If you watch any financial, sports or news programs you've probably seen numerous ads for a variety of firms offering to sell gold. The usual rationale is that the plunging dollar or skyrocketing public debt is going to result in a wave of inflation. Listeners are urged to protect their assets by investing in gold.
In our previous post we examined the correlation of inflation with just these trends. We discovered that the historical record lends little support to the assertion that current developments in the currency markets, monetary policy or fiscal policy will necessarily result in runaway or even accelerating inflation. In a presentation by Inmoo Lee at the DFA College, Mr. Lee examined the correlation between the performance of several commodity based assets and the Consumer Price Index. He examined historical returns for a broad basket of equities (the CRSP 1-10), the Goldman Sachs Commodity Index, gold, oil, TIPS and long, short and intermediate US Treasury instruments. His conclusions would not be well received by gold merchants.
At the outset of his presentation, Mr. Lee made the observation that an investor seeking to effectively hedge against inflation was in reality seeking a real return of zero; not something to which many of us would aspire. Based on his examination of a series of regresssion and return studies for the assets above, his conclusion was that an investor desiring to combat inflation should seek a portfolio with the highest expected return at an appropriate volatility level.
Without delving into the detailed analysis in the presentation linked below, the overall conclusion derived from the studies is that there is in fact a relatively low correlation between the various perceived inflation hedges and the actual inflation rate. While a keen observer might comment that these instruments are leading indicators so would not be expected to evidence a close correlation, the data do not such an hypothesis. What is apparent from the work is that all these instruments but in particular gold and oil, have historically been extremely volatile. Mr. Lee's conclusion is that this excess volatility is not explained by inflationary expectations or underlying inflation rates alone. Other statistical measures (Standard Error and T-statistic) suggest that returns from the GSCI, gold and oil are more random than expected in nature.
The presentation is detailed and heavy on statistical analysis, but the conclusions are clear. Investors seeking to protect their assets from inflation are better served by investing in equities, which have outperformed the inflation hedges in both nominal and real terms. In addition, the high standard deviations associated with these investments can have a detrimental effect on a portfolio, especially one supporting regular distributions. Clients wishing to participate in commodities should understand that a transaction which represents a zero sum, i.e. in which one parties wins at the expense of the other is not an investment but a bet with an essentially random outcome. The seller of an equity does not lose if the purchaser eventually makes money, nor does he gain if the equity declines after the sale. This is not the case with commodities. In the final analysis, only TIPS provided investors with an effective means to mitigate inflation, but at the expense of the higher nominal and real long term returns available from equities.
Inmoo Lee, Inflation and Investment Decisions
http://sites.google.com/site/dkepartners/files?pli=1
Thursday, December 10, 2009
Thursday, November 19, 2009
What's the outlook for inflation????
Many clients are asking, "How should we position our investments to guard against the coming high inflation?" This question presupposes that accelerating inflation is a certainty. Clients are hearing a drumbeat in the financial press and among pundits asserting that high levels of deficit spending, a weak dollar and mounting public debt will undoubtedly lead to an inflationary spiral. As long term observers of the gold and currency markets such conclusions do seem plausible. Gold has been in a multi-year uptrend stretching back to late 1999 and proclamations of the dollar’s imminent demise seem to be a daily headline. Public debt has doubled to roughly $12 trillion in the last 9 fiscal years. But what does the historical record tell us about the likely impact of the current fiscal and monetary trends in the US economy? Is the consensus that rising inflation and loss of the dollar’s reserve status are just around the corner supported by any empirical evidence?We attended the 2009 DFA Financial Advisor College in Santa Monica last week. Amid the usual avalanche of (incredibly detailed and useful) statistical information several presentations addressed these exact questions. The evidence presented was a bit surprising. The future may not be as certain as the pundits would have us believe. We’re going to summarize a few of the presentations that we feel may be of use to you when discussing these issues and others with clients in our next several posts.
The first presentation we'd like to highlight was delivered by Marlena Lee titled "Inflation Forecast". Marlena posed two questions: first, can inflation be accurately predicted and second, is the current monetary and fiscal environment likely to cause inflation?
