Currency - (CC image by Taki Steve on Flickr)

(CC image by Taki Steve on Flickr)

 

“Inflation” and “deflation”: These are two of the most commonly used terms in the world of investing, but what do they really mean?

And, why is it so crucial to understand these concepts before making any long-term forecasts?

 

Why Inflation Matters

In an earlier post, I introduced a framework for building wealth entitled “The Five Components of Successful Investing”.

The five components are the blue boxes in this flowchart, taken from that post:

activemgtplan

Long-term forecasts, the second component of the plan, are the most impacted by inflationary or deflationary forces in the economy.  The stronger and more persistent the inflation, the higher will be the expected returns across most asset classes.  Of course, the cost of living will rise at the same time, limiting the purchasing power of those investment gains.

The rate at which we expect inflation to expand or moderate in the future will also have a major impact on our preferences for certain asset classes over others.  Assets with a fixed stream of cash flows, like bonds, will be badly hurt by rising inflation, whereas gold will shine.  In mild deflation, when prices are gently falling or nearly constant, cash is king.  In that scenario, a wise investor will maintain a large cash reserve and consider writing options or shorting stocks to generate returns.

For these reasons, all long-term forecasting must start with an assessment of whether we expect inflationary or deflationary forces to be operating, and to what extent.

Before I go further down that path, it’s important to define what “inflation” really means.

What is Inflation?

Most people define inflation as the rate at which prices are increasing in an economy.  This is a good definition, but let’s dig deeper into it to avoid some important pitfalls.

Inflation is controlled by three factors, broadly speaking:

  • The supply and demand for goods and services in an economy;
  • The amount of liquid assets circulating in the economy, and;
  • How rapidly money circulates in the economy.

I’ll refer back to these towards the end of this post.

Goods and services are anything that is produced and available for sale to consumers.  This includes physical products, digital goods, and all kinds of services.  It even includes the underground economy or “black market”.  For simplicity, we’ll assume a closed economy, like a country that does not trade with other nations, so we can ignore the impact of cross-border flows of goods, services, and currency.

The second factor includes money, defined as any item that is serves as both a store of value and a medium of exchange.  Today, the vast majority of money in circulation is in the form of bank notes issued by central banks (paper currency, notes, and digital entries), but this category also includes gold, silver, and digital currencies like bitcoin.  A follower of the Austrian school of economics would simply define inflation as the rate of growth of the money supply, but this ignores all forms of credit and other liquid assets besides money.  It also ignores the rate at which money circulates in the economy.  Thus, the money supply by itself is useless for measuring inflation.

By “liquid assets”, I mean anything that can be converted to money in a reasonably efficient and fast way.  This includes far more than the supply of money and credit in the economy, and rightfully so.  For instance, let’s say you are considering the purchase of a new car for $30,000.  If you have $30,000 in your checking account, clearly this is money.  But if you instead have $30,000 of stocks in your online trading account, and all you have to do to get that money into your checking account is to: (1) click “Sell” and (2) request a check from your broker, how is this any different than money?

I’ve also included credit in my definition of “liquid assets”.  There are many types of credit.  As a simple illustration, let’s stay with the car-buying scenario.  Instead of using any money at all for the car, you could get a zero-down loan from your local bank.  That bank will then create the money out of “thin air” and use it to purchase the car on your behalf.  This puts new money into circulation, which will be taken out of circulation as you repay your loan.

The third factor, often forgotten, is arguably the most critical one when trying to predict future inflation rates.  It is the velocity of money – the rate at which all that money, credit, and liquid assets are circulating.  It generally follows a well-defined trend over long periods of time:

Prior to the start of this graph, money velocity also exhibited stable trends (down 1900-1932, up 1932-1960), when removing the impact of the two world wars.

Prior to the start of this graph, money velocity also exhibited stable trends (down 1900-1932, up 1932-1960), when removing the impact of the two world wars.

