Gold & Beyond – 3 Ways to Protect Yourself From Inflation

Once again, Uncle Sam is broke. And unlike when hardworking people like you and me go broke…governments don’t stop spending. They merely fire up the presses and print as much money as they need to pay the bills.

At this point, the US government doesn’t have many options. It’s already borrowed a ton of money from other countries. And it’s run up quite a tab — spending like wild — trying to pull America out of this economic quagmire.

The Fed has to print more money to keep the US afloat.

What has all this got to do with Australia, you might ask? Good question…read on for our simple, one-word answer!

Will it work? Well, flooding the US economy with as much money as possible can be beneficial. But only as a temporary fix.

Over the long term, the US government will only fall deeper and deeper into debt. And the timing couldn’t be worse… because America is already in deep trouble.

The US national debt currently sits at roughly $14 trillion.

Let us put that astronomical number in perspective: The US government is carrying a debt that’s nearly as large as the entire European Union’s GDP!

A debt that large won’t go away any time soon. In fact, the US national debt will grow by an additional $10 trillion over the next 10 years, according to the Congressional Budget Office.

There’s no way the US government is going to be able to pay back its debtors and keep the country going over the next decade without printing more and more money each year.

So, what does this mean for investors like you?

Well, large persistent deficits and an ever-increasing supply of money usually only have one outcome — inflation.

What’s all this got to do with Australia?

In a word — everything.

Blind Freddy knows, even though Australia is a grown-up country with our very own grown-up economy, it’s the US economy that really matters to us.

Our share market slavishly follows the direction of the US markets. When we talk about foreign exchange and currencies, it’s the once- mighty US dollar we talk about.

As the old saying goes, when the US catches a cold, Australia sneezes. The difference this time is the US is already on the sick bed. It has been there since their economy totally blew up in 2007.

It’s still sick today. Very sick. US unemployment remains steadfastly high, over 9%. Most Australians don’t know how lucky we are, with our unemployment rate being around 5% — positively measly in comparison.

But, as any doctor knows, if you pump the patient with enough medicine, even the sickest of sufferers can perk up.

And that’s precisely what Ben Bernanke and his merry men at the Federal Reserve are doing. They are throwing the big guns at the US economy.

For instance…

Pethidine: Interest rates at virtually 0% for an extended period, possibly years.

Morphine: QE2, dumping $600 billion into US economy, effectively printing money.

The Prognosis?

Global inflation. Not now. Maybe not even 2011. But 2012? It appears a near certainty.

And here in Australia, we could end up being right in the eye of the storm.

Our interest rates are already close to 5%. Variable mortgage rates are close to 8%. If US inflation were to eventuate, as seems virtually assured, look out!

The Wealth Killer

When governments produce money out of thin air, it devalues the existing supply of money. Meaning the money you have today isn’t worth what it was yesterday.

And as the prices of everyday items like food and petrol increase, it’s going to take more and more of your debased money to buy them.

This can be a nightmare for anyone saving for retirement. Because that means all that money you’ve been saving is not enough.

It’s going to take more money to retire… more money to buy that beach holiday house… more money to travel… and more money to send your kids to school and university.

Not to mention, your fixed-income streams — like the Age Pension — will also take a hit.

Inflation makes your weekly cheques seem smaller and smaller, because you won’t be able to buy as much as you used to with the same amount of money.

It’s not fair. But you aren’t helpless either. You can protect yourself from inflation right now and still achieve your financial dreams — without having to hit the jackpot to pull it off! Here’s how…

One of the best ways to combat inflation

A great defence against inflation is owning gold.

Gold is durable, malleable, shiny, and more importantly, scarce.

Gold is money. And when paper money is losing value by the day because of loose fiscal policies — like it is now — people turn to gold because it holds its value.

For proof, consider this…

In 1936, when the US was in the grip of the Great Depression, you could buy a very nice suit — trousers, vest, and jacket — for $36. Gold was selling for $36 an ounce then, so an ounce of gold would have bought you a very nice suit 74 years ago.

Today, you can barely buy a pair of togs for $36! But an ounce of gold — currently worth around US$1,500 — buys you a 3-piece Armani suit.