Inflationary expectations on the part of consumers have in the past been the most accurate short-term predictors of inflation. This doesn't imply any particular predictive ability for consumers but if prices are rising and consumers expect them to rise further, inflation tends to become a self-fulfilling prophecy. Professional forecasters on the other hand seem to exhibit somewhat less skill. One year inflation forecasts by professionals (economists, etc. compiled by the Fed) in the period from the first quarter of 2000 through the third quarter of 2009 have a -.10 correlation with actual realized inflation rates. When the forecasts are compared with a one year lagged version of the actual CPI results the correlations rise to .83. This strongly suggests that professionals rely on current inflation rates to be the predictors of future inflation. While this is logical from an efficient market standpoint, the net effect is largely inaccurate and useless information from the predictions. For example, no professionals foresaw the steep drop in the CPI that began in mid-2007. It was not until mid 2008 that forecasters began to predict slowing inflation rates. Similarly, since the end of 2008, predictions have been for rising inflation while the CPI has continued a largely flat or negative rate. There is however, one empirical measure of inflation that does have predictive ability: the interest rate spread between the nominal 10-year Treasury bond and the 10-year TIPS. Since1999, the spread between these two instruments has averaged 2.23%. As of October 27, 2009 the spread was 2.24%. In late 2008 when deflation forces were strong, the spread narrowed to zero and for a brief period to a negative value. Given the remarkable consistency in the long term average spread between these instruments, a logical conclusion is that the credit markets do not envision an impending inflationary spiral.
There currently exists a large body of opinion that cites the explosion of the Federal budget deficit and the sharp rise in public debt as indicators that inflation must surely increase dramatically in the near future. Is this a reasonable expectation? On its face, an unprecedented level of national debt and previously unheard of annual budget shortfalls would seem to suggest inflation. Marlena examined both fiscal and monetary influences on past inflationary periods. Fiscal policy, in terms of the percentage of a country’s debt compared to its GDP in the conventional wisdom is thought to increase inflationary pressures in direct correlation with the increase in the percent of GDP represented by debt. Current debt levels and inflation rates argue otherwise. As of 2007, the outstanding US public debt stood at roughly 40% of GDP. As of June 2009, that level had climbed to 52%. This puts the US within a cluster of developed economies with roughly the same percentages of debt/GDP ratios. The annual inflation rates in these countries during 2008 fell in a range of roughly 2%-4%. This is hardly a severe number. We use a long term inflation average of 3.2% in our purchasing power studies. Within the group, Japan’s public debt level was at the high end of ratios at just over 160% of GDP in 2007. Japan’s annual inflation rate in 2008 however was the lowest of any country in the sample (<2%). Iceland registered the highest 2008 inflation rate in the group at more than 12% yet its debt/GDP ratio was a comfortable 20% in 2007. Clearly the efficacy of the link between high levels of debt and rising inflation rates is sketchy at best.
What about monetary policy? Surely unchecked creation of paper money will eventually translate into a collapse of purchasing power and a tsunami of inflation; or not. Examining data tracking the 12-month changes in the CPI and M2 (the broadest measure of the money supply) from the fourth quarter of 1959 through the second quarter of 2009 yields only a few instances when a strong uptrend in money creation is accompanied by a strong uptick in inflation. When the “output gap” (the difference between current and perceived maximum production levels in the economy divided by the perceived maximum) is overlain on the chart the reason becomes clear. It is only during periods of high capacity utilization that an acceleration of M2 growth is accompanied by an upturn in the CPI. Clearly capacity utilization is an important component when determining the potential inflationary impact of monetary aggregate growth. Capacity utilization in the US economy as measured by the Federal Reserve in October 2009 stood at 70.7%, well below the “maximum” in the upper 80%’s. With slack capacity utilization, strong growth in M2 should not be expected to be an inflation creator based on the historical record.
The final concern addressed in this presentation was the dollar. Myriad commentators and “experts” have been expressing concern that unbridled dollar creation to fund domestic spending will inexorably result in the abandonment of the dollar as the world’s reserve currency. Losing this designation would surely result in runaway inflation (in their expressed opinions). The facts in the currency markets suggest that this is not a likely scenario. The depth of the dollar markets dwarfs the Euro markets, which is the most likely substitute for the dollar as a reserve currency. Further, creating a hybrid “currency of currencies” would suffer the same handicap only worse. Despite the grumbling and lectures, the reality is that the Chinese and other US creditors have no real alternative to holding dollars. No other currency offers the liquidity available in the dollar markets.
The conclusions then are these:
There is great uncertainty about the inflationary future and professional predictions have proven largely inaccurate
The main components of inflation are expectations, money growth and capacity utilization
No one agrees on the relative importance of any of these components
There is no conclusive evidence that high inflation is imminent
There is currently little prospect of the dollar losing it reserve currency status
A link to the presentation slides is below.
https://sites.google.com/site/dkepartners/files
The first presentation we'd like to highlight was delivered by Marlena Lee titled "Inflation Forecast". Marlena posed two questions: first, can inflation be accurately predicted and second, is the current monetary and fiscal environment likely to cause inflation?
