Alternative Investments for Uncertain Times

Posted on October 18th, 2010 in Investments, Newsletter Articles by wayne

With inflation rates running at between 2% and 4% for many Americans, while short term treasury notes yield virtually nothing, safe investments are yielding a real rate of return between -2% to -4%.  Just keeping investment returns that are equal to the inflation rate forces us to move further out on the risk curve than many of us would like.

While there is no such thing as a completely safe investment, by paying attention to macro-economic events in the US and abroad, we can make educated decisions on the types of investments that will likely provide the best returns for our portfolios.  In this article we will look at alternative investments that could enhance your portfolio.

On the domestic front, it appears that the Treasury and the Fed are determined to create two outcomes that they hope will help revive our economy.  It is their desire to reduce the value of the dollar and increase inflation, while keeping short term interest rates near zero for as long as possible.

If our government is successful in producing these outcomes, it will be important to own investments that appreciate when the dollar is devalued as well as investments that provide total returns that exceed the rate of inflation.

Even though it is near an all time high, gold will likely continue to rise if the dollar continues its decline.  Gold can be viewed as an alternative currency.  To understand this concept, look at how much less gold has appreciated when priced in Euros or Yen than it has when priced in dollars over the last five years.  A simple and effective way to own gold is through Exchange Traded Funds (ETFs) such a GLD or AIU.

Another way to take advantage of a falling dollar is to invest in the currencies of nations whose currencies could appreciate relative to the dollar.  As an example, in 1973, when the Japanese Yen was allowed to float against the US dollar, it took 271 Yen to buy a dollar.  Today, a dollar can be bought for only 81 Yen.   The Yen has increased 235% against the US dollar since 1973 and 65% since 2002.

Two counties whose currencies could increase with a continuing decline in the US dollar are Australia and China.  Both countries have large amounts of natural resources, which will rise in value as the dollar declines.  This helps make them less dependent upon the US economy in the future.   ETFs are available to allow for the investment in both country’s currencies.  For Australia, the ETF call sign is FXA and for China the call sign is CYB.

As the dollar declines, the price of commodities (priced in US dollars) will increase.  To invest in a broad basket of various commodities, you might consider the ETF with the call sign DBC.  Agricultural products should also increase, as the dollar decreases.  An ETF that provides a broad basket of agricultural commodities has the call sign DBA.

While the above alternative investments may do well if the value of the dollar continues to decline, they are all risky investments.  For most investors, no more than 10% of your total portfolio should be invested in “alternative investments,” with remainder in equities, fixed income and cash equivalents.  Next month, we will explore investments in these categories that will likely do well as the dollar declines and inflation increases.

The Myth of Low Inflation

Posted on October 18th, 2010 in Financial Abundance, Newsletter Articles, Risk Management by wayne

The Federal Reserve continues to fret over low inflation rates and how this could lead to deflation.  While the Fed claims that we have virtually no inflation, my recent personal experience has been just the opposite.  The cost of living, especially the cost of food, energy and health care, appears to be rising at rates that were last seen in 1981.

To understand this apparent dichotomy, let’s take a look at how the Consumer Price Index (CPI) is calculated.

The CPI is calculated by examining monthly price changes in eight different categories of consumer expenditures.  Each category is assigned a “weight” based on the government’s estimate of what the “average” consumer spends in each category.  The following table provides each category of expenditures as well as the percentage weighting, assigned by the Bureau of Labor Statistics.  The right hand column provides an alternative weighting for a “hypothetical consumer” with lower housing costs.  This could be a consumer that has paid off their mortgage or remained in the same house for many years.

Expenditure                                     CPI-U                  Hypothetical

Category                                       Average                 Consumer

———————————————————————————-

Total (all items)                               100.0%                      100%

Food and beverages                        15.7%                        25%

Housing                                            40.9%                        10%

Apparel                                              4.4%                          5%

Transportation                                  17.1%                       20%

Medical care                                       5.8%                        25%

Recreation                                          6.0%                         4%

Education and communication            5.8%                         3%

Other goods and services                   4.3%                         8%

———————————————————————————-

Total, all items                                  100.0%                  100.0%

If you are interested in exploring the CPI in more detail, this information can be found at   http://www.bls.gov/news.release/cpi.t01.htm

The CPI data supplied by the Bureau of Labor Statistics accurately shows that, with the current governmental category weightings, the CPI increase over the past twelve months is only 1.1%.  However, looking at the increases by expenditure category shows that transportation costs rose 4.6% and health care costs are up 3.4% over this time frame.

The large increases in transportation and medical care costs are offset by housing costs, which are given a weight of 41% of the total CPI basket.  The CPI data shows that housing costs decreased by 0.3% over the past year.  However, unless a home was refinanced or one moved into a smaller residence, most people’s housing costs have increased over the past year due to higher energy prices, property taxes etc.

Since recent costs increases appear to be accelerating, we examined CPI change data that is also available for the past three months.  Using the government provided CPI average weighting and annualizing the data by expenditure category over the last three months, we calculate the current three month “run rate” for the CPI increase as 2.7%, instead of the past year’s 1.1%.

To further test the CPI data, using the published annual CPI increases by expenditure category, we calculated the annual CPI change with the category weightings of the “hypothetical” consumer.  When the “hypothetical” consumer expenditure weightings are used, the inflation rate over the past twelve months doubles to 2.2%.

Finally, we calculated the “hypothetical” consumer expenditure weightings combined with the current “run rate” of inflation.  When the hypothetical consumer weightings are applied to the government supplied CPI data over the past three months, the annualized rate of inflation for our “hypothetical” (but realistic) consumer was a startling 4.0%.

Quantitative Easing Two, due to be announced at the November Fed meeting, will add vast amounts of cash to our economy.  The justification for this program is that our inflation rate is so low that the government needs to increase our rate of inflation.  Would that reasoning be acceptable if the current inflation rate is 4%?

The next time you are paying for groceries, your utility bill or your health insurance, you might discover that you are more like our “hypothetical” consumer whose inflation rate is running at several times the government provided CPI rate.  We can only hope that the Fed changes directions before our inflation rates match those last experienced in 1981.