Inflation Worries

 I have read several articles recently about ways for people to prepare for and cope with inflation. Some people are getting worried, and they have good reasons. The trillions of dollars manufactured by the government since the start of the epidemic will be spent somewhere. The prices of stocks, some types of real estate, and some other assets look at least a little inflated now. The prices of government bonds are very high, propped up by the fed and producing yields on the ten year bond well below the price inflation rate predicted by the spread between TIPS and ordinary treasuries. The people at the fed have announced they are fine with the CPI going above their former target of two percent per year.

Many writers recommend stocks as protection against inflation, pointing out that over long periods American stocks have produced returns several percentage points above the official rate of inflation. Owning stocks is a good idea, but one should not assume that stocks always will protect against inflation in the short or medium term. In the 1970s when the country had both high price inflation and a bad economy, stocks did not do well and were not good protection against inflation.

 Gold, silver, and some foreign currencies did much better then. It is not certain that they would do so in a future inflationary period. There were political changes in the 1970s and late 1960s involving the way national currencies were valued against each other and the collapse  of price controls on precious metals that boosted them. Still a one ounce gold piece at today’s prices will buy a lot more than it would a hundred years ago, and the value of a silver quarter is still good for a hamburger and a Coke at lots of places. 

The return on cash in the form of T bills and short term CDs has usually matched or come close to matching the rate of price inflation, but that is not true now, and the people at the fed plan to keep it not being true for a good while. Long term bonds can suffer doubly from inflation with the real value of their interest payments and payment at maturity declining over time and their prices declining as long term interest rates (which are harder for the fed to control) rise. TIPS are a partial exception – offering protection against losses due to price inflation as measured by the government though not to declining bond prices due to generally rising interest rates. This second risk is especially important for people investing in bond funds instead of owning bonds directly.

Then there is a simple, fairly surefire way to counter price inflation. One can buy durable things, including real estate, that one wants to have and use for years now and use them over time. Changes in the CPI have no effect on your price for something you have already bought. However, it can be hard to decide what durable things one can be sure of wanting to use over long periods and difficult to store some of them.

Planning for and overcoming inflation is a hard problem. Inflation is a wealth tax imposed by the government on assets in general. Even at two percent or less, it has its effect. At higher rates it can get really rough.

Of course predictions of coming increasing inflation -  just as predictions of coming recessions, booms, market crashes, and so on -  are often wrong, and there are other risks to deal with. As usual diversification is a good idea, but perhaps with more attention to inflation than has been needed in the last few decades.

Worries about the Market

A couple of days ago I read a warning about the prices of stocks based on the high value of a couple of macro-technical indicators – the CAPE, a ratio of present stock price to average earnings over the last ten years,  and the q ratio, a ratio of present stock price to an estimated cost of replacing all of a firm’s assets.  Such warnings are commonplace, and may be justified in our present situation. All the two indicators really are are measures which go up when stock prices increase a lot and go down when stock prices decline a lot. As such they can offer suggestions as to when stocks are expensive or cheap. The problems and the silliness begin when people try to go beyond their probabilistic and suggestive utility and treat  them as having almost mystical predictive powers.

It is interesting to look at two periods when the CAPE and the q ratio were low that did turn out to be good times to buy stocks. (It is also worth remembering the ratios have also been low at times when stocks turned out to be bad buys and high when stocks turned out to be good buys.) The first was the decade immediately after World War II. Stocks were a  great buy at that time. However the reason they were is that the economic condition of the country changed  - from depression to a quarter century of the greatest prosperity it had yet experienced. If that had not happened, and if the predictions of the leading economists of the day that the ending of wartime government spending would lead to massive unemployment and a continuing depression had come true, stocks would have been a bad buy irrespective of what the metrics suggested. The second time was in the late 1970’s and the early 1980’s. Once again stocks were a great buy, but once again,  the reason was a change in the conditions of the country. The nation went from the malaise of the inflationary depression of the 1970’s to another  quarter century of  the greatest prosperity it had ever experienced.  If it hadn’t, and if economic, political, and geopolitical events had  continued on the trajectory of the 1970’s,  stocks would have been a bad buy irrespective of the metrics. It was not the indicators, but the impending macro-economic improvements that made stocks a good buy at both of those times.  

