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Stocks are widely believed to provide inflation protection since
factories, equipment and inventories rise in value as prices generally
increase. Historically, stocks have in fact tended to rise with inflation
rates, but too much inflation has caused volatility and raised a question as
to whether stocks really are a reliable inflation hedge.
Stocks in certain sectors have similarly earned a reputation as
recession protection. Stocks designated as “defensive” are those
in industries that make stuff we've simply got to have, such as food and
drugs, or items in the category of “sin,” referring to things we
may not need but will kill to get – traditionally tobacco and alcohol,
and perhaps other things to newer generations.
Such rules of thumb are based on common sense and will always be
valid, although whether they result in gains, simply lower losses, or
neither, depends on the severity of the recession, the urgency of the demand
and a lot of other factors that change as a downturn proceeds.
Of course, we are not talking here about mild inflation or a minor
recession except as early or late stages of the main event. The situation we
are facing is of a magnitude comparable to the Great Depression of the 1930s
and the next-worst bear market, the stagflation period of the 1970s. There
are parallels to both cases, but also ways in which the current crisis
differs significantly.
THE 1930s
There is a very real possibility that the current recession will deepen
into a repeat of the Great Depression of the 1930s, only with consumer prices
rising, not falling.
In the 1930s, the problem was not inflation, but deflation. Cash grew
in value, as did bonds held to maturity. Stocks went both down and up, and ended
the decade down. Stocks that bucked the downtrends were generally the
defensive and countercyclical issues. But hedging inflation was not a factor.
Interestingly, price inflation was minimal during the bull market from 1921
to 1929.
The collapse that ensued bottomed out in 1930, with the Dow Jones
Industrial Average down 89% from its 1929 peak. But it gave way to a bull
market that lasted until 1937, when prices fell again until a few months
after Pearl Harbor.
In 1930, every stock in the Dow declined except three. Those that
gained slightly were Liggett & Myers [Tobacco Co.], General Foods [Corp.]
and Borden Co. – one tobacco company and two food producers. In 1931,
every Dow stock was down, and the same was true in 1937. In 1933, 1935, 1936
and 1938, 80% to 90% of the Dow stocks showed gains. Of course, the fortunes
lost in the stock market of the 1930s were lost because so much stock was
bought on margin, meaning that when prices tumbled, margin calls meant
putting up more money. Holding for prices to come back was not an option for
many people, and those who did hold waited until the 1950s for the Dow to
recover.
But the 1930s proved that food and tobacco, traditional defensive
stocks, bucked the trend during the worst stock market crash in history. Gold-mining
shares, of course, were in a stratosphere of their own.
It also proved that markets don't like extreme deflation any more than
they like extreme inflation. As I stated, though, deflation (at least as it
leads to falling consumer prices) – which is getting increasing
publicity as a present threat – is one “problem” we won't
be facing this time. Sure, as the credit bubble deflates, asset prices will
fall relative to goods prices, but the Federal Reserve stands ready to
replenish the money lost with freshly printed bills. However, this new money
will not reinflate the busted asset bubbles but
simply drive goods prices even higher.
Of course, we will see, and are already seeing, instances where prices
are declining. But inflation is now so pervasive that despite any trade-offs,
the net effect will have to be rising prices.
THE 1970s
Very much like present times, the 1970s combined stagnation and
inflation, notably in skyrocketing gas prices, giving rise to the term
“stagflation.” What was different about the 1970s, though, is
that government and consumer debt were relatively moderate, with both
government and mortgage debt locked in over long time periods.
This gave the Fed the option of countering inflation with aggressive
interest rate hikes when it reached double digits. Today, it doesn't have the
option of raising rates significantly without triggering consumer debt
defaults and mortgage foreclosures that would bring the economy to its knees.
Also, back then, any new government borrowing was financed internally.
Interest paid by the government was offset by interest earned by American
savers. The net effect was not a net drain on national income, though there
were certainly social effects of a domestic transfer of purchasing power from
the less to the more affluent. Now, however, approximately half of our
national debt in public hands is held abroad, and an even larger share of new
issues is sold abroad. As a result, significantly higher interest rates would
result in meaningful drains on our national income. Furthermore, as the
outstanding debt is now very short-term, higher rates would affect the total
of what the government owed, not merely new borrowing. In other words,
American taxpayers have been committed to the mother of all adjustable-rate mortgages!
While the 1960s, called then the Soaring '60s, will be remembered for
its go-go mutual funds, its conglomerates and concept stocks – like
Four Seasons Nursing Centers of America [Inc.] (bankrupt by 1970) and
Performance Systems [Inc.], a franchiser of fried-chicken restaurants, all of
which came to grief by decade's end – the 1970s became famous for the
Nifty 50. These were a group of high-capitalization growth companies that big
mutual funds and institutional investors, by then a dominant force in the
market, could buy and never worry about again. Also called
“one-decision” stocks and “all-weather” stocks, these
big household names by 1971 were selling at 100 times earnings (when they had
earnings), despite a general market decline led by everything else.
