a great year in 2021, it is frustrating to see bonds dragging down the returns of a diversified portfolio.

Inflation Hurts Bonds

Inflation is picking up in the US and globally. Supply chain issues, strong demand for goods, and rising labor costs are increasing prices. The Federal Reserve this week said they would be removing the word “transitory” from their description of inflation. And now that it appears that Jay Powell will remain the Chair, it is believed that the Fed will focus on lowering inflation in 2022. They will reduce their bond buying program which has suppressed interest rates. And they are expected to gradually start increasing the Fed Funds rate in 2022.

It is difficult to make accurate predictions about interest rates, but the consensus is that rates will continue to rise in 2022. So, on the one hand, bonds have very little yield to offer. And on the other hand, you will lose money if interest rates continue to climb. Then, to add insult to injury, most bonds are not maintaining your purchasing power with inflation at 6%.

Bond Themes for 2022

There aren’t a lot of great options for bond investors today. But here are the bond investment themes we believe will benefit your portfolio for the year ahead. This is how we are positioning portfolios

  1. We will be increasing our allocation to Floating Rate bonds (“Bank Loans”). These are bonds with adjustable interest rates. As rates rise, the interest charged goes up. These are a good Satellite for rising rate environments.
  2. Within core bonds, we want to reduce duration to shorter term bonds. This can reduce interest rate risk.
  3. We continue to hold Preferred Stocks for their yield. While their prices will come under pressure if rates rise, they offer a continuous cash flow.
  4. Ladder 5-year fixed annuities. I have been beating this drum for years. Still, multi-year guaranteed annuities (MYGA) have higher yields than CDs, Treasuries, or A-rated corporate and municipal bonds. If you don’t need the liquidity, MYGAs offer a guaranteed yield and principal.
  5. I previously suggested I-Series Savings Bonds rather than TIPS. These are linked to inflation and presently are paying 7.12%. Purchases are limited to $10,000 a year per person, and unfortunately cannot be held in a brokerage account or an IRA. Read my recent article for more details. I personally bought $10,000 of I-Bonds this week.

Purpose of Bonds

Even with a negative environment for bonds, they still have a role in most portfolios. Unless you have the risk capacity to be 100% in stocks, bonds offer crucial diversification. When we have a portfolio with 60% stocks and 40% bonds, we have an opportunity to rebalance. When stocks are down, like in March of 2020, we can use bonds to buy more stocks while they are on sale. And of course, a portfolio with 40% in bonds has much less volatility than one which has 100% stocks.

Yields may eventually go back up to more normal levels. While it would be nice to have higher yields, the process of yields going up will be painful for bond investors. Our themes are trying to reduce this “interest rate risk”. We hope to reset to higher rates in the future, while reducing a potential loss in bond prices in 2022.

Inflation Investments

Inflation Investments

With the cost of living on the rise in 2021, many investors are asking about inflation investments. What is a good way to position your portfolio to grow and maintain its purchasing power? Where should we be positioned for 2022 if higher inflation is going to stick around?

Inflation was 5.4% for the 12 months ending in July. I share these concerns and we are going to discuss several inflation investments below. Before we do, I have to begin with a caveat. We should be cautious about placing a lot of weight in forecasts. Whether we look at predictions of stock market returns, interest rates, or inflation, these are often quite inaccurate. Market timing decisions based on these forecasts seldom add any value in hindsight.

What we do know for sure is that cash will lose its purchasing power. With interest rates near zero on most money market funds and bank accounts, it is a frustrating time to be a conservative investor. We like to consider the Real Yield – the yield minus inflation. It would be good if bonds were giving us a positive Real Yield. Today, however, the Real Yield on a 10-year Treasury bond is negative 4%. This may be the most unattractive Real Yield we have ever seen in US fixed income.

Let’s look at inflation’s impact on stocks and bonds and then discuss three alternatives: TIPs, Commodities, and Real Estate.

Inflation and Stocks

You may hear that inflation is bad for stocks. That is partially true. Rising inflation hurts companies’ profitability and consumers’ wallets. In the short-term, unexpected spikes in inflation seem correlated to below average performance in stocks.

