Investing for Inflation and Volatility
When we talk about inflation, we are either referring to asset price inflation or consumer price inflation. While the former leads to a nominal rise in asset prices, the latter is typically negative for stock prices as higher input and borrowing costs reduce earnings expectations for businesses.
As history’s largest debtor, we know that the U.S. Government is forced to print dollars to pay off its debts with inflation. This artificial market interference could also cause spikes in volatility like what the economy experienced in the 1970s.
Assets like gold, treasury bonds, and stocks are traditionally viewed as effective inflation hedges. As history shows, this may not always be the case. Particularly for stocks.
Stocks Not Guaranteed Hedge Against Inflation
The 1970s were a trying time for the U.S. economy. Much of the decade can be characterized by stagflation and market volatility.
The S&P 500 started the decade around the 800 mark. Ten years later, the index finished the decade down to nearly 300. This was an over 50% drop in nominal terms while factoring in the loss of purchasing power from high inflation numbers would see an even larger drop in real terms.
While the market was dropping lower, interest rates were rising throughout the 1970s. This caused demand to decrease, the cost of debt to rise, and corporate profits to decline.
However, the rise in interest rates and the decline in the stock market were not linear advances. Both experienced a decade of volatility along with their respective movements.
So while stock prices may sometimes provide a hedge against inflation, we can see from the 1970s that this is not always the case and we must consider additional factors when investing for inflationary times.
How Could Volatility Cause a Stock Market Crash?
One of the main considerations of portfolio construction is diversification. For most investors, this means a combination of strategies and asset classes.
Strategies like global macro, risk parity, 130/30 funds, and dollar-cost averaging, and asset classes like growth stocks, value stocks, bonds, real estate, and private equity are some of the more common portfolio pieces.
While most investors would argue that a combination of these strategies and asset classes is considered “diversified”, Chris Cole of Artemis Capital would argue the opposite. This is because most of these portfolios are almost 100% allocated for short volatility.
This has been a fine strategy from the beginning of the 1980s until now when volatility has been historically low. But if we see volatility in the stock market and interest rates like we experienced in the 1970s, we could see a sizeable market crash due to most of the capital in the market not being positioned for volatility.
As the Fed and the government continue to print money to prop up the economy, the probability of experiencing volatility is high as the artificial government stimulus interferes with the free market.
It will be important to be mindful of potential market crashes and volatility for portfolio construction as we move forward in this period of big government and out-of-control central banks.
Gold as an Inflation and Volatility Hedge
Most professional investors or portfolio managers have different opinions and strategies on how to best invest during times of inflation and volatility. But if you scan through their portfolios, there is a common denominator in most of their holdings. Gold.
As fiat currencies like the dollar lose purchasing power from government money printing, gold’s value should rise as the price of goods and services increases.
Gold over time has retained much of the same purchasing power throughout the thousands of years humans have been using it in the financial system. A dollar in 1900 went much farther than it does today when purchasing goods and services while an ounce of gold provides a similar value of goods and services over 100 years later.
This consistency in purchasing power is very important to consider in times of volatility and inflation that we will most likely experience moving forward. Unfortunately (or fortunately for those who are taking advantage of the lower prices), gold is mostly out of favor in mainstream commentary as bitcoin and other historically new asset classes occupy most of the conversations.
But even though gold is somewhat out of favor for commentators, the average 2021 gold price target is around $2300 an ounce, which would be a considerable move to the upside if this target is reached in the back half of the year.
Endless Options
In 2021, it feels like there are endless options for investors. It can be easy to fall into analysis paralysis with the overwhelming amount of options to consider where you put your money.
Since the beginning of the 1980s, the US has mostly experienced steady growth and not a lot of volatility to worry about, which has positioned most of the invested capital to be short volatility.
As governments print money to create inflation, this could bring volatility and a potential market crash investors should be wary of.
If you listen to financial commentators, you will think gold is out of the picture moving forward as a hedge against inflation. But a look at history and inside professional portfolios will paint a much different picture.
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