Paper money changes with the wind. But gold stands up to the test of time. It’s as valuable to us today as it was to the ancient Egyptians.

That’s why if you want to preserve your wealth and stay ahead of inflation, it makes sense to look at gold right now.

These experts agree; have a look…

“They are going to print money until we run out of trees…
I expect gold to be at least $2,000 [an ounce]… maybe even higher.”

— Jim Rogers, famed hedge fund manager and commodity expert

“The price of gold could at least double from here.”
— Andrew Sullivan, CFA, The Motley Fool (US)

“Instead of just going to $5,000, maybe gold’s going to $10,000!”
— Peter Schiff, President, Euro Pacific Capital

Those are some bold statements to be sure. But they certainly don’t seem to be over-the-top extravagant.

After all, according to the Financial Times, analysts believe that if gold were to play the same role today as it did in the 1970s, its price would need to rise to $6,000-$10,000 an ounce!

Right now, the threat of inflation seems as great today as it was in the 1970s. And investors are buying up gold in droves. Gold looks like it could continue to rise in value in the coming years.

Now don’t misunderstand us… we’re not advocating you run out, buy a safe, and start stockpiling gold bars. (You could put your back out doing that!)

Quite the contrary. You see, there’s an easier way to profit from this modern-day gold rush…

Go prospecting…

Demand for gold is skyrocketing right now. And it’s a geological certainty that supplies of gold are and will always be very limited.

Any prospector that finds a new gold deposit right now would make a fortune selling the rights to mine gold at these record high prices.

But finding those great gold miners is sometimes like trying to find a needle in a haystack. Sure, there are a few of them about, but there are also more than a few shonky operators out there too…

The Motley Fool’s free Take Stock email will be keeping a close eye on all things gold. Keep an eye out for it in your in-box.

On the other hand…

As with many investments, there are plenty of experts with sharply diverging views about the prospects for gold.

Billionaire Charlie Munger, Warren Buffett’s erstwhile sidekick, recently had this to say about gold…

“And I don’t see how you become rational hoarding gold. Even if it works, you’re a jerk.”

Buffett himself has similarly not been impressed by the most precious metal of all…

“[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

How to value gold…

But what if Munger and Buffett could actually put a value on gold?

They are acknowledged as the greatest value investors ever, yet we suspect have never wanted to, or been able to, put a value on the precious metal. As such, they’ve steered well clear of gold.

Could this turn out to be the biggest mistake of their long and illustrious investing careers?

Far be it for us to suggest they’ve lost their mojo. Rather, we’ll simply try our best to value gold, and let you make the decisions…

A good way to measure the relationship between gold and the dollar is to divide the market value of the United States’ gold reserves (around 8,130 tons) by the money supply — the total number of dollars in circulation.

A higher percentage suggests high uncertainty (and fear). This index usually hovers in a range of 2% to 4% but has reached a high of 12% in the past (1980).

Even after gold’s steady rise to more than $1,500 per ounce, it stands at around 4%.

In other words, we are nowhere near prior highs, because the increase in the price of gold (the numerator) has been more than outmatched by a record high increase in the money supply (the denominator).

Gold: Beloved for Centuries

We also need to remember that the “record high prices” we’re reading about are misleading, because gold’s former high of $850 in 1980 isn’t adjusted for inflation.

That number would be close to $7,000 in today’s dollars when using the original consumer price index (CPI) methodology and about $2,200 when using revised methodologies.

In other words, we aren’t even close to the inflation-adjusted highs we reached in 1980 — we’re around 50% below them.

All that aside, history is on the side of gold. Currencies come and go, and debt-laden governments are backed into a corner today with record deficits. As long as that remains the case, gold could slowly rise as a store of value.

So what’s an investor to do?

To be frank, we don’t pretend to know whether gold will zig higher to US$2000 an ounce, or zag lower back down to US$800 an ounce.

One thing however is for certain…gold is the flavour of the day, and it pays to follow its movements, up and down. And that’s exactly what we’ll be doing in Take Stock, the Motley Fool’s exclusive free email.

