Posts tagged with: Inflation

Gold is the one and only investment that I strongly believe every investor needs in their portfolio at all times.  However, don’t go overboard and don’t fall for sales pitches that are meant to frighten you into buying gold.  In this episode I’ll teach you the basics of investing in gold, what it can and cannot do for you, and how to get started if you don’t yet have any gold in your portfolio.  I also discuss how to use fundamental and technical analysis on gold to find the best buying opportunities.

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Section 1: Background & Basics

  • History of gold as money
  • Who owns it, and in what form?

Section 2: What Determines the Price?

  • Fundamentals: global supply & demand
  • Financial conditions: Supply of money and credit, interest rates (real and nominal), inflation rate, health of the credit markets, and the rates at which these are changing
  • How I create my forecasts

Section 3: Why You Need Gold – The Rational Arguments

Section 4: Risks, Downsides, and Common Mistakes

  • Keeping too much of your money in gold, silver, or mining companies
  • Buying based on fear or panic
  • Buying from a less-than-reputable dealer
  • Buying at the top of the market
  • Security concerns
  • Tax treatment (United States)

Section 5: How to Begin Today

  • Take stock: How to determine if you are ready to purchase now, or if you should wait
  • Choose what form(s) of gold to buy – or, whether to start with silver because it’s more affordable
  • How to buy gold coins
  • How to buy gold bars in fractional/unallocated form (vaulted storage)
  • How to buy “paper gold” (e.g. ETFs)
  • How to buy shares of gold mining companies
  • Advanced strategies for earning cash flow from gold holdings


JM Bullion: The dealer I trust

BullionVault – secure vaulted storage and online trading of precious metals

Blade Digital Pocket Scale – for weighing coins

History of gold & silver as money

Infographics on the world gold supply and production totals

Above-ground gold reserves by country

Episode 7: Anyone Can Learn Technical Analysis to Boost Profits

Inflation, Deflation, and Your Portfolio


Historical gold price chart:


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Here’s How to See the Trend

(Part 9 of ten-part series on Financial Truths)

Section 1: Why Did Your Short-Term Pattern Fail?

Section 2: Follow the Money: Start with Inflation/Deflation

Section 3: Make a Long-Term Forecast

Section 4: Make an Intermediate-Term Forecast

Section 5: Identify & Trade the Best Opportunities


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Blog Post References:

An Active Management Plan for Self-Directed Investors

Inflation, Deflation, and Your Portfolio

Fearless Forecasting for Long-Term Investors

Fearless Forecasting for Traders


Section 1: Why Did Your Short-Term Pattern Fail?

  • Why do chart patterns fail?  Most often, it’s the higher-level trend – found in the sector, the broad market index, or longer-term stock chart.
  • SBUX looked bullish to a short-term trader on 11/3/15 …

    … but the sector was WAY overextended and at a key level …

    … and the S&P 500 had recovered as much as it could. Nowhere to go but down.

    Long-term chart looked bubbly! SBUX still hasn’t broken this level as of 2/6/17

  • Always study the sector and market (higher-level assets)
  • Always study the intermediate-term and long-term trends (higher-level trends)

Section 2: Follow the Money: Start with Inflation/Deflation

  • What inflation is
  • How we measure inflation
  • Why inflation matters so much
  • How to forecast inflation

Section 3: Make a Long-Term Forecast

  • I introduced this concept in Episode 4
  • Pull up a weekly chart, 25+ years of data
  • Examine the four dimensions of: Price, Pattern, Momentum, and Time (see Episode 7 for details)
  • Choose your baseline asset allocations
    • Best approach: Rank all the choices in your investment universe from highest to lowest Sharpe Ratio
    • Simpler approach: Just adopt my allocations (shown below as of February 2017), but adjust as needed for your risk tolerance, goals, and market outlook
    • More details coming up in Episode 10!
    • As of Feb 2017, I’m bearish on most financial markets over the long-term, so these are conservative allocations despite my relatively young age.

      The sector-by-sector view for serious traders. This shows how I divide my stock allocation across various sectors. They’re ideal targets, not something I try to exactly match my portfolio to. As of Feb 2017.

Section 4: Make an Intermediate-Term Forecast

  • Pull up a daily chart, 8+ years of data
  • Examine the four dimensions of: Price, Pattern, Momentum, and Time (see Episode 7 for details)
  • “Flex” your baseline allocations, going overweight the assets that you expect to rise in the intermediate-term, and underweight or short the ones you expect to fall (review Episode 4 for more details)
  • Overweight bonds, underweight stocks, and short the US dollar as of early Feb 2017. But I’m still diversified.

