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Guarding against a dollar fall, 2 of 2: portfolio choices [ClearOnMoney]
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Guarding against a dollar fall, 2 of 2: portfolio choices

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Commentary

Guarding against a dollar fall, 2 of 2: portfolio choices

23 Nov 2009 by Jim Fickett.

In Part one I gave reasons for my current expectations, which are: (1) a slow and erratic fall in the exchange value of the dollar, and (2) no significant inflation for the next few years, followed by serious inflation – all with a very uncertain time frame. This, Part two, is about a few of the top investment choices to protect against a falling dollar, and some of the main issues in making portfolio choices.

The problem is more difficult than many realize, mainly because of taxes. Consider first a trivial example, where you have your savings in paper money under the mattress, you go to the money changer and exchange for a more stable currency and then, ten years later, when the dollar has dropped by half, you convert back. All that has really happened is that you have preserved the value of your savings, but the IRS would say you have a 100% profit. After you pay, say, 25% tax on the “profit”, you have lost 12.5% of the value of your savings. Investments in a tax-deferred retirement account are eventually taxed when withdrawn so, while the computation is more complicated, the same concerns apply. In short, in most cases you need not just inflation protection but real returns, just to stay even.

Treasury Inflation-Protected Securities (TIPS) are often recommended as a way to preserve savings in the face of inflation. The basic idea of TIPS is that your principal is adjusted in proportion with inflation (as measured by the consumer price index) and then you are paid a small, fixed interest rate on the adjusted principal. The interest rate on TIPS is quite low (1.1% for 10-yr TIPS on 23 Nov, according to Bloomberg.com). If one wants a conservative, buy-and-hold strategy with no market timing, TIPS may be a good choice, and one can hope that inflation stays low enough that the interest rate can cover the tax loss. But if inflation does get out of hand, a TIPS investment will likely lose money in real terms.

Foreign currency, bonds, and equities. The case for foreign currencies is similar to that for TIPS, though somewhat more complex. You need to understand fiscal and monetary conditions, and likely future interest rates, in the foreign country. Since one needs a real return, a foreign investment, rather than just exchange, may make more sense. For example, if you believe (1) that the South Korean won is undervalued or at least stable, and (2) that an Asian recovery is already solid, and (3) that the South Korean economy is likely to grow strongly over the next few years, then a non-currency-hedged investment in a South Korean ETF might be a good choice. Similarly, if you find the case for commodities compelling, then an investment in Canada or Norway, whose economies are strongly linked to commodities and which have stable currencies, could make sense. Of course any such investment is risky and requires significant research beforehand.

Another way to obtain a real return and beat the tax loss is to take advantage of the cyclical swings of markets. If inflation does rise significantly, many people will try to get into inflation-protected investments late in the game, driving up prices. If you can time an investment to get in before everyone else does, then the crowd's rush may benefit you. This strategy makes the most sense with investments where it is possible for advisors to tell an exciting story about very high possible gains. (It is even better if you think the exciting stories have some real substance to them.)

Commodities (as well as emerging market equities, already considered) are probably the prime candidates for taking advantage of both real value and volatility. The case for commodities is quite strong: (1) physical demand often means that some level of real value is guaranteed for the long haul, (2) there is a general move already afoot for retail investors to increase investment into commodities; it is very likely not anywhere near the end, (3) many foreign governments, including China, see commodities as one way to diversify out of dollars, (4) the emerging market growth story, which many people find compelling, implies strong demand for commodities for some time, and (5) for many commodities, the easier sources have been exploited, and further sourcing will require higher investment, meaning higher prices.

There is, of course, considerable variation in the investment case from one commodity to the next, even if the general case is fairly clear. For example copper is almost certainly in a bubble, while natural gas is almost certainly underpriced for the long term. There are also major differences in the means available to invest. For example, buying an ETF that continually rolls into new futures contracts exposes one to substantial costs that many investors fail to understand.

One person recently remarked, after my precious metals posts, that she did not have time to think about individual commodities, and would probably only consider a general commodity ETF. This is certainly a valid point of view. However I would note that there are far fewer major commodities with liquid markets than there there are stocks. So the case for commodity ETFs is not as strong as the case for equity ETFs. In other words, it is an approachable problem to find the commodities that are currently good values.

For commodities, as well as foreign equities and bonds, the question of timing is a difficult one. My best guess is that optimism about a quick recovery will flag in 2010, while inflation will still be some way off. This would suggest waiting for opportunities to buy more cheaply than today. However there is considerable uncertainty, so perhaps dollar-cost-averaging into a position, over a period of a year or two, would be a better option.

Gold has some properties of commodities and some of currency. Overall the considerations already laid out cover most of the issues around gold.

A house. The first big advantage of buying a primary residence as inflation protection is that the tax problem is much less onerous. That is, the capital gains exclusion of $250,000 ($500,000 if married) eliminates or reduces the tax hit. The second big advantage is that debt is eroded by inflation. If you take out a fixed-rate loan at today's low rates, and inflation and interest rates rise, then the real cost of paying off the loan is likely to fall dramatically.

The Economist recently pointed out that house prices often fall when high inflation takes hold. This is perhaps because many people only consider the affordability of payments, and inflation results in higher interest rates and payments. This suggests that a long-term horizon is necessary if one wants to use a house purchase to protect from inflation.

The timing of a house purchase is probably easier than timing of equity or commodity purchases. The subprime problems have peaked and the lower end of the market is probably somewhere near the bottom in prices. However the foreclosure crisis is now moving up-market both in credit scores and prices, and it is likely that mid- and upper-end house prices have further to fall. Even if house prices do not fall significantly further, another boom is unlikely in the near future: inventories and vacancy rates are still high and mortgage lending is still tight. The key things in a timing decision are probably (1) prices, (2) mortgage interest rates, which will probably begin to rise when the Fed finishes its mortgage security purchases next spring, and (3) any special government incentives.

Footnote: retirement income with no inflation adjustment. If you have a retirement plan that promises a fixed monthly payment for life, with no adjustment for inflation, you need to consider that later payments may turn out to be worth much less, due to inflation. If possible, it might be worthwhile to consider taking a smaller, but inflation adjusted, monthly payment, or a lump sum that you invest yourself. There are significant risks in each choice, of course. The point here is to say that this is another area where the effects of inflation need to be carefully considered.