Stocks prices tend to be low when people are dubious about the economic state and future of the country. Times when such pessimism is unwarranted are often good  times to buy. Stock prices tend to be high when people are expecting   growth and prosperity. Times when such optimism is wrong are often  bad times to buy. Whether stocks are too expensive now will be answered by how the nation’s economy does in the next few years, and that is a hard question to consider. The anti-growth policies and plans of the present administration are a serious threat. The ability of firms to lower costs of debt and the continuing effects of new technologies are good signs. The fact is that we don’t know for sure what will happen, and no chart, wave theory, or horoscope will tell us. That is why investors should be careful and diversified in their investments. 

Pay Cash

In 2005 and 2006 Debby and I worked at a large university in the Rio Grande valley of Texas, a densely populated, semi-tropical region  at the far southern end of the state. The RGV, as it is called, is separated from the rest of Texas  by large expanses of fairly empty country. The main cities in the valley are over two hundred miles south of San Antonio, a city many  people think of  as  being in “south Texas”, and over a hundred miles from Corpus Christi or Laredo.  It is officially a poverty stricken area, and there are some very poor people there as in most places, but it is not the  poor place the official statistics would have one believe. There is a whole lot of commerce going on there on a cash basis, unreported to and unmeasured by the government. Some of it is in the illegal drug trade along the border of course, but a good deal of it is in honest, ordinary, mutually beneficial transactions between  individuals who prefer to do their business in cash and away from the eyes of the government.The RGV is an extreme example, but the same thing goes on most places in the country. It is called the cash economy. It is probably more prevalent in rural and inner city areas than in suburbs, but you can see it all over.

I think people should pay cash  when they can.  They should do it out of benevolence toward their fellow citizens, concern for their own privacy, and  in the general interest of keeping the government from getting even bigger and more intrusive. (The argument that the captive taxpayers pay more taxes because some of those in the cash economy pay less than the government wants is specious. If the politicians ever did get their hands on the money “owed” on activities in the off the books portion of the cash economy, they probably would spend it, not grant anyone a tax cut.)  

Besides, paying with cash is just good business. A generation or so ago, people did it all the time.  A person can’t overspend the cash in his billfold, and no one will charge him interest or fees on the purchases he makes with it. It is sometimes possible to get a discount on purchases by paying in cash.  Cash is fully anonymous, and using it allows a person to keep at least a part of his private personal business private.  (There are already some legal items such as ammunition  which probably should be bought only with cash. If recent trends were to continue, the list of those things would get longer.)

Debby and I are making it a habit to use cash instead of checks or cards for most of our transactions with local small businesses and independent operations. At a minimum that saves them the percentage they would have had to pay the credit card company. I urge others to do the same and pay the babysitter, the kid who mows the lawn, the repairman, the local restaurant,  or the woman in the antique shop in cash. It’s easy, once you get used to it.   

The Return of John Pugsley

Many years ago John Pugsley published The Alpha Strategy, a book warning of the reckless and dangerous government policies of the day and advocating that people protect themselves from inflation by stocking up with long term (indeed multi-year if shelf life allowed)  supplies of food, tools, household goods, clothing items not subject to changing fashion, wine, and other storable items and by investing in commodities in preference to stocks or bonds. Pugsley’s thesis made good sense as a response to the events of the inflationary depression of the 1970’s. The book was well received and sold well enough to  make a best sellers’ list.  

