As world markets continue to hum along, with most economic data such as GDP and employment rates indicating a recovery, it may be easy to buy the narrative that this is due to an improved global financial foundation.
The other perspective is that these small returns are the disappointing results of the ongoing quantitative easing programs, and have come at great costs, many of which have yet to manifest.
The debate over whether we are in the foothills of a grand recovery or about to drive off a precipitous cliff is one for other venues. In today’s post, we assume that the reader is at least open to the possibility that the second, less savory scenario may well come to pass, and is interested in protecting him or herself against the embodiments of inflation, typically: rising consumer costs and a weakening currency. These tactics apply equally to any country, but for the sake of simplicity, I will discuss matters in USD.
1) A traditional way to build a foundation for your future while shorting the dollar: Buy a home.
In the US, home prices have corrected between 15-40% from their all-time highs during 2006-2008. This followed decades of housing price increases, and lulled much of the population into the false understanding that housing is an asset, but not a liability.
As the housing crisis taught us, unless you are renting your property for income, houses create negative cash flow – something that you can seemingly ignore when your house value is increasing 15% per year.
Although most houses in the US are still depressed from their highs, there are signs of new bubbles forming, particularly on the West Coast. If you are fearful that another correction is imminent, particularly if interest rates – and by proxy mortgage rates – continue to rise, then you may want to steer clear of housing for now.
However, if you are investing for the long term, and you expect higher inflation, there are few better ways to benefit from it than by borrowing for extended terms at fixed interest rates. If you were to borrow $200,000 for 30 years at 4% today, making $1,500 monthly payments (including interest, principal, insurance, and taxes), expecting just 5% annual inflation for the duration, your 360th and last payment would be worth just $322 in today’s purchasing power. At 10% per year, your last payment would only be worth $64, about as much as a nice meal at a restaurant.
From this perspective, you can play the inflation from two angles: a) Over time, even if there is a correction in the short term, the value of your home will increase commensurate with inflation, and b) The actual burden of your debt will decrease over time.
2) A non-traditional way to preserve your purchasing power: Go short on government debt.
Over the past 30 years, US treasury bonds have seen a magnificent run up in value. As interest rates go down, the value of existing bonds goes up, and bond funds have made a fortune in the meantime.
Naturally, buying bonds has always been pitched as a prudent and patriotic decision. But as times change, so do investment strategies. As it happens, US bonds may now be in one of the largest asset bubbles of all time. Which needle will pop it remains to be seen, whether China or Japan decide to offload some of their $2T+ in reserves, the US public becomes fearful, or (highly unlikely) the Fed tapers its bond-purchase program. However, asset prices are cyclical by nature, and very few things can go up for 30 years without a major readjustment.
If you are imprudent and unpatriotic enough to take this viewpoint, then there are many ways to undertake a bond short. You can purchase synthetic ETFs that track the inverse of T-bills of varying maturity, or for a super-bear move, try a leveraged ETF such as the ProShares UltraShort 20+ year Treasury (TBT). But Caveat Emptor: These are not plays for average investors. Before investing in any ETF products, you need to thoroughly understand the concepts of daily return and beta slippage.
Another way to short bonds with less risk is through options. Most retail trading platforms such as Scottrade or E-Trade allow for the buying and selling of options and other derivatives. In this case, you would want to buy a put on a US treasury fund or proxy. This gives you the option to sell the security at a given strike price within a certain time-frame. For instance, if a bond fund is trading at $100 per share today, and you expect it to go to $70 within 2 years, you can buy a 24-month option to sell it at $90. Then, in two years, if you are correct, you can simultaneously buy the security at $70 and sell it for $90. The difference is your profit, minus the premium that you paid to initiate the option. If you somehow get it wrong, and the share price goes to $120, then you’ll be out of pocket in the amount of the premium, but nothing more, thereby capping your risk.
3) A futuristic high-risk/high-reward play: Purchase digital currencies such as Bitcoin
Though only 4 years old, the modern class of digital crypto currencies (those that solve the double-spending problem in a decentralized fashion) have made big waves in the last year – most notable of the bunch being Bitcoin. Despite a smattering of bad press associating Bitcoin with criminal activity, it continues a remarkable expansion in global user-base and usability.
Designed to mimic Gold in many respects (i.e. limited in quantity, easily recognizable, easily divisible, difficult to counterfeit, etc.), Bitcoin has been prone to wild swings in valuation. Critics point to this as deal-breaking volatility, whereas Bitcoin supporters believe that the two or three major bubbles that the currency has gone through are simply birthing pangs of a beautiful creature which has yet to enter adulthood.
Whether you are a supporter or a skeptic, if you believe that your country is headed for significantly higher inflation, you may want to take a look at Bitcoin. Despite its volatility, it has never had a down year, and is up over 500% in the last 6 months. If you can stomach the swings, you may find that a modest position in Bitcoin can provide surprising returns to a long-term portfolio.
Disclosure: The author is long single-family housing, short the US dollar, and long Bitcoin. Views expressed are his alone and not to be interpreted as investment advice.