 

In the extreme case, the Treasury could print warehouses full of cash and drop it by helicopter, but if everyone stuffs it under their mattresses then it will have no impact on prices today.  Yet we can be certain that as soon as velocity begins to rise again, pent-up inflation will be released.   It is just a matter of time until it occurs.  We’re seeing this same phenomenon today in all the world’s leading economies, just not to such a dramatic level.  Central banks continue to stimulate growth by pumping money into the banking system, but its effect remains limited because it is not being deployed into the broader economy.

Now that we’ve defined inflation, let’s consider the factors that cause the inflation rate to go up or down (all other factors held equal).

Inflation increases when:

  • The supply of goods contracts (e.g. production quotas or natural disasters);
  • The supply of liquid assets increases (e.g. growth in money supply, financial asset values);
  • Liquid assets begin to circulate more rapidly.  For instance, when people expect rapid inflation, they spend their money more quickly.

Inflation decreases when:

  • The supply of goods expands;
  • The supply of liquid assets decreases (e.g. banks pull back on lending);
  • Liquid assets begin to circulate more slowly.  For instance, when people worry about the economy, they tend to hold onto their money longer.

(Which scenario fits today’s economy?  More the second scenario than the first, I’d say!  We see this in the inability of inflation to hit the Federal Reserve’s 2% target level, despite massive money-printing.)

If the rate of inflation is negative, i.e. price levels are dropping, we say that “deflation” is happening.

 

How is Inflation Measured?

It’s easy to measure inflation if you’re only interested in past or present values of the inflation rate.  Government agencies regularly publish inflation data, often labeled as a Consumer Price Index (CPI).  These series measure the rate at which prices are increasing for consumers in the economy.  Price levels at the producer level, like commodities and raw materials used by manufacturers to produce consumer goods, are measured by a Producer Price Index (PPI).  A more obscure measure of price levels, yet one that is arguably more valuable for investors, is the GDP (Gross Domestic Product) deflator.  The GDP deflator is the inflation series used to convert the GDP of a nation (a measure of its annual production of goods and services) into today’s prices.  I prefer to use the GDP deflator when running analyses because it aggregates all transactions in the economy, including those at the consumer and producer levels.

PriceStats and State Street have collaborated to develop their own inflation series, giving an alternate view that in many ways is more comprehensive than official series.

The tougher task is determining how much inflation to expect in the future.  The prices of gold and silver offer some insight into how much inflation investors are expecting, but these markets are small and subject to many forces beyond just inflation expectations.  Tracking gold and silver prices isn’t enough.

Without a good forecast of inflation, all our long-term forecasts will be too high or too low, and we won’t be adequately protected against distastrous outcomes.

 

Forecasting Inflation

It’s a whole lot easier to predict future inflation once you break it down into the three factors that I listed earlier.  Here is each one, with a list of questions to ask yourself when assessing each:

Supply vs. demand of goods & services

  1. How rapidly will technology advance?
  2. Will energy become more abundant, or more scarce?
  3. How rapidly will governments increase their spending?  Will some pull back?
  4. Will the population expand rapidly, or level off?

Amount of liquid assets circulating in the economy

  1. Will central banks follow loose (expansionary) or tight (contractionary) policies?
  2. Will government policies cause banks to hold on to reserves, or incentivize them to lend to the public?
  3. How will investors preferences change between non-liquid assets, like privately owned businesses, and liquid ones, like publicly traded companies?

The velocity of money

  1. Which will be stronger, fear or greed?
  2. How likely is it that a major war will break out, pulling money off the sidelines into the war effort?
  3. Has velocity been trending downward or upward, and for how long?  Is it due for a reversal?

 

After reflecting on these questions, you’ll be able to make more confident long-term forecasts.

Think of a swimmer going along with the current, or fighting against it – this is the difference between a forecast that starts with a good understanding of inflation, and one that does not.  Whether you’re a long-term investor or a frequent trader, you’ll want the current on your side.

 

 

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(CC image by Jim Linwood on Flickr)

(CC image by Jim Linwood on Flickr)

 

Have you ever been to one of the world’s financial centers – London, New York, Hong Kong, Chicago, to name a few – and seen the huge glass-walled towers full of luxury offices?