However, when we look longer, stocks have done the better job of staying ahead of inflation than other assets. Over five or ten years, stocks have generally outpaced inflation by a wide margin. That’s true even in periods of higher inflation. There are always some down periods for stocks, but as an asset class, stocks typically have the best chance of beating inflation over a 20-30 year horizon as an investor or as a retiree.

We can’t discuss stocks and inflation without considering two important points.

First, if there is high inflation in the US, we expect that the Dollar will decline in value as a currency. If the Dollar weakens, this would be positive for foreign stocks or emerging market stocks. Because foreign stocks trade in other currencies, a falling dollar would boost their values for US investors. Our international holdings provide a hedge against a falling dollar.

Second, the Federal Reserve may act soon to slow inflation by raising interest rates. This would help slow the economy. However, if the Fed presses too hard on the brake pedal, they could crash the economy, the stock market, and send bond prices falling, too. In this scenario, cash at 0% could still outperform stocks and bonds for a year or longer! That’s why Wall Street has long said “Don’t fight the Fed.” The Fed’s mandate is to manage inflation and they are now having to figure out how to keep the economy growing. But not growing too much to cause inflation! This will prove more difficult as government spending and debt grows to walk this tightrope.

Inflation and Bonds

With Real Yields negative today, it may seem an unappealing time to own bonds, especially high quality bonds. Earning one percent while inflation is 5% is frustrating. The challenge is to maintain an appropriate risk tolerance across the whole portfolio.

If you have a 60/40 portfolio with 60% in stocks and 40% in bonds, should you sell your bonds? The stock market is at an all-time high right now and US growth stocks could be overvalued. So it is not a great buying opportunity to replace all your bonds with stocks today. Instead, consider your reason for owning bonds. We own bonds to offset the risk of stocks. This gives us an opportunity to have some stability and survive the next bear market. Bonds give us a chance to rebalance. So, I doubt that anyone who is 60/40 or 70/30 will want to go to 100% stocks in this environment today.

Still, I think we can add some value to fixed income holdings. Here are a couple of ways we have been addressing fixed income holdings for our clients:

  • Ladder 5-year Fixed Annuities. Today’s rate is 2.75%, which is below inflation, but more than double what we can find in Treasury bonds, Municipal bonds, or CDs.
  • Emerging Market Bonds. As a long-term investment, we see attractive relative yields and improving fundamentals.
  • Preferred Stocks, offering an attractive yield.

TIPS

Treasury Inflation Protected Securities are US government bonds which adjust to the CPI. These should be the perfect inflation investment. TIPS were designed to offer a return of inflation plus some small amount. In the past, these may have offered CPI plus say one percent. Then if CPI is 5.4%, you would earn 6.4% for the year.

Unfortunately, in today’s low yield environment, TIPS sell at a negative yield. For example, the yield on the Vanguard short-term TIPS ETF (VTIP) is presently negative 2.24%. That means you will earn inflation minus 2.24%. Today, TIPS are guaranteed to not keep up with inflation! I suppose if you think inflation is staying higher than 5%, TIPS could still be attractive relative to owning regular short-term Treasury Bonds. But TIPS today will not actually keep up with inflation.

Instead of TIPS, individual investors should look at I-Bonds. I-Bonds are a cousin of the old-school EE US Savings Bonds. The I-series savings bonds, however, are inflation linked. I-bonds bought today will pay CPI plus 0%. Then your investment is guaranteed to keep up with inflation, unlike TIPS. A couple of things to know about I-bonds:

  • You can only buy I-bonds directly from the US Treasury. We cannot hold I-Bonds in a brokerage account. There is no secondary market for I-bonds, you can only redeem at a bank or electronically.
  • I-Bond purchases are limited to a maximum of $10,000 a year in electronic form and $5,000 a year as paper bonds, per person. You can buy I-bonds as a gift for minors, and the annual limits are based on the recipient, not the purchaser.
  • I-bonds pay interest for 30 years. You can redeem an I-bond after 12 months. If you sell between 1 and 5 years, you lose the last three months of interest.

Commodities

Because inflation means that the cost of materials is rising, owning commodities as part of a portfolio may offer a hedge on inflation. Long-term, commodities have not performed as well as stocks, but they do have periods when they do well. While bonds are relatively stable and consistent, commodities can have a lot