by Alexander Green, Investment U Chief Investment Strategist
Monday, January 09, 2012: Issue #1682

Not long ago, my colleague Mark Skousen asked a roomful of attendees at an investment conference how many of them owned gold. Virtually every hand in the room went up.

“And how many of you have ever sold any of your gold?”

Virtually every hand in the room came down.

For many investors, gold is their “forever investment,” the one asset they never plan to sell. That could be a mistake, a big one.

I can assure you that the institutional investors who have bid gold up the last few years consider the metal a “hot date,” not a long-term marriage. And that bodes ill for prices in the short to medium term.

Yes, I was bearish on gold a year ago. But I’m more bearish on it today. After all, the trend is your friend.

True, gold went up in the first half of 2011 and didn’t peak until August. But take a look at a five-month chart.

It’s not a pretty picture.

Of course, gold is hard to value under the best of circumstances. It has very few industrial uses. It generates no earnings, pays no dividends, accrues no interest and provides no rental income. That means the best any of us can do is guess where it’s headed next.

So why am I guessing it will be lower? Let me count the ways:

1. Gold is a wonderful inflation hedge. But the metal is up more than five-fold over the last 12 years and inflation is still not a problem. Is it not conceivable that inflation could tick up and gold – having already discounted this – moves lower?

2. Gold is a great performer in an economic crisis. But we already had the crisis. It ended in 2008. Things are getting slowly better, not worse.

3. With gold prices still in the stratosphere and the value of the rupee falling, India – the world’s biggest consumer of gold – is likely to experience a pronounced drop-off in demand this year. Not good.

4. Gold is now well above the marginal cost of production. New mines are opening and old mines are re-opening. It’s Economics 101. Greater supply depresses prices.

5. If you believe the gargantuan debt load that Washington has run up will cause gold to rally from here, you may want to think again. Japan’s debt load as a percentage of GDP is more than twice ours and the end result has been disinflation, not inflation. Why will it be different this time? Indeed, George Soros and several other major speculators are openly forecasting outright deflation. That would not be good for gold.

6. Note that while gold ended the year up in 2011, gold shares dropped 16%. Already, equity investors are taking a dim view of the sustainability of gold’s advance. I think they’re right.

7. Investment demand for gold has soared in recent years. Seven years ago, it made up just 16% of total demand. Today it’s more than 40%. But hedge fund managers who piled into gold, unlike Mom and Pop, have no emotional commitment to the metal. These are hair-trigger traders. When the primary trend turns unequivocally south, you can bet these guys will dump gold faster than a freshman girlfriend.

I’m not suggesting that anyone bail out of gold. You should hold at least 5% of your liquid assets in gold and gold stocks, and perhaps more. But if you’re one of those folks I meet who has 30%, 50% … even 80% in the barbarous relic, you’re really sitting at the roulette table at 3 AM.

No one can say unequivocally that the bet won’t pay off. But there could be a steep price to pay if it doesn’t. The last time gold was a bubble, investors were down more than 60% two decades later.

As Mark Twain said, “History may not repeat itself. But it rhymes.”

Good Investing,

Alexander Green

by Alexander Green, Investment U’s Chief Investment Strategist
Thursday, October 28, 2010: Issue #1376

Six months ago, I made a strong case for buying inflation-adjusted Treasuries, better known as TIPS.

I suggested that Washington’s massive fiscal stimulus, plus record-low interest rates, might ultimately prove inflationary.

So far, they haven’t. But investors clearly feel that inflation – the thief that robs us all – is just around the corner.

Look at the traditional inflation harbinger – gold. The metal has hit one new high after another this year.

TIPS (Treasury Inflation-Protected Securities) have soared, too. In fact, they’ve rallied so far that for the first time ever, five-year TIPS were sold at auction earlier this week with a yield of minus 0.5%.

That’s right… they guarantee a negative yield. Yet investors are gobbling them up anyway.

What’s going on here? Let’s start at the beginning…

The Inside Track on TIPS

Here are some Treasury Inflation-Protected Securities (TIPS) characteristics…

• They pay interest every six months, just like a regular Treasury bond.
• Unlike traditional bonds, your principal increases each year by the amount of inflation, as measured by the consumer price index (CPI). The semi-annual interest payments also increase by the amount of inflation.
• The interest you receive is exempt from state and local income taxes (but not federal).
• TIPS are less volatile than traditional bonds.
• TIPS are excellent diversifiers.

