Gold bugs naturally point to gold as the best hedge against inflation. But is it the best investment to hold? It seems to me that real estate and stocks would also increase in value during times of inflation. Yes, I know there are mutual funds that invest in mining stocks, too. My problem with those is if the price of gold is already inflated by speculation, then those mining stocks may be overpriced today.
I’m trying to hold a long term view. For someone who wants to invest, but is concerned with inflation in the short to medium term, where is the best place to put money? How well does stocks, bonds, real estate, and gold typically do when inflation hits?
Similarly, I Bonds are inflation-adjusted, so if all that stimulus money being pumped into the economy triggers some serious inflation, those bonds will be paying some nice interest rates. The rates are reset every six months, and the interest is tax-deferred (you don’t pay Fed tax on it until you actually redeem the bond - they’re exempt from state taxes entirely).
There are limits on how much you can purchase, alas (in a calendar year, $5k purchased online, $5k purchased from a bank), and there are some restrictions on early withdrawal (best if held at least 5 years).
At the moment they look awful, because inflation over the preceding six months was negative (i.e., there was deflation), so they’re currently paying a whopping 0.00%. Yup, stuff-it-in-a-mattress rates (the rate can never be less than zero). But until the May 1 reset, the bonds I’ve got were paying between 6% and 7%, with which I was quite happy, thank you very much!
I guess I still don’t understand why TIPS or I Bonds could be superior to stocks. If inflation hits, then holding cash is bad and it is better to own goods or items. I can understand the argument to hold gold, since it is an item that is easy to sock away. But what’s wrong with holding a real estate property, since that is also a ‘good’. Or holding stock in a company? Why would gold or TIPS or I Bonds be superior to those other investments?
Non-inflation-protected bonds are probably the worst thing to own when the inflation rate rises. When inflation rises, interest rates rise. When interest rates rise, bond prices fall.
Stocks are theoretically OK during times of inflation, since corporate profits (and thus dividends) can rise with the rising price level. In practice, however, inflation plays havoc with stocks. Markets hate uncertainty, and see-saws in the inflation rate are a huge element of uncertainty. Different companies will be impacted by inflation in different and unpredictable ways, as some find it easier to raise prices than others. Plus, inflation tends to be followed by recession, when the government finally tightens the money spigot. The high-inflation years between 1965 and 1982 were the worst years for the stock market between 1932 and 2000.
Real estate can be OK, but as we’ve seen, real estate tends to be subject to its own price cycle and doesn’t always mirror the general inflation rate. Real estate prices rose during the 1990’s and crashed over the last two years despite relatively stable prices in the overall economy. If we have general price inflation over the next few years, real estate may not keep pace.
Gold is a traditional inflation hedge, but as you note, by the time inflation hits, fearful investors have usually bid up the price of gold already. TIPS are indeed the best inflation hedge.
But why? The very definition of inflation is rising prices, so everything costs more than it did a year ago, right? Granted, not all prices go up at the same rate (maybe oil prices go up faster than food, or vice versa) but generally speaking, shouldn’t investing your money in almost anything (other than cash or fixed rate bonds) mean inflation will make that investment’s price go up? Won’t that investment stock/oil/gold/real-estate/metals/art/whatever track inflation just as well as TIPS?
Yes, you run some risk of the stock going down for reasons unrelated to inflation (like declining profits or whatever) but you also get the potential upside, too. So looking at it solely from the inflation risk, the stock should be just as god as TIPS, yes?
I understand that TIPS come with a government guarantee and stocks don’t, so yes, TIPS may have less downside. But of course, that’s already factored into the price of TIPS. As a hedge against inflation, why isn’t buying almost anything other than cash an effective inflation hedge?
Because the value of most assets doesn’t vary smoothly with changes in consumer price levels. The value of a stock is the discounted value of all future earnings streams which the stock will generate. Accelerating inflation introduces a huge wild card into those future cash streams. Companies and industries do well or poorly based not on their abstract ability to compete, but on their price flexibility relative to their labor force and suppliers. Plus as noted, higher inflation now is often a harbinger of a crackdown later. It isn’t as simple as saying, “Hey, prices went up by ten percent, so Microsoft is now worth ten percent more.”
IMHO, stocks should do ok during times of inflation, since the rise in nominal interest rates should be offset by faster nominal earnings growth.
For those who like formulas:
PDV = DIV / (rTBond + equity premium - nominal earnings growth)
= DIV / (real risk free rate + inflation + equity premium - real earnings growth - inflation)
= DIV/ (real risk free rate + equity premium - real earnings growth)
Now inflation might make investment planning harder, thereby lowering real earnings growth. But I’d expect that effect to be nontrivial, but not overwhelming either.
However. Stocks did poorly during the 1970s and valuations (PEs) declined. So the market perceived inflation to be a big problem. And that led to both low returns in the 1970s and a great bull market during the 1980s. That said, I would still expect stocks to outperform gold over most 20 year periods. Gold has a fair amount of volatility, but lousy long run returns.