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How to Survive and Profit from Stagflation

InvestorEducation / Stagflation Jun 10, 2008 - 07:26 AM GMT

By: Martin_Hutchinson


IBest Financial Markets Analysis Articlencreasingly in recent weeks commentators have begun speculating about the dreaded “S-word”- stagflation- and whether or not such a protracted period featuring both high prices and high unemployment would blight the U.S. economy.

The stagflation debate arose anew on Friday when a worse-than-expected employment report and a record single-day surge in crude oil prices made economists once again consider the possibility that the U.S. economy could drop into a recession even as inflationary pressures spiraled higher.

For economists, this is viewed as the ultimate “worst-case” scenario. The probability is probably low. Nevertheless, it's a real-enough possibility that investors should prepare for it.

The Sad, Sad Seventies

Here's the bad news: Preparing for stagflation is tough. You can probably count on one hand the number of rich neighbors you've had who can brag about the fortunes they amassed during the 1970's. There just aren't that many such folks around.

To be sure, people made money in gold- if they bought and sold at exactly the right time, being given the magic revelation in early 1980 that the period of stagflation was ending. And a small cadre profited from housing.

When you get right down to it, nobody really prospered much during the 1970s. The stock market went nowhere, and inflation raged. In real terms, stocks lost three-quarters of their value between 1966 and 1982. Any money you made via a lucky tech-stock pick was probably consumed over the next few years by inflation, so (in inflation-adjusted terms) you actually might have ended up worse off than when you started.

If these anecdotes have persuaded you to believe that you won't like stagflation very much, you're very perceptive. Thanks to the “stag” prefix of stagflation, the odds of a really great speculative investment that pays 1,000% are reduced. And because of the “flation” suffix, the chances that a solid conservative investment strategy that absolutely guarantees you a safe retirement are dramatically reduced- if not eliminated outright.

All you can really do is adjust your portfolio to minimize damage, and adjust your lifestyle to minimize expenses and maximize cash flow. Let's look at some strategies.

Stagflation Play No. 1: Housing

The simplest stagflation-proof investment is housing. While mortgage interest rates are still around 6% and inflation is above 4%, the real cost of borrowing is very cheap and housing prices are likely to rise. At least, that's what usually happens.

Unfortunately, we're currently in the midst of the biggest bear market for housing since World War II, and home prices seem to be nowhere near the bottom. Nonetheless, take a moment to remind yourself of an important point: Housing prices will not keep dropping forever.

Nationwide, a decline of about 25% to 30% is about the limit- and every percentage point increase in the rate of inflation is a percentage point that house prices don't have to drop, because wages (which tend to track inflation) will rise to meet house prices.

So if you have spare cash, good credit and good access to the home foreclosures in your area- and if prices seem to be bottoming out- you could do a lot worse than to pick up a rental property or two.

Even during periods of stagflation, people have to live somewhere. And unless the “stag” component gets really bad, as a landlord you can afford to put up the rent yourself from time to time.

Just make sure of two key things: Finance the investment very conservatively (a down payment of 30% is the way to get the cheapest mortgage) and be pretty sure your rental income will exceed your financial outlays.

Precious Metals Plays

The kerfuffle about madly rising oil prices has obscured the fact that gold prices haven't risen nearly as much, and are still below the $900 per ounce level. Since the equivalent of the record peak in 1980 in today's money is over $2,200 per ounce, gold has a long way to rally from here. Gold is a thin market, and so it's likely that its price will fluctuate wildly both up and down- the up being a huge profit opportunity and the down being a huge risk if you get too greedy.

Nevertheless, the SPDR Gold Shares Trust ( GLD ) exchange-traded fund (ETF) is well worth holding as a protection against increasing inflation. Just don't expect to sleep at night if you buy too much.

You may do even better in silver. The iShares Silver Trust ( SLV ) ETF invests in silver just as GLD does in gold. However, silver is only at one-third of its 1980 high of $50, even in nominal terms, meaning that at the current price of $17 silver has a huge upside if inflationary speculation were to really take hold.

Silver is also a thin market, however, so it's only for the risk-tolerant.

Cash is King - Even With Funds

For the rest of your portfolio, I'd actually suggest a money-market fund. In the early phase of stagflation, interest rates are far lower than the inflation rate, and so money market funds lose you money in real terms- AND you have to pay tax on the income to Uncle Sam. However, once stagflation has taken hold, investors will no longer accept interest rates below inflation, and so both short-term and long-term rates zoom skyward.

This reality makes bonds an awful investment: You lose the value of your principal, owing to inflation, and the actual cash value of your bonds declines as interest rates rise.

However, money-market funds are reinvested every three months or so, and quickly get the advantage of higher interest rates, enabling them to keep pace with inflation. In the later stages of stagflation, when the U.S. Federal Reserve gets serious about stopping it, interest rates move much higher than the rate of inflation, so your money market fund becomes nicely profitable even when other investments are still in the doldrums.

Calling the End

It's vitally important to know when stagflation is ending. All the investments that made sense in a period of stagflation make much less sense once the stagflation ends: Gold, silver and, especially, oil, are likely to see their values fall like a stone dropped from a very high place.

The trick here is to watch short-term interest rates. Only when they have been far above the inflation rate for a lengthy period- in 1979-82, for instance, it took nearly three years- inflation will finally come down and sustained economic expansion will be able to resume.

As we've noted several times here at Money Morning , Brazil has done very well in the past few years with inflation of 5% and interest rates above 12%. The U.S. equivalent would have the benchmark Federal Funds rate above 10%, while inflation is still at its current level of 4% to 5% (in 1980, when inflation was higher, the Fed Funds rate peaked at 20%). So wait till that happens. A Fed Funds rate of 5%, 7% or even 8% won't do it- these are wimpy half-measures. Indeed, only when the Federal Funds rate surpasses the 10% level- and stays there awhile- can we be certain that stagflation is being driven back.

Finally, let's get to some good news. If you still have some cash at the end, when the Fed finally gets around to raising interest rates high enough to kill inflation, and the economy emerges from stagnation, you're in a wonderful position.

Somebody once asked the oil billionaire J. Paul Getty how to become a billionaire. “Start as a millionaire,” he responded, “and buy in 1932.”

The same was very nearly true for those who started as millionaires and bought in 1982, particularly if they leveraged a bit. The secret was to know when stagflation was ending- and to have the million dollars to invest at the end of that very difficult 15 years.

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By Martin Hutchinson
Contributing Editor

Money Morning/The Money Map Report

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