But can TIPS possibly be worth holding, even when they sport a negative yield?

Perhaps for long-term investors (as I’ll explain in a moment). But not for short-term traders. Here’s why…

Think Twice Before Buying TIPS for the Short-Term

Current yields of less than zero on TIPS are due to rock-bottom Treasury rates and fears of higher inflation just over the horizon.

It’s simple math. Five-year Treasuries are yielding a paltry 1.2%. Given the weak dollar and Washington’s addiction to spending, traders and investors are betting that inflation will run at 1.7% or more.

That makes five-year TIPS just as attractive as five-year bonds, since 1.7% minus the 0.5% negative yield equals 1.2%.

Inflation or Disinflation?

Of course, the financial markets are a bit schizophrenic right now. Inflation protectors like gold and TIPS have rallied. But so have inflation-sensitive investments like investment grade bonds. Investors can’t seem to decide whether we’re in for inflation or disinflation.

And of course, nobody knows for sure. But TIPS have rallied by 10% over the last year, with no uptick in inflation. If the folks betting on disinflation – or its more severe cousin, outright deflation – are right, these bonds could undergo a serious price adjustment, giving investors a haircut in the process.

TIPS investors aren’t just guaranteed negative yields right now. They may also experience a negative total return for several years in a row.

So why shouldn’t long-term investors sell them outright?

How to Tackle TIPS if You’re a Long-Term or Short-Term Investor

Some would be prudent to do just that. The only catch is this: What if the inflation hawks are right?

If they are, TIPS will give a higher future return than traditional fixed-income investments – and with the highest degree of safety. (They are, after all, obligations of the U.S. government.)

True, there are other inflation alternatives. But gold has already quintupled over the last decade. And that other famous inflation hedge – your home – is likely to remain mired in quicksand for years to come, thanks to the overhang of foreclosures and other unsold properties.

The bottom line is this:

• Long-term investors – those with a time horizon of five years or more – should hold onto their TIPS.
• But traders and other investors with a shorter time horizon should probably give them a miss.

History shows that once an asset class turns hot – whether it’s stocks, bonds, gold, real estate or TIPS – it rarely delivers the kind of returns it did when it was heating up.

This time could be different, of course. But that’s how investors always rationalize their investments at the top.

The oldest advice is still the best: Caveat emptor.

Alexander Green

by Alexander Green, Chief Investment Strategist
Tuesday, June 1, 2010: Issue #1271

U.S. Treasury bonds are the safest investment in the world.

However, that doesn’t mean they can’t be dangerous. Far from it.

Yet a few days ago, The Wall Street Journal reported that, “Long-dated Treasury securities are now the most favored financial assets for global investors fleeing the eurozone’s debt crisis.”

Talk about jumping out of the frying pan and into the fire…

Don’t get me wrong. I’m not one of those end-of-the-worlders who expect the U.S. government to default on its sovereign obligations. That won’t happen.

It wouldn’t even be necessary. After all, history shows that governments always prefer to inflate their way out of a debt crisis by cranking up the printing presses instead. That way they can achieve a de facto debt reduction simply by devaluing the currency.

If you’ve seen the photographs of German citizens hauling wheelbarrows full of cash into the bank during the days of the Weimar Republic, you know what I’m talking about.

Of course, I don’t expect inflation like that. And neither should you.

But what kind of inflation does an investor expect who loans his money to the government for 30 years at a rate of just 4.1%?

Why U.S. Treasury Bonds Could Bulldoze Your Portfolio

That 4.1% figure is the current yield on the long end – and it’s a bet that has a little upside potential and a whole world of downside risk. Why?

Imagine a seesaw with interest rates and inflation on one end and bond prices on the other. If inflation goes down, bond prices go up. And vice-versa.

But how far down can rates go on the long end? Unless we have the sort of deflationary environment that Japan suffered in the 1990s, the appreciation potential here is minimal.

On the other hand, if inflation rears its ugly head, long bonds will get clobbered. And the worse inflation gets, the worse these bonds will do.

I realize that inflation is not an immediate threat. Technology and deregulation have brought costs down over the past decade. And even oil prices have moderated lately.

But if the bond market gets even a whiff of higher inflation, these bonds will drop like a stone. And I’m betting that investors who weren’t around during the early 1980s – and even many who were – don’t realize it.

