Unlike Mad Magazine’s Alfred E. Newman, I've worried all my life and nothing really bad has gone wrong, so it’s a system that has worked for me. Therefore, in a week during which the Dow Jones Average hit an all-time high, I’ll throw a wet blanket on everyone’s irrational exuberance as follows: An economy continuing to grow steadily leads to overheating, inflation and higher interest rates sooner or later. The best guess of people who study business cycles is that we have, perhaps, until the end of the decade to enjoy what promises to be a world-wide economic boom. When it reaches full flower, the demand for borrowed money will cause interest rates to rise. When those loan proceeds run dry, and everyone is over-leveraged, we’ll be back to paying 23 percent interest on copy machine leases like I had to do back in the ‘70s. The economy will suffer as a result and a falling stock market will anticipate that decline before it happens. “Stagflation” is the President Ford-era term that described inflation combined with a sour economy.
As for right now, when it’s not consumed by panic selling, the stock market rises as it reflects anticipated future profits thanks to low inflation, low interest and a growing economy.
But I’m a person who always likes some back-up. What will investing entail when we’re peering into the abyss in four or five years? What could be our back-up?
The answer is provided by Craig L. Israelsen in Financial Planning which summarizes his findings relating to years of higher and lower inflation from 1970 to 2013. Dividing the years above and below the median inflation figure of 3.37 percent, he illustrates the asset classes that performed the best depending on which inflationary environment prevailed.
In the half of the years in which inflation was low, small company stocks performed the best. Average returns were 18.3 percent. Even in high inflationary periods, small companies prevailed with average returns of 10.4 percent. Large companies, by comparison, had total returns averaging 15.9 percent during low inflation and 6.4 percent during high inflation. Rain or shine, small companies bring more volatility and risk which earns them the “risk premium” distributed by the “invisible hand” of economic forces. Meanwhile, real estate earned about the same --- 15 percent --- in both high and low inflationary periods. Bonds were also about neck and neck at around 7 percent regardless of inflation.
However, the numbers above were just gross figures ignoring the effect of inflation on total returns. The net gains after factoring in the erosion of value caused by inflation yielded more sobering results. Large company stocks in high inflation years had net increases of only 1.8 percent. U.S, bonds were also hit hard and had net returns of only 2 percent. Real Estate held up with net returns of 9 percent, and commodities were the real winner in the net return sweepstakes with 18.3 percent returns during periods of high inflation. The median inflation rate for the troubled high-inflation years was about 6 percent, which means that commodities actually gained a total of 24.3 percent.
What this tells us is that diversification across different asset classes can help to protect against the downside when it comes. We shouldn't attempt a futile effort to time the markets, but it could make sense to consider some real estate and natural resources funds as part of a diversification strategy. Maybe investing in them now while they’re a relatively cheap could make sense.
Remember also that while capital values decline for some asset types during high inflationary periods, the decline will only be temporary and there can be offsetting rewards. Bond funds, for example, may drop in capital value, temporarily, but the average amount of interest paid on the fund will be rising as old bonds are replaced with new ones paying inflation’s higher interest rate. By the same token, large company stocks will drop in value, but dividends will look better --- especially as a percentage return on reduced stock prices, and they provide a floor under the stock price. So, even in a crash, there’s a sunny side of the street for those who understand what’s happening, who plan ahead, and who don’t do something rash at the time.