When you hear about the massive salaries and bonuses being paid to the high-ranking people inside those offices, which house companies like Goldman Sachs, JP Morgan, Morgan Stanley, Lehman Brothers (rest in peace), Bear Stearns (another RIP, maybe they’re not so smart after all?), PIMCO, Wellington, Edward Jones, and so many more – how does it make you feel?

Certainly, these firms perform many useful functions for large institutional investors, who must maintain portfolios full of thousands of individual securities and file tons of paperwork.

But what about the office down the street in your town?  The branch office that handles the accounts of high net-worth individuals, corporate middle managers, hard-working entrepreneurs and diligent savers from all walks of life.  They work in the brand-new building, drive around luxury cars, and advertise constantly on TV.  They must be doing something really hard to earn all that money, right?

What if I told you that they’re not doing a single thing you can’t do, if you have only:

  • A computer or tablet,
  • The ability to listen to podcasts (a shameless plug for our podcast!) at some point during your week, like during your commute,
  • A minimum of 1-2 hours per week to review your investments (or only per quarter, if you prefer a more “hands-off” approach).

The more time and dedication you’re willing to put in to building these skills, the better your results will be, of course.  But even with just the basics, you can do most of what the “professional” advisors down the block are doing, and you can do it for a much cheaper price.

Even if your portfolio is as high as $10 million, this is within your reach.  You can learn it, and you don’t need to be a math whiz to do so.

Let me illustrate.

 

The Five Components of Successful Investing

This is the approach I developed to manage my own assets, which I accumulated across 10+ years of working in the corporate world.  Although I’ve developed advanced analytical tools to perform  each one of these steps, this is the overall process I follow.  You can do it too.

 

activemgtplan

Each step will be the foundation for lots and lots of future podcasts and posts.  For now, I’ll introduce the topic by giving just a brief outline of each step.

 

1. Determine why you’re investing.

Is your goal to have a secure retirement?  To save for your kids’ college?  To leave a legacy for future generations?  To become filthy rich and own 5 Lamborghinis?  No matter how ordinary or ambitious the goals, you need to know what they are.

Your goals impact your risk tolerance as well.  I like to distill the concept of risk tolerance to one sentence to make it easier to think about.  “If my net worth went down by [X%] in a short period of time, I would get very worried about my investments.”  Fill in the [X%] for yourself, it is a personal choice.  Yours might be as low as 2%, or as high as 100%!

Lastly, figure out your liquidity reserve.  That is, how much money you must keep safe and secure because you might need it in the not-too-distant future.  This is an emergency fund for job loss or, if you’re self-employed, a downturn in your business.  Three months, six months, or a year of expenses are common amounts.  Add on any big expenses you know are coming up soon, like a car purchase or down payment on a house.  The total is your liquidity reserve, or how much you absolutely must keep away from potential risk.

2. Develop long-term forecasts.

When it comes to forecasting, you can do all of the work yourself, rely on outside resources like Torpedo Trading, or fall somewhere in between the two extremes.  If you want to develop your own forecasts, you could mimic my comprehensive approach.  I developed my forecasts using: historical returns adjusted for long-term cycles, volatility assumptions, and correlation matrices.  If not, it’s much simpler to tune in to the podcast and follow the blog since you will find the results of all this hard work there, for free!  Alternatively, you could make your own forecasts based on independent research, talking with other investors, your favorite advisory services, astronomical cycles, or whatever you heard on CNBC yesterday.  (OK, not the last two examples.)

I re-evaluate my forecasts about once per quarter, sometimes sooner if there is a major shift in market conditions for a particular asset class.  Trends I define as long-term usually last 10 years or more, so they will not change much.

I chose about 25 asset classes in total, including: the 11 stock sectors, gold, oil, corporate bonds, Treasury bonds, and others.  You could use as few as 6 to 8 and get decent coverage of the investing spectrum.

Once you have a forecasted return and volatility level for each asset class, just put all your money into the one with the highest forecasted return.