They are so busy patting themselves on the back for eliminating default risk – and picking up a 4% yield versus next-to-nothing on the short end – that they are forgetting about interest rate risk: the risk that higher inflation will send long yields soaring and bond prices crashing.

Don’t Let the Government Trick You into Speculating

Seth Klarman, President of the Baupost Group, an investment firm in Boston that manages $22 billion, says the U.S. government is inadvertently provoking its citizens into taking very bad risks right now.

How?

“By holding short-term interest rates near zero, the government is basically tricking the population into going long on just about every security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can’t stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate.”

Of course, most people aren’t exactly in a speculating mood right now.

So what are they doing? They’re buying super safe long-term Treasuries and earning over 4%.

Except that’s not a safe investment – as many will eventually learn to their chagrin.

Good investing,

Alexander Green

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by Alexander Green, Chief Investment Strategist
Monday, May 10, 2010: Issue #1256

Two weeks ago, I wrote a column recommending Treasury Inflation-Protected Securities (TIPS) as protection against potential inflation down the road.

It prompted a flood of questions and challenges. I want to address those, but let me start by briefly re-stating my case:

1. Unprecedented government spending – including $108 trillion in unfunded liabilities for social security, Medicare and new universal healthcare benefits – is putting the nation at risk.
2. With interest rates near zero, the Federal Reserve cannot take one traditional step – lowering short-term rates – to revitalize a weakened economy.
3. In a severe economic downturn or double-dip recession, politicians – with the reluctant assistance of the Fed – could opt to spend even more massively to try to jump-start the economy.
4. The result could be stagflation: slow growth with higher inflation. (And although we haven’t seen it here in almost 30 years, perhaps even hyper-inflation.)

I don’t know what the odds of this happening are – and neither does anyone else. But I think investors would be foolish not to at least consider the possibility…

Inflation or Deflation? Hedge Your Bets This Way…

Respondents who disagreed generally fell into one of two camps…

• They either believed that deflation is more likely than inflation.
• They thought inflation was likely, but since Congress will almost certainly be the culprit, they don’t want to reward the mischief-makers by buying any kind of government securities.

Let me handle the former objection first: Is deflation more likely than inflation? Perhaps. No one can say. You should probably own a good slug of Triple-A insured municipal bonds just in case. (Because future tax rates are almost certainly going higher.)

By all means, make some plans for a deflationary scenario. But plan for the possibility of inflation, too. This is what diversification is all about. Hedge your bets.

But why use TIPS as your hedge, rather than a traditional inflation hedge like precious metals? In my view, you should use both. But remember, gold and silver are less than perfect hedges.

They have both performed exceptionally well over the last 10 years, for example. Gold has more than quadrupled. Silver has done even better. But the 20 years before that were an unmitigated disaster.

But no matter whether inflation is low or high, TIPS will protect you. How?

The Benefits of Buying Treasury Inflation-Protected Securities

• Regular Interest Payments: TIPS pay interest every six months, just like a regular Treasury bond. But unlike traditional bonds, your principal increases each year by the amount of inflation, as measured by the consumer price index (CPI). Semi-annual interest payments also increase by the amount of inflation.
• Tax Benefits: The interest you receive is exempt from state and local income taxes (but not federal). TIPS are also less volatile than traditional bonds and are also excellent diversifiers.

There are three good ways to buy inflation-protected Treasuries:

1. Directly: http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_buy.htm
2. Through the Vanguard Inflation-Protected Securities Fund (VIPSX).
3. Through its ETF equivalent – the iShares Barclays TIPS Bond Fund (NYSE: TIP).

I recommend TIPS for two primary reasons…

1. I’m not a moralist trying to claim the high ground. I’m just trying to protect myself, my family and my heirs from potentially destructive hyper-inflation. I don’t want to remain true to my free-market principles only to see the net worth I’ve accumulated over a lifetime torpedoed.
2. There is no private-sector alternative here. For good reason, private and public companies don’t want to leave themselves vulnerable to sky-high interest and principal payments down the road if inflation takes off. So they don’t issue inflation-protected securities. That makes TIPS the only game in town.

I know that some libertarians and laissez-faire capitalists will refuse to buy Treasury securities, period. But as I’ve pointed out, other inflation hedges sometimes don’t work. So there is no small risk taking another approach.

In sum, there is only one investment that guarantees a return that exceeds inflation in the years ahead: TIPS.

And in my view, that makes them an indispensable part of your portfolio.

Good investing,

Alexander Green

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