Protect Your Portfolio with These All-Weather Securities
President Harry Truman once said he wanted to hire a one-armed economist. When asked why, he replied, so the economist couldn’t say “on the other hand.”
For Barack Obama, finding a one-armed economist is even more pressing. Obama is faced with deciding which limb of the three-armed monster–deflation, inflation or stagflation–could be most damaging to the nation’s well-being. Unfortunately, we income investors face the same dilemma.
Failure to accurately decipher the coming economic storm could be injurious to your financial health. And seldom has the environment been so hard to read.
Right now, we’re seeing deflation or falling prices. Home prices, for instance, are down across the country an average -18% since 2008. The the total value of all goods and services bought and sold, or GDP, fell -6.3% in the fourth quarter of 2008 and another -5.5% in the first quarter of 2009. The average change in prices of goods and services purchased, or the Consumer Price Index (CPI), is down more than -5.5% in the last six months. That’s deflation!
The effect of deflation on your portfolio? If you’re like most Americans, the value of your home has fallen sharply. Your stocks are down in conjunction with the S&P 500 which lost nearly -40% in 2008. You are receiving less dividend income as dividend stalwarts such as General Electric (NYSE: GE) slashed payouts for the first time in decades.
If deflation alone was the issue, you could protect your portfolio by hunkering down in the most defensive bonds and stocks. But it’s not.
To combat deflation, the U.S. government and countries worldwide have created stimulus packages almost without precedent. In the U.S. alone, the amount is $787 billion. In addition, the balance sheet of the Federal Reserve has expanded massively. Counting all the government programs such as TARP and TALF, some estimates have the government now sloshing $12.8 trillion dollars through the U.S. economy — that’s $12,800,000,000 — an estimated $42,000 for every man, woman, and child in America.
The effect of all this money could be massive inflation where the dollar loses value and prices rise to offset the decline. Federal Reserve Chairman Ben Bernanke admitted the task of taming inflation won’t be easy. The fact that the Fed‘s balance sheet has ballooned “could complicate the Fed’s task of raising short-term interest rates… if inflation expectations were to begin to move higher,” Bernanke said at a credit market symposium last month.
The effect on your wealth could be devastating. Any bonds you own will decline sharply in value. The fixed income stream you receive will have less purchasing power. Most stocks also will lose value except those that sell commodities.
Finally, some economists are forecasting the worst of deflation and inflation, an unholy brew called stagflation, where growth is slow and inflation soars. The standard measure of stagflation is called the “Misery Index,” calculated by adding unemployment and inflation rates. If inflation rears up and unemployment goes beyond 10%, as some predict, it will be miserable indeed on your portfolio.
The question is how can you protect your portfolio from a trifecta of deflation, inflation, stagflation scenarios? Fortunately, there’s a simple four-letter solution: TIPS (for Treasury Inflation-Protected Securities).
TIPS are linked to changes in inflation as measured by the Consumer Price Index (CPI). The principal value of the TIPS bonds is adjusted every six months to the CPI. When the CPI moves higher, the principal increases. The interest you receive on the bonds is a percentage of the principal so it also increases. This increase in turn raises the bond‘s yield and provides you protection against inflation.
Suppose there’s no inflation. At maturity, you are guaranteed to receive back either the inflation-adjusted principal or no less than the par value of the bonds when issued, so the bonds also provide protection against deflation.
With deflation the main issue right now, why are we recommending you consider TIPS? Why not wait until you see the whites of inflation’s eyes before firing? The CPI actually fell more than -5% in the last six months. When inflation falls, the value of TIPS and the funds which hold them can decline.
HowADRs41er, TIPS don’t only provide essential insurance against inflation. Remember, they also protect your principal against deflation. As such, they can be considered a core portfolio holding at all times.
And there’s another reason that’s even more compelling. Right now, TIPS are undervalued. The 10-year Treasury bond is yielding 3.2% and the 10- year TIP 1.5%. That assumes a 1.7% rate of inflation over the next decade, one which given all the monetary stimulus appears ridiculously low. In such an environment, the value of your TIPS or TIP fund can rise dramatically.
You can buy and sell TIPS from your broker or directly from the government by going to www.TreasuryDirect.gov. The advantage of holding individual TIPS is you get you’re your principal when they mature. The trade off is they are only yielding less than 2%.
For a better yield and a diverse portfolio of TIPS that mature at different times, you may want to look at a fund focused on TIPS.