However, his timing was awful. The book came out in 1980 and was widely distributed in 1981 just as Paul Volker’s fed was reversing the inflationary policies of the last decade and Ronald Reagan was giving the nation a different set of government policies, policies that would help lead to a quarter century of peace, unparalleled prosperity, declining inflation, and high real investment returns on both stocks and bonds. A person following Pugsley’s advice in 1981 would have missed out on some of the greatest investment opportunities of all time and would have lost money on a number of investments in commodities, including  precious metals.  Pugsley continued writing for many years before his death in 2011, but it is fair to say that he was never again as well known as he had been for a while in 1981.

Now, though, we have an inflationist federal reserve printing  money at truly shocking rates, a stagnant economy, high unemployment coupled with high monetary inflation, a lost decade and a third in the stock market, a pair of long and pointless wars in Asia, a pervasive sense of malaise with large numbers of people believing their children will have less opportunity and poorer lives than their own, an increasingly intrusive government imposing anti-growth regulations and restraints on the economy, and in George W. Bush and Obama a pair of presidents quite reminiscent of Richard Nixon and Jimmy Carter. It’s not exactly a repetition of the 1970’s, but there are some  similarities.

There are of course significant differences as well. The biggest is that this time there is no international threat comparable to the Cold War, which in the 1970’s the United States was losing. Also while we have had very serious monetary inflation, so far we have had only moderate price inflation this time unlike the 1970’s which had both.  Interest rates of all durations are at multi-decade  lows instead of the multi-decade highs of the 1970’s, and bonds have not yet  fallen into a bear market. 

 Still it may be time to take another look at John Pugsley and his alpha strategy of over thirty years ago.  Unless this is one of those rare times when it is valid to make the dreaded claim  that it’s  different this time, our present monetary inflation probably will lead to higher rates of  price inflation. It takes a great deal of faith in Ben Bernanke to assume the fed can act in just the right way at just the right time to prevent all that new money from producing higher prices above and beyond the stated inflation target limits.  Bonds have been in a secular bull market since about the time Pugsley published his book. With the P/E of a ten year treasury at over fifty to one and the P/E on a five year treasury at over one hundred and twenty five to one, and with both delivering a before tax nominal yield less than the present rate of inflation, it is hard not  to think that that bull market probably is in a bubble phase. Stocks are more attractive. They have done poorly for over a decade and will eventually do well, but it is not prudent  to be invested one hundred percent in stocks or anything else. Gold and silver have already had a multi-year run and may be near or even past long  term tops.  Cash has no immediate risk, but faces the near certainty that the longer it is held the less it will buy.

So it may not be a bad idea to follow some of Pugsley’s advice and do some stocking up on durable items to lock in lower prices than we will see in  the future. His book has useful advice on what things to buy and what things to avoid and tips on storage, insurance, and other practical considerations. The opportunity cost of doing  some of this versus investing more in bonds is quite low right now, and the risk is far less.  Doing a little investing in commodities may not be a bad idea either. Of course I would follow his alpha strategy only in  moderation and not whole hog. Remember 1981.  

GDP and What We See

The United States is now said to be out of recession and to have been out of recession for a good while because the government’s reported gross domestic product has been increasing. Yet polls show that a large percentage of the population believes the country in still in a recession. An unusually high levels of unemployment and underemployment, a lower average net worth of households, a depressed market for residential real estate,  and other factors support that opinion and indicate that the economy is still doing poorly.

Various writers have pointed out the shortcomings of GDP statistics as an indicator of the health of the economy. There are significant problems with both the collection of the data and the methods of analysis. Additionally activity in the so-called underground economy of both illicit activities and otherwise legal but unreported cash transactions is not measured. Neither is activity in the fully legal and  probably much larger second underground economy of goods and services produced by people for themselves with no money changing hands – everything from home gardening and canning to do it yourself-ers painting their houses to friends helping each other with car repairs and  household wiring.  Also GDP calculations treat all types of measured economic activity as  equivalent. A given amount of money spent on a Solyndra or a Cool Hand Luke stimulus project of activity no more productive than digging holes and filling them back up counts exactly as much as the same amount spent on developing the next iPhone.

