Mean Markets and Lizard Brains Read online

  FIGURE 5.3 Is the Federal Reserve Creating Inflation Again?

  Source: U.S. Federal Reserve

  To repeat the mantra of this chapter as expressed by Milton Friedman, inflation is always and everywhere a monetary phenomenon. Thus, as long as we keep a clear eye on money growth, we should have early warning of any major change in inflation. If money growth increases, then inflation will follow and investments should be in tangible assets including gold and land, and in currencies other than the U.S. dollar. If deflation becomes likely because of slow monetary growth, then financial assets, particularly certain bonds, should do well. For example, the simple U.S. Treasury bond, even with a yield of just 5% per year, could be extremely profitable in a deflationary environment.

  Buy Your Inflation Insurance at Irrationally Low Prices

  In addition to looking out for changes in the money supply, there are a number of financial steps that make sense in any environment.

  Recall from our discussion of human nature that our lizard brains tend to put too much weight on recent experience. Since Paul Volcker stopped inflation in 1979, the United States has experienced nearly perfect inflation rates. This suggests that most investors will be too little concerned with the possibility of either inflation or deflation. Having spent 20 years in a Goldilocks zone of low and stable inflation rates, we are likely to overlook the possibility of problems.

  A funny thing happens to the stock of insurance companies after disasters. When a hurricane, fire, or earthquake hits, the insurance companies pay claims that can add up to billions of dollars. What do you think happens to the stock price of these companies immediately after disaster strikes? You might expect the stock prices to decline to reflect the billions of dollars in claims. Quite often, however, the result is exactly the opposite and the stocks rally.

  Why do insurance company stocks rise on bad news? The answer is that people tend to buy insurance after big disasters. So the insurance firms are indeed hurt by the claims that they pay, but they also gain from the marketing of their product. Often the gains exceed the losses, and this can cause the stock price of insurance companies to go up after a disaster.

  This response to disaster points out that in insurance, just as in other areas, most people tend to be exactly out of sync with the money-making strategy. The time to buy insurance is obviously before the event, when no one is buying and the insurance rates are low, not after the event when everyone is buying and rates are high.

  Twenty years of Goldilocks has lulled most of us into exactly the wrong position. We have come to expect price stability. That means our lizard brains are likely to be underprepared for price instability, in the form of either inflation or deflation. To the extent that many of us are in the same position, now is the time to insure ourselves against price instability on favorable terms.

  Here are three strategies to protect your wealth against both inflation and deflation. They are all ways to buy insurance in case we leave the Goldilocks world of low and stable inflation.

  Buy at Today’s Prices

  The first technique is simply to buy at today’s prices. If you buy the home that you plan to live in for some time, then you are protected against price swings. While you may suffer as compared to your alternatives, you will be safe within your home. Similarly, some states allow you to pay college tuition ahead of schedule.

  If you buy the stocks of companies that own natural resources, then you are protected from commodity price changes. For example, if you own the stock of oil companies, then you will benefit from any subsequent rise in oil prices. If you buy the correct amount of such stocks, you can completely protect yourself from the effects of commodity price changes.

  If You Borrow, Lock in Current Rates

  Recall that high inflation is a jubilee where debts are effectively erased. The higher the inflation rate, the lower the true cost of repaying debt. In the 1920s, German debtors were able to pay off their mortgages with marks that were essentially worthless. Thus, high inflation provides a financial windfall to debtors.

  This inflationary benefit to debtors is true, however, only for those with fixed-rate debt. A growing percentage of Americans are financing their debt with adjustable-rate loans. If inflation rises, these people will find that their payments have increased commensurately with the new inflation.

  If you want to insure yourself against price changes, choose fixed rates for all of your debt. With fixed rates, your debts decrease in real value in inflationary environments. What about in deflationary times? In deflationary times, you can refinance your debts at lower rates.

  So fixed-rate loans are better than variable-rate loans in inflationary times, and fixed-rate loans are no worse than variable-rate loans in deflationary times. Are fixed rates, therefore, a free lunch? The answer is they are not, because the fixed-rate loans are offered at higher rates than variable loans. The extra monthly payment for a fixed loan can be viewed as purchasing insurance against price changes. If the previous analysis is correct, then the world may be pricing such insurance at unusually low and attractive prices. Thus, borrowing at a fixed rate may not be a free lunch, but it might represent a value meal.

  Buy Inflation-Protected Securities

  The U.S. government sells bonds that provide complete protection against inflation. The amount that these bonds pay is adjusted each year for the prevailing inflation rate. If inflation is high, the bonds pay more to reflect the lower value of each dollar.