JUST KIDDING!  That’s NEVER a good idea because of something called correlation.  Quite simply, correlation is the tendency for two asset classes to move up or down at the same time.  Even if you think bonds will have a lower return than stocks, you still want to include some bonds because they offer you diversification.  During a year in which stocks drop 25%, bonds may lose only 5% or even go up in value.  You might not have sufficient risk tolerance to take a 25% loss, but could absorb a smaller loss.

If you don’t want to be checking your portfolio or trading weekly or monthly, stop here!  Your plan looks like this instead, a shortened version of the one from earlier in this post:

activemgtplan-simple

Simply keeping your asset allocation in line with the long-term targets will put you in good position for long-term gains.  Once you’re confident in steps 1 and 2, it’s also enough to feel comfortable putting your advisor out of a job!

On the other hand, if you like to trade and you want the best plan, read on!

 

3. Develop intermediate-term forecasts.

By intermediate-term, I mean around 6 to 14 months.  I find that to be the typical trend length in most markets.

Intermediate-term cycles operate within longer-term trends, which last from several years to decades.  Aligning yourself with intermediate-term cycles takes more work and involves more risk than simply tracking the slow-moving long-term trends, but offers tremendously higher rewards.

I use a form of intermarket analysis that I developed with inspiration from an acclaimed book by John Murphy.  I also use a few other advanced technical tools to identify likely turning points.  More info on my approach can be found in this blog post.

You’ll use these intermediate-term forecasts to flex your asset allocations up or down from their long-term targets.  For example, you might have set a long-term allocation target of 50% for stocks, but your risk tolerance and goals permit you to vary that percentage in a range between 30% and 70%.  If you’re forecasting an intermediate-term rise in stocks, you would increase your stock holdings towards 70%.  When your forecast changes, anticipating a drop in stocks, you would begin selling stocks down to 30% of your total portfolio.

 

My current intermediate-term targets. I'm not bullish on stocks or bonds right now.

My current intermediate-term targets (some asset classes have been grouped together here, like all the stock sectors). I’m not bullish on stocks or bonds right now.

 

4. Be aware of short-term market moves.

Notice I don’t say “develop short-term forecasts” or “watch charts every single day” here.  This would be a full time job by itself.  We’ve all got a life to live!

I’m not opposed to day trading, but it’s foolish to be playing tiny moves in an hourly or shorter chart unless you’ve already got extremely sound intermediate-term and long-term forecasts.  Those moves will always dwarf the short-term oscillations.

If you’re under- or over-weighted in an asset class based on the intermediate term forecast, you’ll be trying to increase or reduce your position in that asset class.  Simply be aware of whether the last few days have trended down or up so you’re buying on a dip or selling on a pop.

I use my live stream and YouTube channel, both of which are free to watch, to keep viewers up-to-date on the latest developments in the financial markets.  Please consider subscribing to be updated when I release new content on those platforms.

 

5. Choose what you’ll buy and sell from each asset class.

I call this step “mapping your investment universe”.  Learn how it works and see an example here.

I usually recommend the major ETFs because they’re liquid and cost-effective.

It’s certainly appropriate to pick individual securities instead of ETFs here, wherever you feel comfortable doing so.  For example, maybe you work in the health care sector so you keep up on the trends in that area.  Or perhaps you love the latest tech products, and you’ve got a good lead on what will be hot and what won’t.

As part of this step, you’ll also want to consider whether options (calls or puts) are appropriate for you or not.

At Torpedo Trading, we maintain a list of preferred ETFs for each asset class.  The list changes from time to time as the fund companies make changes or add new funds.  This list will be provided to members once our membership program goes live.

 

More to Come

Stay tuned for future podcasts and posts that will dive much deeper into each of the steps above.  I hope this post will serve as a helpful reference for the overall process and how it works.

I’m here to help you take control of your investments, and avoid being gouged by expensive advisors.  This framework will set you on the path towards success.