Section 5: Identify & Trade the Best Opportunities

  • You’re free to trade anything within the asset class or sector; just stay reasonably close to your asset allocation targets
  • Remember that options and futures are leveraged.  Don’t underestimate the exposure.
  • Update periodically
    • Re-evaluate the long-term trend every few months, or sooner if the intermediate-term trend has changed
    • Re-evaluate the intermediate-term trend every few weeks, or sooner if market conditions warrant
  • Learn more macro trading strategies and stay current on market news by viewing our online trading videos and live streams


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(CC image by Mario Donati on Flickr)

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We’ve seen relatively low and stable inflation levels for the last 30 years, so it’s easy to forget that it hasn’t always been this way.  What will the next 30 years bring?  More of the same, a return to the high inflation of the 1970s and early 1980s, or deflation as in the Great Recession of 2009-2010?  Or, could we experience all of the above?  Is your portfolio ready?

My prior post explains the real meaning of the terms “inflation” and “deflation” with several examples.  It also guides you towards making better forecasts of inflation, based on its three main drivers.

When the inflation rate shifts suddenly, it causes major damage to investors who haven’t prepared for these episodes.  Often, it’s the investors with the most conservative approach that are left worst-off once the dust settles.

If my forecast comes to pass, few investors will be spared from the damage.  That’s because the conditions today are ripe for BOTH deflation AND inflation, one after the other.  Only by taking specific steps now, and remaining alert as events unfold, will you emerge with your portfolio intact.


Historical Perspective

Prior to 1971, when the United States fully broke all ties between the dollar and gold, consumer prices in the United States underwent phases of high inflation and deflation.  However, when averaging across these cycles, prices maintained stability over the long run.   This happened because the dollar was backed by gold and the supply of gold grew only as quickly as it could be mined and processed.  Overall price levels stayed roughly the same from generation to generation, rather than increasing over time like everyone accepts as normal today.  (Look at how much prices have gone up from 1975 to 2015 – imagine if college was still that cheap today!)

Since 1971, the inflation rate has been less volatile, as the U.S. Federal Reserve has closely managed monetary policy in the United States.  The Fed’s objectives, as defined by the Federal Reserve Act, are to maximize employment, maintain stable prices, and moderate long-term interest rates.  These objectives existed long before 1971, but in the eyes of the Fed’s Board of Governors and the Federal Open Market Committee (FOMC) who are charged with carrying out these goals, “stable prices” now means something very different than it used to.  Today, they say that “stable prices” does not mean actually mean “stable prices” over the long run, but gradually rising prices!  If they really cared about stable prices, you’d still be able to buy a postage stamp for 13 cents or a car for $3,800, as in 1975.

The Fed has managed to keep prices rising gently for most of the last 45 years because it has responded swiftly and dramatically to any threat of falling prices in the economy, whether real or perceived.  By contrast, they react slowly when the economy is booming because they do not want to be blamed for the damage that would occur if they suddenly withdrew stimulus from the economy.  This behavior creates a strong bias towards rising prices rather than stable or falling prices, as we see below.


The Fed’s focus has been on using monetary policy to smoothing out the boom-bust cycles that naturally occur in a free market economy.  When the economy starts to contract, the Fed expands the money supply through actions like buying US Treasury bonds (indirectly, because doing so directly would be illegal!), cuts key interest rates, or takes other actions to try to juice up the economy.

On the surface, this seems like a great thing for everyone.  Who cares if prices go up over time, as long as it’s gradual and predictable and there are no major shocks to the system?  If they’ve kept inflation tightly controlled for decades, certainly they can continue to do so?

Not so fast.  This “over-management” of the economy harms us all, especially savers and investors.  It allows bubbles to grow bigger and bigger over a longer period of time, rather than deflating on their own.  We saw massive bubbles burst in currencies (1997), real estate (2008), stocks (1987, 2000, 2008), banks (1980s S&L crisis), junk bonds (1989), and commodities (2008, 2014-15) to name just a few.  These bubbles would likely have still happened without misguided policy from the Fed and the U.S. government, they would just have been smaller and easier to recover from.

In summary, the Fed has kept the inflation rate moderate and positive for decades, but at the cost of pushing more volatility into asset markets.  This is wonderful news for alert traders and active investors, but bad news for savers and passive investors.