Inflationary expectations on the part of consumers have in the past been the most accurate short-term predictors of inflation. This doesn't imply any particular predictive ability for consumers but if prices are rising and consumers expect them to rise further, inflation tends to become a self-fulfilling prophecy. Professional forecasters on the other hand seem to exhibit somewhat less skill. One year inflation forecasts by professionals (economists, etc. compiled by the Fed) in the period from the first quarter of 2000 through the third quarter of 2009 have a -.10 correlation with actual realized inflation rates. When the forecasts are compared with a one year lagged version of the actual CPI results the correlations rise to .83. This strongly suggests that professionals rely on current inflation rates to be the predictors of future inflation. While this is logical from an efficient market standpoint, the net effect is largely inaccurate and useless information from the predictions. For example, no professionals foresaw the steep drop in the CPI that began in mid-2007. It was not until mid 2008 that forecasters began to predict slowing inflation rates. Similarly, since the end of 2008, predictions have been for rising inflation while the CPI has continued a largely flat or negative rate. There is however, one empirical measure of inflation that does have predictive ability: the interest rate spread between the nominal 10-year Treasury bond and the 10-year TIPS. Since1999, the spread between these two instruments has averaged 2.23%. As of October 27, 2009 the spread was 2.24%. In late 2008 when deflation forces were strong, the spread narrowed to zero and for a brief period to a negative value. Given the remarkable consistency in the long term average spread between these instruments, a logical conclusion is that the credit markets do not envision an impending inflationary spiral.
There currently exists a large body of opinion that cites the explosion of the Federal budget deficit and the sharp rise in public debt as indicators that inflation must surely increase dramatically in the near future. Is this a reasonable expectation? On its face, an unprecedented level of national debt and previously unheard of annual budget shortfalls would seem to suggest inflation. Marlena examined both fiscal and monetary influences on past inflationary periods. Fiscal policy, in terms of the percentage of a country’s debt compared to its GDP in the conventional wisdom is thought to increase inflationary pressures in direct correlation with the increase in the percent of GDP represented by debt. Current debt levels and inflation rates argue otherwise. As of 2007, the outstanding US public debt stood at roughly 40% of GDP. As of June 2009, that level had climbed to 52%. This puts the US within a cluster of developed economies with roughly the same percentages of debt/GDP ratios. The annual inflation rates in these countries during 2008 fell in a range of roughly 2%-4%. This is hardly a severe number. We use a long term inflation average of 3.2% in our purchasing power studies. Within the group, Japan’s public debt level was at the high end of ratios at just over 160% of GDP in 2007. Japan’s annual inflation rate in 2008 however was the lowest of any country in the sample (<2%). Iceland registered the highest 2008 inflation rate in the group at more than 12% yet its debt/GDP ratio was a comfortable 20% in 2007. Clearly the efficacy of the link between high levels of debt and rising inflation rates is sketchy at best.
What about monetary policy? Surely unchecked creation of paper money will eventually translate into a collapse of purchasing power and a tsunami of inflation; or not. Examining data tracking the 12-month changes in the CPI and M2 (the broadest measure of the money supply) from the fourth quarter of 1959 through the second quarter of 2009 yields only a few instances when a strong uptrend in money creation is accompanied by a strong uptick in inflation. When the “output gap” (the difference between current and perceived maximum production levels in the economy divided by the perceived maximum) is overlain on the chart the reason becomes clear. It is only during periods of high capacity utilization that an acceleration of M2 growth is accompanied by an upturn in the CPI. Clearly capacity utilization is an important component when determining the potential inflationary impact of monetary aggregate growth. Capacity utilization in the US economy as measured by the Federal Reserve in October 2009 stood at 70.7%, well below the “maximum” in the upper 80%’s. With slack capacity utilization, strong growth in M2 should not be expected to be an inflation creator based on the historical record.
The final concern addressed in this presentation was the dollar. Myriad commentators and “experts” have been expressing concern that unbridled dollar creation to fund domestic spending will inexorably result in the abandonment of the dollar as the world’s reserve currency. Losing this designation would surely result in runaway inflation (in their expressed opinions). The facts in the currency markets suggest that this is not a likely scenario. The depth of the dollar markets dwarfs the Euro markets, which is the most likely substitute for the dollar as a reserve currency. Further, creating a hybrid “currency of currencies” would suffer the same handicap only worse. Despite the grumbling and lectures, the reality is that the Chinese and other US creditors have no real alternative to holding dollars. No other currency offers the liquidity available in the dollar markets.