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(CC image by Core Media Product Demo on Flickr)

(CC image by Core Media Product Demo on Flickr)

 

If you trade stocks, you’ve heard it before.  We all have.  From a colleague, family member, friend, or a mainstream investment advisor.

“You can’t beat the market.”  “Picking stocks is a fool’s game.”  “Stick to low-cost index funds.”  “Buy and hold for the long run.”

The list of prominent names who advocate for passive investing over active investing includes, to name just a few:

  • Jack Bogle, founder & former CEO of Vanguard Group;
  • Warren Buffett, founder & CEO of Berkshire Hathaway, who bet $1 million that a basket of 5 hedge funds would not beat an index fund;
  • Burton Malkiel, Princeton economist and author of Random Walk Down Wall Street;
  • Dave Ramsey, radio host and author of personal finance books including The Total Money Makeover. (Dave seems to be OK with actively managed funds, as long as you don’t do anything besides buy-and-hold the fund)

These folks would have us believe that the recipe for building wealth through investments is the following:

  1. Shovel money into low-cost indexed mutual funds and exchange-traded funds (ETFs) that mimic a broad market index, such as the S&P 500, FTSE 100, Euronext 100, DAX, or the S&P/ASX 200.  Or better yet, a global fund that includes all of them.
  2. Sit and wait for many years, while trying really hard not to look at your broker or retirement provider’s statements, lest you be tempted to sell.
  3. Retire rich.

Sounds simple, right?  It is!  Being somewhere between “mediocre” and “below average” isn’t too tough, if that’s your goal.

Why “below average”, not average?  If you hold a broad market index, aren’t you achieving the same return as the average market participant?

No.

 

Why holding index funds puts you at a disadvantage

Some companies perform better financially than other companies.  (Duh!)

There are exceptionally well-run companies, terribly-run companies, and many in between.  As a passive investor, you’re the last to discover which are the good ones and which are the bad ones.  Active investors are constantly researching these firms to separate the wheat from the chaff.  Accordingly, they bid up the prices of the stronger ones and sell the shares of the weaker ones, so that over time their market values move in the right directions.  This process generally happens over a period of time, with the first movers getting the rewards for their work and the late movers stuck on sinking ships or chasing trendy companies that have already reached stratospheric levels.

Some companies are a disaster waiting to happen – a powder keg that will blow a hole in the value of your portfolio.  What if you could avoid them?

As an example, let’s examine the performance of the Energy Select SPDR Fund (XLE) starting with the major peak that occurred on July 24, 2014.  This fund is the largest ETF tracking the energy sector.

The chart below illustrates the XLE (the black line) and ten of its largest holdings (the colored lines) in 2014, all indexed to a starting value of 100 for clearer comparisons.  The XLE fell by over 40% to a low in January 2016, followed by a recovery of about half its losses.  However, all energy stocks are not created equal.  A sharp investor could have avoided the pain, or even experienced gains during this tumultuous period.

xle-2014-16

After initially being sold off alongside the rest of the sector, independent refiner Valero Energy (VLO) had vaulted to a gain of over 50% by the end of 2015, thanks to strong refining margins, low debt, and productive capital investments.  Refiners like Valero actually benefit from declines in the price of oil, the raw material for its refineries, as long as profit margins hold steady.

Other components of the XLE fared better than the index, including Exxon Mobil (XOL) (10% decline) and EOG Resources, Inc. (EOG) (15% decline) compared to a 29% decline in the XLE as a whole.

On the flip side, Chesapeake Energy (CHK) collapsed, shedding 90% of its value and dragging down the energy ETF along with it.  The natural gas producer suffered steep drops in the value of its shale assets, many of which could not produce at a profit as oil and gas prices plunged.  It continues to suffer under the burden of substantial debt.

You didn’t need to be a professional investor to see the potential for huge differences in how these companies would perform.  Two tools – (1) a simple stock screener filtering on debt levels and (2) an understanding of the basic differences between a refiner, pipeline company, an explorer, and a producer – would have helped you hang on to 15 or 20 percent of your investment that would otherwise have been lost in XLE.