When the bear market of 1973–74 settled in, 27 of the Nifty 50
dropped an average of 84% from their 1971–72 highs. The Dow, which
closed 1972 at 1,929.02, closed 1973 at 850.86 and 1974 at 616.24 before
beginning its recovery the following year. In 1973, only six of the Dow
stocks rose significantly, and in 1974, only five – and with one
exception, they were different stocks.
But here's what's interesting: All six of the 1973 gainers were
basic-raw-materials companies, consistent with a pattern whereby commodities
and financial markets go in opposite directions.
Not only that, but their returns were strong, led by Allied Chemical
[Corp.]'s total return of 73.4%, Alcoa [Inc.]'s 40.6% and Bethlehem Steel
[Corp.]'s 18%.
In 1974, stagflation had begun, with unemployment over 7% and
inflation over 10%. The Arab oil embargo was in full swing, causing fuel
shortages and plant closings. Two companies benefiting from the oil crisis
led the Dow in 1974: Johns Manville Corp., which sold fuel-saving insulation
materials, and United Aircraft [Corp.], whose fuel-efficient jet engines were
in demand from the aircraft industry.
In 1975, the market picked up again, this time led by cyclical stocks.
Profiting from what was termed “a new era of pricing power,” the
basic industries such as steel, chemicals, aluminum, paper and copper enjoyed
a short-lived revival.
By the end of the 1970s, the cyclicals were
back in a slump, and leaders were the energy issues and related technology
stocks, small biotech issues and defense/aerospace stocks, reacting to the
Iran hostage crisis and anticipating a Republican administration. On another
tier, small-capitalization stocks did prove their worth as an inflation
hedge, outperforming inflation and registering a positive return over the
decade. In a global economy where the action is abroad, however, it is hard
to imagine that small-caps, which would generally have minimal, if any,
international exposure, would outperform in today's market.
With that exception, the 1970s proved that in extreme inflation,
stocks in general do not hold up as well as an inflation hedge. Gold, of
course, is in its own world; gold-mining stocks were off the charts. The
1970s experience proved something else of great and relevant importance: The
inverse market relationship of commodities (including basic materials,
agriculture, energy and metals) to stocks in general gains validity the more
serious economic problems become. It's financial paper versus tangible stuff.
So what to do with your U.S. stock investments now? My basic
recommendation is to restructure your domestic stock portfolio with
conservative, dividend-paying foreign stocks that will produce currency
appreciation and keep you out of the collapsing dollar and immune from any
desperate measures or political gambits that the U.S. government might resort
to as the economic predicament worsens.
Some domestic stocks are worth holding on to, such as mining companies
and producers of basic materials, energy and agricultural commodities that
trade worldwide in dollars and will benefit from a commodities boom. I would
hold the major oil producers, but be prepared for an excess-profits tax. A
better bet would probably be oil service companies, which benefit more
directly from a strong oil market and are unlikely to be hit with
excess-profits taxes. Makers of farm equipment or fertilizer companies are
proven as a way of participating in the agricultural boom. Exporters and
multinationals with good foreign exposure should also do well.
The most important part of any U.S. allocation would be to avoid like
the plague any stocks largely dependent on American consumers, especially
when it comes to discretionary purchases or repaying their debts. That
includes financials, retailers, home builders and consumer discretionary. I
would also avoid any high-multiple stocks, which excludes most technology or
biotechnology companies.
Another thought: Any U.S. company not adversely affected by inflation
and producing a good global earnings stream is a possible target for
acquisition by a sovereign-wealth fund – or private foreign buyer.
That's bad news for the American economy but potentially good news for some
American shareholders. Witness Anheuser-Busch Cos. Inc.
Peter D. Schiff
President/Chief Global Strategist
Euro Pacific Capital, Inc.
20271 Acacia Street, #200 Newport Beach,
CA 92660
Toll-free: 888-377-3722 / Direct:
203-972-9300 Fax: 949-863-7100
www.europac.net
pschiff@europac.net
For a more in
depth analysis of the tenuous position of the American economy, the housing
and mortgage markets, and U.S. dollar denominated investments, read my new
book : The Little Book of
Bull Moves in Bear Markets" (Wiley, 2008).
More
importantly take action to protect your wealth and preserve your purchasing
power before it’s too late. Protect your wealth and preserve your
purchasing power before it’s too late. Discover the best way to buy
gold at www.goldyoucanfold.com ,
download my free research report on the powerful case for investing in
foreign equities available at www.researchreportone.com
, and subscribe to my free, on-line investment newsletter at http://www.europac.net/newsletter/newsletter.asp
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