After a well-deserved break, the markets are back and in full swing action.
We couldn’t be more excited.
With the uncertainties of 2009 behind us, the start of 2010 has been nothing short of amazing. Just last month, we had analysts on opposite sides of the table arguing and debating the sustainability of the economic turnaround. But with the New Year in full effect, the analysts and economic forecasters have changed their tune and are now singing the same song. The majority of them now believe that our markets will not only sustain this growth, but continue to climb slowly throughout the year.
Here at Equedia, we certainly believe ourselves to be optimists and love hearing the positive outlook given by these analysts and forecasters.
But not for the reasons you may believe
You see, we have continually tracked the numbers and the predictions of these economic analysts and forecasters. Whenever they make a prediction, we listen very closely. But that’s where it gets interesting. If they predict one thing, we place bets in the opposite direction. Let’s give you a few examples of why we do this.
Remember when oil was gaining strength in 2008? Analysts, including Goldman Sachs, were calling for oil to hit $200/bbl. That’s when we went short. Shortly after the highs of near $150/bbl, oil began its plunge. Then analysts once again changed their views and called for $25 oil:
“With demand vanishing across all key oil consuming regions, benchmark crude oil prices continue to plummet,” Merrill said in a research note. “A temporary drop below $25 a barrel is possible if the global recession extends to China.”
The global recession did extend to China. That’s when we went long. Since then, oil has never looked back and now trades at over $80/bbl.
What about when they told everyone to horde and hang on to their cash in March of 2009 when the market crashed to its lowest point in years? That was our signal to empty our pockets and invest in mining and resource stocks (see Playing Ball with Resources by clicking here.)
Since then, the TSX Venture (an exchange weighted heavily in mining and resource) has gained more than any other exchange (see Where the Billionaires Invest by clicking here.)
Inflation
One of the biggest problem our economy now faces is the uncertainty of how strong inflation will hit and how soon. The governments (both in the US and Canada) will undoubtedly have to raise interest rates which cannot remain at these levels.
Now the fear arises when you combine the amount of money that is being printed (see The Impressive News Release by clicking here) with how low current interest rates are.
As many of you already know and have experienced not too long ago, raising interest rates is the prime combatant of inflationary pressures. In the United States, interest rates are decided by the Federal Reserve (see What the Fed Doesn’t Want You to Know by clicking here.)
As explained by Investopedia, interest rates directly affect the credit market (loans) because higher interest rates make borrowing more costly. By changing interest rates, the Fed tries to achieve maximum employment, stable prices and a good level growth. As interest rates drop, consumer spending increases, and this in turn stimulates economic growth.
Contrary to popular belief, excessive economic growth can in fact be very detrimental. At one extreme, an economy that is growing too fast can experience hyperinflation, resulting in major problems.
Keep in mind that while inflation is a major issue, it is not the only factor informing the Fed’s decisions on interest rates. For example, the Fed might ease interest rates during a financial crisis to provide liquidity (flexibility to get out of investments) to U.S. financial markets, thus preventing a market meltdown. This has been the clear goal of the our recent economic crisis.
The amount of borrowing already achieved is still not yet enough to get our economies back to where they were just a few years ago. Combine that with the growth our economies need to achieve to replace all the lost jobs, plus the amount of borrowing that’s being done at current interest rates, and we end up with a serious problem.
How does that relate to your portfolio?
The impact of inflation on your portfolio depends on the type of securities you hold. If you invest only in stocks, worrying about inflation shouldn’t keep you up at night. Over the long run, a company’s revenue and earnings should increase at the same pace as inflation.
The exception to this is stagflation.
The combination of a bad economy with an increase in costs is bad for stocks (which is what is happening as we speak.) Also, a company is in the same situation as a normal consumer – the more cash it carries, the more its purchasing power decreases with increases in inflation.
The main problem with stocks and inflation is that a company’s returns tend to be overstated. In times of high inflation, a company may look like it’s prospering, when really inflation is the reason behind the growth. When analyzing financial statements, it’s also important to remember that inflation can wreak havoc on earnings depending on what technique the company is using to value inventory.
Fixed-income investors are the hardest hit by inflation. Suppose that a year ago you invested $1,000 in a Treasury bill with a 10% yield. Now that you are about to collect the $1,100 owed to you, is your $100 (10%) return real? Of course not! Assuming inflation was positive for the year, your purchasing power has fallen and, therefore, so has your real return. We have to take into account the chunk inflation has taken out of your return. If inflation was 4%, then your return is really 6%.
This example highlights the difference between nominal interest rates and real interest rates. The nominal interest rate is the growth rate of your money, while the real interest rate is the growth of your purchasing power. In other words, the real rate of interest is the nominal rate reduced by the rate of inflation. In our example, the nominal rate is 10% and the real rate is 6% (10% – 4% = 6%).
As an investor, you must look at your real rate of return.
Unfortunately, investors often look only at the nominal return and forget about their purchasing power altogether. (credit Investopedia)
/>The best way to combat this scenario is to invest in inflation-hedging bets while maintaining your diversity in stocks. This means putting your money in hard assets like real estate or precious metals such as silver and gold while adding stock positions tied to the mining and resource sectors.
As mentioned in the above scenario, If you invest only in stocks, worrying about inflation shouldn’t keep you up at night as a company’s revenue and earnings should increase at the same pace as inflation.
But if you factor in mining and resource based investments into the equation, there is an opportunity to not only beat inflation, but also protect yourself against stagflation.
That is why to this day we can continue to remain bullish in the resource sector. Every day the resource and miners are continuing their climb and this is clearly evident in the market performance of the Canadian miners. Positive news announcements from precious metals juniors have helped many of them achieve new 52-week highs.
We`re looking forward to 2010.
Until next week,
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