But because index funds have all the stocks, and there tend to be more winners than losers, it all works out in the long run, right?  Wrong, because…

Most indexes are capitalization-weighted

What does this mean?  Each stock’s share in the fund is proportional to its market capitalization (the price per share multiplied by the number of shares outstanding) relative to the market capitalization of the index.  So, the stocks that make up the highest weight in the index are the ones that have already been bid up by the market to the point where they are worth more than the others.  By investing in a fund that mirrors one of these index, you’re piling into the stocks that already have reached celebrity status.  You don’t own tomorrow’s Amazon or Facebook, or enough of it to matter, because they are too small today to get much (or any) weight within the large ETFs.

For some companies with strong cash flows and well-established business models (think: Exxon Mobil, Wal-Mart, Boeing), high valuations can make sense.  But for every one of those, there is an overvalued dud.  Remember Enron, Eastman Kodak, Woolworth’s, Trans World Airlines, Pan Am, WorldCom, RCA, Compaq, or Pets.com?   At one time, each of these was a hot stock with a very high market capitalization, but now they are all confined to the history books.  Which of today’s high flyers will join that infamous list one day?  Apple?  Volkswagen?  BP?   All of the above?

The “illusion of diversification”.

It is easy to be lulled into a false sense of security by thinking you are diversified because you hold 20 or 30 of the biggest publicly traded companies in a sector instead of just one.  But, it’s typical for the largest 4 or 5 to comprise over half of the weight in a sector ETF.

What about holding all the sectors?  If you own many retailers, chemical companies, oil refiners, banks, wireless providers, technology firms, and mining companies, surely that is enough diversification?.  In 2008 and 2009, that didn’t work so well.

S&P 500 Index, from 2006 to 2009

S&P 500 Index, from 2006 to 2009

 

Correlations between different stocks and sectors always increase during times of financial stress – which are precisely the times when you need true diversification the most.

Another way of saying this is that when the markets are panicked, everything gets sold – the baby, the bathwater, the tub, the copper pipes in the bathroom, the house itself, and the land it rests on.  Imagine if you had just retired in 2007 with a “diversified portfolio” full of stocks.  By 2009, half your assets had vaporized.

True diversification requires owning multiple asset classes, including alternative assets, in proportions that are optimal for today’s investing environment.  I also encourage investors to consider using options to manage portfolio risk.  This will be a topic for future posts.

 

ETFs are more popular than ever, creating opportunity for active investors

Hedge funds are closing at an increasing pace.  Institutional money managers and individual investors are flocking to ETFs in record numbers.  Since gaining mainstream status in the 1990s, index funds have captured a larger share of overall stock assets nearly every year since 2000, according to CNN Money.  There are over 1,000 ETFs today, with new ones released every week.  They track a mind-boggling number of indexes, with tongue-twisting names like the “Dow Jones FEAS Titans 50 Equal Weighted Index” and the “Dow Jones Europe Developed Markets Select Real Estate Securities Index.”

This article, from Julia La Roche at Yahoo Finance, is a reminder of how dangerous this phenomenon can be for buy-and-hold index fund investors.  In it, independent researcher Steven Bregman warns of an “indexation vortex that’s distorted clearing prices in every type of asset in every corner of the globe.”  He emphasizes the systemic risk that ETFs pose, an argument that has become more mainstream lately as ETF “flash crashes” become a more common occurrence.  But I’d like to focus on what I feel is the critical point here – the tremendous opportunity the ETF boom provides to active investors.  That is, the “golden age of active management.”

Every dollar that moves OUT of an active fund (e.g. hedge fund or actively managed mutual fund) or an active strategy-based approach INTO a passive, indexing plan puts you and I one step closer to being one of the “first movers” I mentioned earlier.  It’s as if you own a home improvement store in your city, you’ve just watched Home Depot close its doors, and Lowe’s has announced a going-out-of-business sale.  Fewer investors identifying mispriced stocks leaves more money on the table for savvy active investors.

It’s a fantastic time to manage your own investments!

 

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