  Let’s compare the payoff to an investment in a 10-year inflation-protected bond to an investment in a traditional bond without inflation protection. To be concrete, we will compare a $1,000 investment into U.S. government bonds with and without inflation protection. Both bonds pay interest over the years and then make a lump-sum payment at the end. Whereas a traditional, noninflation-protected bond simply returns $1,000, the inflation-protected bond adjusts the $1,000 based on the amount of inflation.

  Thus, the inflation-protected bond returns at least $1,000, and perhaps more. How much more? That depends on the inflation rate. To see the specifics, Table 5.1 compares the final payment for the inflation-protected and the noninflation-protected bonds under four different inflation scenarios.

  Scenario 1 is no inflation. Scenario 2 is a continuation of the Goldilocks environment of 3% inflation per year. Scenario 3 is a return to the late 1970s in the United States with 13% inflation per year. Just for fun, scenario 4 considers prices rising at 500% a year (although this inflation rate is high, it is far lower than the rate in Germany during the hyperinflation). So what do our bonds pay in these four scenarios?

  Table 5.1 shows that when the original $1,000 is returned, the inflation-protected bond is always at least as good as the standard bond and usually much better. Even in extreme conditions, the inflation-protected bond ensures that the investor is protected.

  TABLE 5.1 TIPS Provide Inflation Protection (Payment at Maturity per $1,000 Investment)

  This inflation protection, however, comes at a price. That price is the lower interest rate paid on the inflation-protected bond. Currently, that difference is about 3% a year. Therefore, the most that inflation insurance could cost you is about $30 a year for each $1,000 investment. This maximum price will be paid only if there is no inflation at all. If there is even modest inflation, however, the price of insurance is even less than $30 a year for each $1,000 investment.

  Because inflation protection has been unnecessary over the last 20 years, the behavioral economic research suggests that our lizard brains, and consequently the market, may be undervaluing the inflation-protected bond. Furthermore, U.S. government bonds are fantastic investments in deflationary times. Therefore the inflation-protected bonds are almost unique in being great investments under both inflation and deflation. Thus, I believe that the inflation-protected bonds represent good value.

  There are two types of U.S. government, inflation-protected bonds. They are the I-series of U.S. savings bonds, and the Treasury Inflation Protected Se
curities or “TIPS.” There are some legal differences between the two types of bonds. For example, the savings bonds are restricted both in the amount of purchase and the type of investor (mainly U.S. citizens). Both bond types, however, are essentially identical when it comes to inflation protection.

  What about stocks as a protection against inflation or deflation? At first glance, this seems like a crazy suggestion. Consider three of the most famous periods of inflation and deflation. They are the current Japanese deflation, the U.S. deflation during the Great Depression, and the U.S. inflation of the 1970s. In all three periods, stocks were terrible investments. So stocks would appear to be a very bad way to protect wealth against an end-of-the-Goldilocks era of price stability.

  While stocks were bad investments in past periods of price instability, they may be good investments now. Company profits have a built-in inflation protection, just like the U.S. government bonds. Inflation, without other economic change, simply inflates a company’s revenue and costs. Thus, company profit—the difference between revenue and cost—ought to rise in lockstep with inflation.

  If corporate profits are inflation protected, why have stocks done poorly in previous periods of price instability? The answer may be that in those previous periods the inflation and deflation were symptoms of deeper problems. For example, the poor stock performance in the United States during the 1970s may not have been caused by inflation. Perhaps the oil shocks of the time caused both inflation and poor stock performance. Thus, in future periods of price instability, stocks may provide protection.

  Magic Paper

  As Professor Friedman suggests, money is a fascinating topic. The magical little pieces of paper and electronic entries in bank computers allow us to leave behind the inefficiencies of barter and to amass wealth that we will use over many years.

  The form of money has changed over time from commodities to precious metals to the current standard of fiat currencies. These modern forms of money are perfect with the exception of one enormous risk. That risk is that monetary authorities will misuse their power to determine the rate of inflation. In the past, such monetary mischief has bankrupted many families.

  The United States has lived through 20 Goldilocks years during which inflation has hovered near optimal levels. The science of irrationality suggests that these halcyon years will have left most of us unprepared for any future price instability. Therefore, when most people’s lizard brains feel that the risks of price instability are negligible, we may have an opportunity to buy low-cost protection for our wealth. Fortunately, there are both traditional and innovative investments that allow us to protect our wealth.

  Update since the First Edition

  Inflation has been on the rise, with 2007 registering the highest rate in almost 20 years (Figure 5.4). Between 1991 and 2006, inflation was low and stable, with annual rates confined within a tight range of 1.6 percent to 3.4 percent; 2007 was a break out to the high side. In addition, the continued decline in the U.S. dollar and oil prices substantially over $100/barrel suggest inflationary pressures that will show up in 2008 and beyond.

  What’s Next?

