Question: I've read that inflation could pick up in coming years. What can I do about it?
The Investing Answer: Every few decades, investors start to grow concerned about the runaway effects of inflation. In response, they reflexively place their funds into gold, silver and other precious metals. But that's a huge mistake -- gold and these other hard assets are simply "perceived" hedges against inflation. As we've recently seen, gold prices have tumbled as the reality of increased gold production reminds us of the immutable laws of supply and demand. If the world needs more gold, producers will simply mine more.
Of course, the next time we get a temporary inflation scare, you'll hear lots of talk about gold again, as fearful investors seek bullion.
What should you do? Ignore the crowd.
Let's take a closer look.
1. Building A House Never Gets Cheaper...
Considering housing prices have fallen far from their 2007 peaks, this may seem like an unusual inflation hedge. Yet over the course of decades, housing prices have managed to keep pace with inflation for a few simple reasons.
First, unless you live in places like Texas where there is still so much land to develop, you have likely noticed that most markets have few ideal lots left. Where I live, in New York's Hudson Valley, development pressures have led many towns to restrict new building lot sizes to at least 3 acres. In response, land prices climb ever higher.
More to the point, the cost to build a house never gets cheaper. The raw materials and labor required to build a house always rise.
Let me give you an example. My parents bought a home in the early 1970s for around $70,000 and sold it a decade later for $200,000. (A 186% increase!!) That was an era of high inflation, and the cost of almost everything was rising at a fast pace. Indeed, people also received solid income boosts as employers understood the need for pay raises. And higher pay meant higher buying power for consumers, which helped to support ever-rising home prices.
Make no mistake: You shouldn't expect your home to appreciate in value much faster than inflation. That was the mistake many people made in the past decade. And anytime home prices do rise much faster than inflation for an extended period, a hangover is almost inevitable. Still, with home prices now back in check, the stage looks set for appreciation at least on par with inflation.
Robert Shiller, an economist with a keen eye on housing trends, analyzed the historical relationship between housing prices and inflation and found that, "Over the 100 years ending in 1990 -- before the recent housing boom -- real (i.e. adjusted for inflation) home prices rose only 0.2% a year, on average." Yet he notes that the Federal Reserve is actually trying to induce a bit of inflation in the economy, and he figures inflation by itself is likely to trigger a 25% gain in home prices over the next decade. "All else equal, the current Fed policy would have this effect: A home selling for $200,000 today will sell for around $250,000 in 2023, though the real price -- corrected for inflation -- would be unchanged," he adds.
2. This Land Buy Paces The Stock Market...
Even if you already own a home, buying land as an investment can be a great move. It's simply a matter of supply and demand, and in many parts of the country, the supply of truly desirable land is becoming more limited. Hard data about historical land price trends are hard to pin down; besides, those trends are influenced much more by local factors than national factors.
Still, as I noted a few years ago: "According to a study conducted by Kansas State University, the average annual return on U.S. farmland since 1950, including crop yield and land appreciation, is 11.5%, compared with a 12% annualized total return for the stock market." Roughly 60% of that annual gain came from rising land prices (with the other 40% due to profits earned by farming, which is of little use to landowners).
One of the reasons to consider land right now is historically low borrowing costs. If you put 50% down and finance the rest at 4%, your land is likely to deliver a solid long-term return when inflation rears its ugly head again, especially since your mortgage payments won't budge. (Of course, property taxes are likely to rise in tandem with inflation.)
3. Inflation Just Can't Keep Up With This Instrument...
Stocks have risen roughly 9% annually since the 1920s, and inflation gets some of the credit. Rising prices cause companies to raise their own selling prices, as they seek to maintain stable profit margins. That's as true for GM (NYSE: GM) with its cars as it is with Coca-Cola (NYSE: KO) and its soft drinks.
Stocks in fact, actually outpace inflation, in large part because of continual increases in operating efficiency. A Coca-Cola bottling plant can churn out more bottles and cans today than in past decades, just as automakers can now make more cars and trucks with fewer employees. Those efficiency gains explain why corporate profits have recently grown at 6% to 8%, even as the U.S. economy grows just 2%.
Of course, stocks fare poorly in times of high inflation, as was the case of the 1970s. So patience is sometimes required. In the 1980s and 1990s, inflation sharply slowed, but stocks rallied sharply, effectively catching up with their period of underperformance relative to inflation rates.
More broadly, focus on any stocks with the ability to pass on price increases without losing sales. Electric utilities are a good example, as regulators let them hike their prices in tandem with their own rising costs. Consumer staple stocks such as Johnson & Johnson (NYSE: JNJ) are often seen as great inflation hedges. The Consumer Staples Select Sector SPDR ETF (NYSE: XLP), which owns stocks such as Procter & Gamble (NYSE: PG), Colgate-Palmolive (NYSE: CL) and others, is also a good way to own companies with pricing power.
One final thought: If the U.S. economy starts to grow at a faster pace in coming quarters, look for inflation concerns to renew. After all, a stronger economy starts to bump up against its natural limits, what economists call "capacity utilization," and once we hit those limits, then bottlenecks start to appear in the economy, forcing companies to raise prices. These inflation hedges should help you avoid losing too much sleep when inflation starts to percolate.
This article was originally published at InvestingAnswers.com
Forget Gold -- 3 Better Ways To Protect Your Portfolio From Inflation