Wild Inflation

As well as gold we’re concentrating on inflation too. Although Charlie Munger clearly isn’t too keen on gold, he’s definitely worried about inflation.

Munger’s trademark succinctness was on display recently in his unequivocal response to a question about possible inflation:

“Bet on it.”

That’s a strong statement from one of the smartest people alive. And Munger isn’t alone — famed US contrarian and value investor David Dreman expects “wild inflation” thanks to the after-effects of government stimulus efforts.

These two great investors appear to be looking well into the future, focusing on that enormous US deficit spending that will likely push up prices of everyday goods and services.

Deficit spending means money must be created to pay for it, and more money dilutes the buying power of existing money.

This sad tale has been replayed many times over the centuries, and these investing sages see it happening in the future.

3 Ways To Beat The Scourge of Inflation

Inflation is such a scourge because it reduces purchasing power. Warren Buffett has likened it to a “gigantic corporate tapeworm” because it sucks the life out of capital-intensive businesses.

Inflation also reduces the value of cash; in fact, in the most extreme case — hyperinflation — people’s cash savings are wiped out entirely.

There are three key ways to protect yourself, though.

1. Reduce Bond Exposure

Long-term bonds destroy wealth in inflationary environments. This is because bonds deliver a fixed income stream — one that doesn’t increase even if the value of currency declines.

A $10 interest payment may sound decent right now, but if $10 doesn’t buy you a can of Coke a decade from now, you’ve lost out.

For older investors living on their investment income, reducing exposure to bonds is scary. But with bonds, while your payments may not decline, your purchasing power will.

Fortunately, shares offer an alternative.

2. Buy Shares

Owning a business (OK, a piece of a business, at least) is a solid strategy in an inflationary environment.

Unlike the fixed income stream provided by bonds, companies’ earnings can rise even under inflationary conditions.

But some businesses are more desirable than others. Look for companies with low levels of tangible assets (like plants and machinery); they’re better off because they don’t have to pay ever-increasing prices each year on capital expenditures just to maintain their position.

Strike capital intensive businesses off your list, in other words.

Utilities can also be poor investments, because they must expend large sums every year in today’s dollars on infrastructure, which doesn’t pay off until sometime in the future — and then with inflated, less valuable dollars.

Another trait to look for is the ability to raise prices. Companies with strong competitive positions and/or great brands have loyal followings that enable them to predictably increase prices.

Another, more risky strategy is to invest in companies with debt. Because the amount of debt is fixed, if the currency loses value, that debt becomes easier to repay — increasing the company’s value.

3. Buy Tangible Assets

Property: Real estate is the classic hedge against inflation. That said, we’re not great fans of Australian property at today’s prices, broadly agreeing with Gerard Minack of Morgan Stanley who said in August 2010 the explosion in house prices in the past decade had forced them well beyond ”fair value”.

As to whether that means a house-price crash is imminent, we have our doubts. But as a form of investment, current rental yields are generally very modest, and we think capital appreciation may well be below the levels seen over the past decade.

Non-Income-Producing Assets: If “stuff” gets more expensive under inflation, why not own the “stuff”? “Stuff” in this context includes farm products, oil, natural gas, or metals like copper, gold, and silver.

Even diamonds, artwork, and luxury goods have appeal because they can often be counted on to hold their value. These assets are what we like to call “out of the system,” meaning they are a store of wealth that can’t be destroyed by inflation as currency would be.

Assets that don’t produce income are trickier to value; however, careful study of these markets, combined with good timing, can produce excellent results.

Oil and natural gas companies and metal mining companies have exposure to commodity price moves and could thus be considered in this vein.

Inflation is worrying some of our greatest investing minds. Whether it’s gold and silver bullion, mining companies or even property, the above suggestions could provide you with your choice of weapon in the battle against inflation.

Summing Up

So there you have it. The Motley Fool’s comprehensive guide to life, the universe, the markets, inflation, property and gold.

We don’t suppose to have all the answers, far from it. As Niels Bohr, described as one of the most influential scientists of the 20th century, once said…

“Prediction is very difficult, especially if it’s about the future.”

But it won’t stop us trying. After all, if the future was predictable, life would be very boring!

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Bruce Jackson
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