  Now that Goldilocks is dead or dying, is it obvious that the outcome will be continued higher inflation? I think not.

  It is useful to repeat what is known about inflation before moving on to what is unknown. Given the amount of angst regarding inflation, the underlying reality is simple. More money means more inflation. Thus, predicting U.S. inflation rates is the same as predicting the behavior of the U.S. Federal Reserve. If the Fed creates a lot of dollars, each dollar will have lower value.

  FIGURE 5.4 U.S. Inflation Is at a Multiyear High

  Source: U.S. Bureau of Labor Statistics

  What we know today, that we didn’t know when the first edition was published, is that Ben Bernanke is the successor to Alan Greenspan as chairman of the Federal Reserve. Certainly, the first assessment of Ben Bernanke suggests that inflation will become too hot. “Helicopter Ben” is the moniker earned by Chairman Bernanke when he noted in a speech (before he was appointed chairman) that deflation could always be avoided by creating money. The source of the nickname is Milton Friedman’s view that if deflation became a problem, it could be resolved simply by throwing money from a helicopter.

  To date, Helicopter Ben has been true to his nickname, in spirit if not in specifics. While he has not been seen with stacks of Ben Franklins in a Sikorsky, he has increased inflationary pressures by repeatedly cutting interest rates.

  Helicopter Ben sits at the controls, ready to solve any economic problem by providing more money. Should we all buy gold and oil and impressionist paintings? No. The investing world is not that simple. While Helicopter Ben may have a penchant for inflation, he may not choose to produce inflation if the pain of liquidity becomes too great.

  High inflation might, for example, create higher mortgage rates as lenders demand compensation for the declining purchasing power of a dollar. Thus, an effort to ease the housing problems through loose monetary policy might paradoxically have the opposite effect. In such a scenario, the Fed may choose deflation. Thus, while the Federal Reserve has complete control over inflation, it is constrained by the consequences of its actions. It would be ironic if Helicopter Ben presided over deflation, and that may happen.

  In the first edition, I remained officially neutral as to whether Goldilocks would die on an inflationary or deflationary sword. I retain this belief. One of the core truths about investing is that the consensus is comfortable, but unprofitable. In recent years, the fears of deflation have receded, and advertisements for gold can be seen on a regular basis on financial networks. To a contrarian, the popular fear of inflation suggests that deflation is more likely. The most interesting outcome for a student of the lizard brain would be a relatively rapid move from high inflation to deflation.

  While I remain agnostic on the direction of future price changes, I still endorse the prescriptions from the first edition on how to buy protection against large changes in inflation rates. The cost of price protection has risen from its low levels of a few years ago, but I still believe the world is too optimistic about price stability. Thus, price protection, particularly against deflation, may still be a good value.

  chapter six

  DEFICITS AND DOLLARS Uncle Sam the International Beggar

  Neither a Borrower Nor a Lender Be

  A few years ago I went to dinner in Los Angeles with a group of close friends and a couple whom we had recently met. Because some people had very expensive meals with cocktails while others consumed very little, we decided not to divide the bill equally, but rather to each pay for our own consumption. When the bill came we all pitched in what we felt was our fair share (or so we thought).

  We came up about $40 short of the tab. Since I had eaten a very modest dinner consisting of a turkey burger and a diet coke, I was pretty sure that I had not made a major mistake in calculating my share; nevertheless I pitched in an extra $5. So did most everyone else, and we paid the bill.

  A few days later we revisited the embarrassing shortfall, and we began to piece together the puzzle. Because we were all good friends, we soon figured out that the new couple had consumed the most extravagant meals and had drunk the fancy cocktails yet had contributed almost nothing to the bill. We thus labeled the man “Cheapskate” (he had “paid” for the couple’s dinner).

  We resolved that in future interactions, we would not allow Cheapskate to take advantage of us. We even practiced confronting Cheapskate over the bill. “I had the turkey burger, what did you have?” Even though such displays are deeply embarrassing, we found them preferable to having Cheapskate take us for more money.

  Our role-playing was never put to use with Cheapskate because he met a fate similar to Elvis. He died on the toilet from a heart attack just weeks after shorting us on the bill. After his death, his girlfriend discovered that she had a big mess to clean up—Cheapskate owed money to almost every single person he knew.
/>   A small-scale con artist with a drug dependency, Cheapskate had put “the touch” on everyone by borrowing money and never repaying it. Interestingly, although he owed many people money, his total debt was only a few thousand dollars. People were quick to cut him off. Just as he was never going to get more than $5 from me, others were not willing to make repeated loans.

  A lesson from Cheapskate’s life is that it is hard to be a perennial borrower. People are built with instincts that prevent and limit exploitation. When we loan money, we expect repayment and stop lending to deadbeats.