The conclusions then are these:
There is great uncertainty about the inflationary future and professional predictions have proven largely inaccurate
The main components of inflation are expectations, money growth and capacity utilization
No one agrees on the relative importance of any of these components
There is no conclusive evidence that high inflation is imminent
There is currently little prospect of the dollar losing it reserve currency status
A link to the presentation slides is below.
https://sites.google.com/site/dkepartners/files
Wednesday, October 7, 2009
Surprising Results
Reversion to the mean is one of the most persistent equity market characteristics. This concept refers to the tendency of prices to follow a long term average trend. While strong divergences either above or below the long term average do occur with regularity these moves have been consistently reversed as time progresses. Our latest example of this tenet is the behavior of equity markets over the past 12 months. After deep declines from last year's annual peaks in July, worldwide equity prices plunged for nearly 6 months interrupted by a modest rebound last December. At the early March lows, many broad indices had declined more than 50% from their most recent highs. Amid the pervasive pessimism at that point, a strong rebound was born that almost unbelievably carried through to the most recent market highs in mid-September. Not only did prices recover, the performance for many mutual funds over the 6 month period from March through August 2009 was among the best in their history. The attached file illustrates this point for the DFA component funds with histories of at least 10 years. What lies ahead? No one knows. Events of the last 12 months should amply illustrate the folly of translating current events into market predictions.
https://sites.google.com/site/dkepartners/files
https://sites.google.com/site/dkepartners/files
Sunday, July 5, 2009
The continuity of a financial services practice is important to many people. Three stakeholder groups will be impacted by the sudden death or disability of a key financial professional:
1. Members of the financial professional’s family;
2. People in the firm (partners, other professionals and staff);
3. People outside the firm (clients, vendors, lenders, regulators, etc.)
Knowing that there are plans for the continuation of services to clients will help assure the continuation of the practice and the certainty of income to family members, partners, employees and other professionals in the firm resulting in greater confidence in the practice’s plan and path. Transition, succession and continuity Fire DrillsTM help financial professionals consider and mitigate the impact of each financial adviser’s sudden death or eventual retirement on the firm, its clients, the professional’s family, and outside stakeholders.
In addition to the personal loss and grief that a sudden death or disability brings to a firm, the financial professional’s death or retirement also impacts the firm’s strategic and marketing plans. One way to anticipate that impact is to review data, which are probably already available, in the context of a financial professional’s sudden death or retirement and also in the longer-term context of the firm’s transition and succession plans. The potential loss of revenue and clients are risks that need to be anticipated and managed. A firm does this in two ways: first, by gaining clarity about the individual professional’s clients and prospective clients, and about the firm’s needs and expectations, and second, by developing the capability to manage change constructively in all three of these stakeholder groups.
You can start the continuity planning process for your firm by downloading the Financial Advisor’s Fire DrillTM by clicking on the link. It provides information about the process and a variety of checklists you can use to organize and share your information. Clients like working with and receiving the personal attention a small, high quality financial practice can provide, but you can be sure that they also have moments of anxiety when the worry about what might happen to them if you were to be “hit by a bus.” Letting your clients and others know that you have considered the issues surrounding continuity planning will help relieve these often unspoken anxieties. [Mike and Bonnie Hartley]
https://sites.google.com/site/dkepartners/files
1. Members of the financial professional’s family;
2. People in the firm (partners, other professionals and staff);
3. People outside the firm (clients, vendors, lenders, regulators, etc.)
Knowing that there are plans for the continuation of services to clients will help assure the continuation of the practice and the certainty of income to family members, partners, employees and other professionals in the firm resulting in greater confidence in the practice’s plan and path. Transition, succession and continuity Fire DrillsTM help financial professionals consider and mitigate the impact of each financial adviser’s sudden death or eventual retirement on the firm, its clients, the professional’s family, and outside stakeholders.
In addition to the personal loss and grief that a sudden death or disability brings to a firm, the financial professional’s death or retirement also impacts the firm’s strategic and marketing plans. One way to anticipate that impact is to review data, which are probably already available, in the context of a financial professional’s sudden death or retirement and also in the longer-term context of the firm’s transition and succession plans. The potential loss of revenue and clients are risks that need to be anticipated and managed. A firm does this in two ways: first, by gaining clarity about the individual professional’s clients and prospective clients, and about the firm’s needs and expectations, and second, by developing the capability to manage change constructively in all three of these stakeholder groups.