In ordinary times these and other difficulties do not prevent the GDP statistics from being useful in estimating the health of the economy. People can assume that the omissions, problems of method, and systematic errors will have about the same effect as a percentage of the whole at one time as another and use the trends in the GDP as indicators of a growing, stagnant, or declining economy. However that is acceptable only so long as the assumption is valid.  If the percentage of economic activity that is either unreported or unproductive changes significantly, the GDP statistics will give a false reading on the health of the economy.  This happened immediately after World War II when the official GDP registered a serious decline because of a decrease in government spending on the war, but the real economy saw neither a depression nor serious unemployment but rather an improvement in the average standard of living.   The earlier war time GDP was artificially high relative to the actual health of the domestic economy because so much of that GDP was spending on the war – spending which, while necessary, did not produce as much as the numbers alone would have indicated in the way of goods and services for the domestic economy. We have had something similar in reverse order in the last few years. The post-2008 GDP statistics are artificially high relative to the actual health of the domestic economy because an abnormally high percentage of the GDP has been unproductive and/or inefficient government spending which has produced comparatively less in the way of useful and desirable goods and services in the real economy. The country is thus doing worse than the GDP numbers indicate, and citizens may indeed believe their lying eyes rather than what the politicians are telling them. 

Less Vigorous Consumers

It is not news that the economy of the United States, irrespective of an upward blip in the gross domestic product in the third quarter of this year, is not doing well. The country has seen huge declines on its citizens personal balance sheets due to falling prices for stocks and real estate. Unemployment is abnormally high. The federal deficit is ballooning. The fed is inflating the currency at a dangerous rate as the dollar declines in value against gold and other currencies. Financial institutions are weak and plagued by bad and non-performing loans. On top of all that we have the most anti-growth and anti-business government since the 1970’s. Its current proposals include plans to increases taxes and regulations, punish people for using energy, and impose various costly mandates onto the members of the real economy while expanding the size and cost of government.

These are real and serious problems that will have deleterious effects on the growth of the economy for some time. However there is another factor, not often noticed, that I think will have at least some dampening effect on economic growth as measured by GDP, and thus probably on equity markets and on tax collections. That is the trend for more people to do more things for themselves outside of the counted, measured, and taxed economy.

My wife and I are an example. We have been semi-retired for three years. Before retirement we had fairly demanding full time jobs. Now we work at writing and do a little part time teaching, but a lot of our time is free. We have been using some of that new free time to do more things for ourselves that we might have hired done when we were busier and making more money.
When the exterior of our house needed painting a while back, I did it myself. The total GDP-impacting cost of the project was around a hundred dollars for paint. Before retirement, I might have used a painting contractor instead and paid him somewhere between two and four thousand dollars for the job. Our outcome – a repainted house- would have been the same, but the impact on GDP would have been quite different. My wife has stained or painted several cabinets and doors around our house in the last couple of years. She would probably have had someone do it if she had still been working full time. Again the result for us was the same, but instead of adding several thousand dollars to the GDP, she spent a couple or three hundred on materials. There are plenty of other examples – painting interiors, removing dead trees, roofing a storage shed, remodeling a half bath, growing a vegetable garden, doing some electrical wiring, cooking more while going to restaurants less, building walkways, and so on – where we are now doing more things ourselves, bringing us significant value but not doing much at all for the measured economy.

I think it is likely that more people will be behaving in a similar way in the next few years, partly because of the large number of boomers moving into retirement and partly as a reaction to the recent financial crisis. I have also noticed that, on average, people become less concerned about status and trendiness as they age and thus less likely to spend lots of money pursuing current fashion. Then there is the simple fact that many people, by the time they reach the age of retirement, already have a large fraction of the things they want. It seems to add up to boomers perhaps becoming far less vigorous consumers than they have been in the past.

