VIDEO: How to Hedge Against Mounting Risks
Welcome to my video presentation for Friday, June 18. In the article below, I elaborate on these investment themes in more detail.
We’ve been enjoying a robust stock market rally since the November 2020 general election. However, volatility has spiked lately amid concerns of inflation and the possibility that the U.S. equity market is overvalued and headed for a correction.
Today, I want to step back from the daily gyrations of the markets to examine time-tested ways to safeguard your investments from the types of threats we currently face.
The hedonic treadmill…
The “hedonic treadmill” is a term coined by psychologists to describe the tendency of people to quickly return to their emotional status quo after major positive or negative events. I see this dynamic at work among investors and the pundit class.
Sure, aggressive fiscal and monetary stimulus policies are causing financial distortions and fueling inflation. But the pessimists seem to have forgotten that last year, during the nadir of the coronavirus crisis, humanity was staring into the abyss. Let’s be grateful for this year’s economic recovery, bull market, and falling COVID-19 rates.
I’m still bullish about stocks and I don’t expect a full-fledged correction this year. But as the pandemic-battered economy claws its way back to a semblance of normalcy, you should brace yourself for roller-coaster action along the way.
Likewise, I don’t expect anything close to “hyperinflation” to emerge this year or next, but it’s prudent to add inflation protection to your holdings. Under current conditions, at least 15% of your portfolio should be devoted to hedges (as a general rule of thumb).
Whether surges of inflation turn out to be transitory or more lasting, you should fortify your portfolio regardless. Protecting wealth is as important as building wealth. It’s time for some “insurance.”
Don’t tug on Shiller’s CAPE…
First, let’s put equity valuations into context. Consider the cyclically adjusted price-to-earnings ratio (CAPE). Renowned economist Professor Robert Shiller of Yale University invented the CAPE ratio (also known as the Shiller P/E) to provide a deeper understanding of market valuation.
The CAPE ratio is defined as price divided by the average of 10 years of earnings (the moving average), adjusted for inflation. The ratio currently stands at 37.46, which is 136.6% higher than the historical mean of 15.83.
According to this long-term chart of the CAPE ratio, stocks in the S&P 500 currently sport valuations higher than during the financially calamitous years of 1929, 1987 and 2000:
The sky-high CAPE ratio warns of danger, but you don’t have to take it lying down.
The Midas method…
Historically, gold has served as an inflation hedge, as well as a safe haven during storms of volatility. Investors should view this week’s short-term momentum selling of gold as a chance to buy portfolio insurance on the cheap.
After Federal Reserve Chief Jerome Powell indicated Wednesday that rates could start going up in 2023 (as opposed to the original time frame of 2024), Treasury yields climbed as bond prices fell. Higher yields increase the opportunity cost of holding non-interest-bearing gold.
In the wake of Powell’s surprisingly hawkish tone this week, gold prices saw their biggest drop since November 2020. The yellow metal is now trading at levels not witnessed since the end of April 2021.
However, the precious metal’s recent sell-off should prove temporary as investors eventually respond to higher inflation by fortifying their portfolios with gold as a hedge.
Green acres is the place to be…
Agriculture-linked assets represent an often-neglected inflation hedge. They also provide growth during economic recoveries. Ag-assets aren’t as sexy as “meme” stocks, so you don’t hear them touted by the carnival barkers on CNBC. But food is arguably the most essential commodity of all.
During Wednesday’s Geneva summit between U.S. President Joe Biden and Russian President Vladimir Putin, the major points of contention were cyberattacks, human rights, and election meddling. However, left unmentioned was the geopolitical struggle over food (see chart).
The world is consuming more food than it produces, largely because of population growth, rising affluence in developing nations, and extreme weather in major food-exporting countries. Severe drought in recent days in the western region of the U.S. underscores the fragility of the ecosystem as global warming worsens.
Historically, when overall inflation rises, the prices of agricultural commodities rise even faster. If you’re risk averse and seek safe and easy plays on agriculture, consider exchange-traded funds (ETFs).
Don’t forget to TIP…
U.S. Treasury inflation-protected securities (or TIPS) are proven inflation protection tools. TIPS are tied to the consumer price index (CPI). When the CPI goes up, the principal values of TIPS rise, too.
Investors are scooping up TIPS at an accelerating pace. Fueling the buying frenzy are worries that inflation protection could become prohibitively expensive as the price of these instruments are bid higher.
In addition to low-cost TIPS, I recommend that your inflation protection strategy includes a diversified mix of commodity and real estate stocks, as well as emerging markets exposure. By increasing your stake in developing economies, you’re protecting your assets from the risk of a U.S.-centric versus global inflation shock.
Editor’s Note: I’ve just provided you with basic steps to both grow and safeguard your wealth. Looking for additional methods? Turn to my colleague, Jim Pearce.
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