You can start the continuity planning process for your firm by downloading the Financial Advisor’s Fire DrillTM by clicking on the link. It provides information about the process and a variety of checklists you can use to organize and share your information. Clients like working with and receiving the personal attention a small, high quality financial practice can provide, but you can be sure that they also have moments of anxiety when the worry about what might happen to them if you were to be “hit by a bus.” Letting your clients and others know that you have considered the issues surrounding continuity planning will help relieve these often unspoken anxieties. [Mike and Bonnie Hartley]
https://sites.google.com/site/dkepartners/files
Friday, June 12, 2009
Real returns and purchasing power
We always emphasize purchasing power over nominal dollars when analyzing the probabilities that a portfolio allocation will have an acceptable chance to support a client's financial goals and objectives. Over the past year of atypical volatility and negative returns some clients have been driven from or dramatically reduced their equity positions in exchange for the relative safety and low volatility of fixed income. One of our greatest responsibilities as advisors is to effectively communicate the risk/reward equation to clients. It's always important to remind them that inflation is an ever present factor constantly eroding purchasing power. The overriding question any (especially retired) client has is, "Will I outlive my money?" Exchanging volatility for stability can alleviate short term anxiety, but is it a viable long term strategy? In the video linked below, David Booth presents a series of observations about the efficacy of a "run away" strategy with some surprising statistics about the real returns of T-Bills vs. equities. The historical real returns available from a safe (Government) fixed income portfolio have rarely been sufficient to support typical portfolio cash demands for a significant length of time. The net effect of abandoning equities will likely be to dramatically increase the risk of portfolio failure (zero purchasing power). It may "feel safe" to eliminate risk by sheltering assets in short term Government instruments, but clients then increase the exposure of their portfolios to another risk dimension: the risk that assets won't maintain a rate of growth sufficient to support the client's lifestyle desires. Please take a few minutes to view David's video. It can be shared with clients. If you have difficulty opening the link please contact me.
Byron
http://dfaus.com/u/yx
Byron
http://dfaus.com/u/yx
Thursday, June 11, 2009
What's important to discuss?
In order to ensure that we address issues and questions that are relevant to our partners (in addition to issues of general practice interest), we'd like to solicit your input on some specific posting subjects. We've listed topics below we believe will be of particular interest. Please take a few moments to register on the blog through the "Comments" section at the end of this post and then to rate the topics in order of greatest to lowest interest. If you have difficulty with the registration process, contact us and we'll be happy to assist. Should there be items of particular interest not listed, feel free to add them to your response! We appreciate your participation.
Byron
1. Building a business continuity plan for disaster recovery
2. What happens to my practice and to my clients if I am incapacitated?
3. How to evaluate and choose a CRM
4. Should I worry about tracking error?
5. How will DKE's transition to the Black Diamond Portfolio Management System impact my practice?
6. How can I use technology better to improve practice productivity?
7. What is the best way to present the DFA story?
Byron
1. Building a business continuity plan for disaster recovery
2. What happens to my practice and to my clients if I am incapacitated?
3. How to evaluate and choose a CRM
4. Should I worry about tracking error?
5. How will DKE's transition to the Black Diamond Portfolio Management System impact my practice?
6. How can I use technology better to improve practice productivity?
7. What is the best way to present the DFA story?
Sunday, May 24, 2009
This forum has so much potential
I think it is really great to have this forum for discussing, asking questions, and sharing information.
Working with DKE has meant terrific guidance in a number of the things needed to be a successful financial advisor. There are some other areas, though, in which we are all a little bit “on our own” and it might be great to compare notes and share ideas and “best practices.” Here is a partial list of those areas. I hope someone will note some I may have missed:
- Regulatory Compliance;
- Advertising;
- Software such as CRM systems;
- Dealing with other professionals such as lawyers.
Can this be a place where we can help each other out? I sure hope so.
-Steve Blum
Working with DKE has meant terrific guidance in a number of the things needed to be a successful financial advisor. There are some other areas, though, in which we are all a little bit “on our own” and it might be great to compare notes and share ideas and “best practices.” Here is a partial list of those areas. I hope someone will note some I may have missed:
- Regulatory Compliance;
- Advertising;
- Software such as CRM systems;
- Dealing with other professionals such as lawyers.
Can this be a place where we can help each other out? I sure hope so.
-Steve Blum
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