Currently the Federal Reserve is lowering both short-term and long-term interest rates in an effort to spur the economy. By adding more money and lowering borrowing rates, they are hoping to get businesses borrowing and expanding, banks lending, and people employed. In a very efficient economy (one in which the money is put to a good use) this will cause businesses to expand. This is what happened in the early 1990’s.
If businesses are not willing to expand, however, the additional funds can lead to inflation. In the 1960’s and 1970’s this is what occurred. Because taxes were so high there was little incentive to expand a business, yet there was plenty of cash. This started an inflationary cycle. Eventually the Federal reserve, under Paul Volker, had to raise interest rates to the high teens to slow the economy and end the inflationary cycle. Typically one gets a mixture of both growth and inflation.
So what does one buy to protect a portfolio from inflation? Gold? Inflation protected treasuries? Luckily for the stock investor, while stocks may initially drop in prices in response to inflation (because the market will demand a greater return to cover inflation), because companies will generally be able to pass price increases along to consumers, and because the price of the components of a company will grow with inflation, buying common stocks is a good inflation hedge. In fact, stocks are one of the few investments that will actually provide a return in excess of inflation.
To get extra “bang” from inflation in times when the economy is expanding, like now, try buying companies that produce raw materials. If inflation picks up, the price of oil, gold, steel, aluminum, uranium, and everything else will increase as well. This means that the “earnings” of companies that produce those products will increase. (Earnings is in quotes because the true value for those earnings remains the same, just the numerical value increases. Right now gold and other precious metals are in a bubble, so it would be too late to buy gold producers, but an investment in a steel, oil, or copper producer might make sense. Uranium also looks attractive with the world starting to turn to nuclear power. Uranium producers therefore provide both a good inflation hedge and the likelihood of increasing business and earnings.
One must be careful with raw material producers, however. They tend to move up and down with the business cycle. One must therefore be ready to sell when the business cycle starts to turn. Unlike the other investments recommended on this blog, they are not a long-term holding (maybe to be held for a year or two, but not for 10-20 years.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.