News and Politics

The market has just taken out the lows of the 2000-2002 bear market and reached dozen year lows. This is completely understandable in term of a set of risks that are starting to resemble those of the 1970’s. In the short run we have a monetary crisis and a nasty recession that is pretty much worldwide. For the medium term we have a federal government that is operationally hostile to economic growth and the creation of wealth, as its tax, regulation, “fairness”, and “green” policies and proposals already clearly show. And in the long run we have a massive increase in the national debt, due to war and “stimulus”, just at the time when, because of the retirement of the boomers, we can least afford it. The last is particularly dangerous. In the 1970’s the government repudiated a large fraction of its debt through inflation, decimating the citizens’ savings of the post-WWII prosperity in the process. It then confiscated more of people’s savings by creating and taxing high nominal (though low or negative real) interest rates on those savings. There is every incentive for them to do it again now, particularly given that the party in power does not see savers or investors as part of its constituency. It is also important to remember that the inflationary depression of the 1970’s ended only when we got an inflation fighting fed, a pro-growth administration in Washington, and the explosive development of new companies and entire industries, many driven by innovations in technology. None of these things is on the horizon right now.

There is a lot of discussion about a crisis for people who are under water with their mortgages, and I find it puzzling. I understand the problems of those who are delinquent in their payments on mortgages, but I cannot see a crisis for most of those who are under water, but still making their payments. It is certainly unpleasant for a person’s house to be worth less on the market than the amount he owes on it. It makes the household balance sheet look bad, but unless a person sells the property, he does not have to cover any actual cash losses. He has the house he agreed to buy at the monthly payments he agreed to make. Eventually, as he pays down his debt and the real estate market turns, he will be above water again. After all, despite anything politicians or realtors might tell us, there really isn’t any natural or Constitutional right to annual appreciation in real estate.

The government announced last week that it was putting the squeeze on UBS to reveal names of its American depositors to the IRS. The news led to the usual bleating about “tax cheats” and “those not paying their fair share costing the rest of us”. Most of this is unseemly nonsense. A cheat is someone who defrauds another person or who breaks a rule of fairness or conduct to which he has agreed. Running from bandits or hiding from the tax collectors is not cheating. The question of whether to pay taxes is an almost purely pragmatic question, not a moral one. (There is a ethical issue about paying one’s share of the legitimate activities of the government and not being a free rider, but for most taxpayers that issue does not come up, because the government claims enough by withholding and through W-2’s and 1099’s to more than render that concern moot.) To claim otherwise is to assert that a government has an unlimited moral claim over people’s lives and efforts and that whatever it decides to take from them is right, solely because it has decided to take it. The point about “cheaters” increasing costs for the rest of us is no more valid. We need to remember that the problem for members a herd of gazelles being chased by a pack of hyenas is the hyenas, not the faster gazelles. We suffer harm at the hands of the tax collectors, not from our more nimble countrymen who avoid them. Besides, as a practical matter, does anyone believe that, if this government miraculously collected what it wants from all the “cheats”, it would lower taxes on everyone else? There is not much plausibility for that one.

Also last week, one our politicians admonished his fellow citizens for being cowards on the issue of race. He is of course right, though not in the way he meant. Our culture is deeply dishonest about race. Future generations likely will consider our hypocrisy and perversity on the question at least as harshly and ironically as many now view the attitudes of the Victorians on sex. We could take steps to become more honest. We could be sure we really do rate persons by their individual characteristics and not their ancestry. We could realize that one may criticize or even condemn a person’s acts or attitudes without having racial prejudice against him. We could reject undeserved guilt. The crimes of slavery and Jim Crow were egregious. No one alive today had anything to do with slavery. Only a few, in places such as the U. S. Senate, who played a role in Jim Crow are still alive. Those who had nothing to do with it need to refuse to accept guilt for something they did not do. That would make for more honesty, though probably not of the kind the politician wanted.