Thursday, December 24, 2009

Investing During Stagflation.

At some point, even if the economy is slowing, the Fed will have to step in and fight inflation. The question becomes: How much employment and growth do you sacrifice today in order to not have to deal with inflation in the future?Unfortunately, the 1970s also give us the formula for solving the inflation problem: Higher interest rates. Then-Fed Chairman Paul Volcker bled double digit inflation out of the economy in the early '80s by raising the overnight bank lending rate (and thus the prime rate) to as high as 20%. While no one is predicting a repeat of that scenario, there's little doubt interest rates will have to go up. That raises the question of how to be invested when interest rates are rising, even as the economy struggles to grow and inflation is still running amok.Once again, if you believe that the coming decade will look a lot like the 70s, you can find reasons to believe all major investment classes will perform similarly. In a stagflationary environment, stocks, bonds, and real estate are likely to underperform commodities and gold. In fact, during the stagflation of the '70s , bonds were called "certificates of confiscation" by many professionals in fixed income. From June 1970-1980, the best performing asset classes were oil (+34.7%), gold (+31.6%), U.S coins (+27.7%) and silver (+23.7%). The worst performers were T-Bills (+7.7%). foreign exchange (+7.3%), bonds (+6.6%) and stocks (+6.1%) In summary, hold only short term domestic bonds. Keep a diversified equity portfolio, but focus on companies that are immune to, or can benefit from inflation. That means favoring growth stocks over value.

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