Current Conditions

Under a “lower-for-longer” interest-rate policy like we observe today, businesses respond by expanding debt, refinancing old debt that they’ll still never be able to pay back, and other financial engineering like massive stock buybacks, all of which are value-destroying in the long run.  They don’t deploy as much capital into real investment that would produce long-run growth and more jobs.  Furthermore, retirees, and savers have to set aside more money when interest rates are low, otherwise they won’t have enough interest and dividends to live on.  Pension funds and insurance companies must set aside more money to meet future obligations.  What does this all mean?  Money sits idle or chases bad investments instead of being invested into job creation, good technologies, or production plants.

We see this most clearly in the velocity of money: the rate at which money, credit, and liquid assets circulate in the economy.  Lower velocity means more money sitting idle instead of being used to purchase goods and services.

A similarly steep drop in velocity happened right before the Great Depression.

A similarly steep drop in velocity happened right before the Great Depression.


At the same time, the money supply is rapidly expanding:


Most measures of credit I monitor are growing too.  Corporate debt, student loans, and auto loans are breaking records month after month.

Yet despite all this credit creation, and consumer prices that are nominally rising, I see deflationary pressures far outweighing any inflationary ones.  Neither government nor the Fed can stop it using their existing tools.

Commodity prices continue to trend downward:

These are two commonly-cited indexes of commodity prices I track. The Dow Jones-UBS index (purple line), has more weight in energy than the CCI (red line).

These are two commonly-cited indexes of commodity prices I track. The Dow Jones-UBS index (purple line), has more weight in energy than the CCI (red line).


Gold and gold stocks remain below their 2011 highs:



Investors’ inflation expectations keep falling:



Lastly, actual realized inflation continues to fall short of investor expectations:



These charts don’t look anything like what we’d expect to see if inflation were right around the corner.  This is deflation all the way.


What’s Next?

When debt builds up in the economy, all is well-and-good until enough borrowers become unable to service their debts.  Debt levels across households, corporations, and governments continue to grow far faster than incomes.  This is unsustainable.  Default rates will reach crisis levels in one area first – state and local governments are a likely starting point, but I cannot be certain which area will tip off the crisis.  It could even be a geopolitical crisis, natural disaster, or any number of events that could set the process in motion.  Timing is even more difficult to predict, but it’s hard to imagine we can go another 3-5 years on the path we’re on.

As default rates rise, the crisis will spread to other sectors of the economy with a speed and severity that will exceed politicians’ and the Fed’s abilities to respond.  Therefore, expect a sudden decrease in virtually all asset prices, with few places to hide.  Gold, income-producing real assets like land and some real estate, will be best protected.  This will be the deflationary phase of the crisis.  (I’d argue the deflationary pressures we see today are a sign that the crisis period has already started!).

But I don’t expect politicians or central bankers to accept this reality for long.  There will be too much pressure on them to act, and to act in ways we have not seen before.

As an example, I believe we are likely to see a large-scale debt forgiveness program for households accompanied by a revaluation of the U.S. dollar at a lower level.  I also think we’ll see a global renegotiation of debts, since a great deal of debt is owed to other governments.   U.S. President-Elect Trump, whether you like him or not, certainly is a man who understands how to renegotiate debt and emerge from bankruptcies.  To make these measures more effective, I also expect governments will initiate capital controls, restricting the movement of money across borders.  We may also see an attempt to introduce regional currencies or a global currency at this time.  These actions will represent the inflationary phase of the crisis.

The length of time we remain in the deflationary and inflationary phases will depend on how effective global policymakers are at achieving consensus during the crisis.  The more rapidly they are able to successfully “reset” the global economy, the faster we’ll move from deflation to inflation and then return to some semblance of normalcy.


How To Stay Safe, Or Even Profit, From These Events

If there is one thing all good traders love, it is volatility.  Even in times of crisis, markets remain open (with limited exceptions).  Many of the skills I teach will help you preserve your capital and even make money during both phases of the crisis.  For instance, shorting stocks, buying put options, and trading the VIX in a crisis environment can be immensely profitable!  Keep in mind that these strategies do carry risk, and should be used carefully as your own financial situation permits.

You should also consider owning some hard assets like gold, silver, and income-producing real estate if you are able.  Minimizing your own personal debt will benefit you in a crisis period as well.  Stay tuned for more on all these topics.

Above all else, it goes without saying that you’ll want to take steps to ensure your personal safety, diversify your skillsets, and overall become more self-sufficient.  I highly recommend Jack Spirko’s podcast, The Survival Podcast, for a rational and thoughtful discussion of preparedness topics.  I’ve been a listener and subscriber for many years.

Deflation and inflation don’t have to catch you off-guard.  By sharpening your trading skills, you can use volatility to your advantage.


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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:


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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