Inflation? No Problem. Float With It

Finding investments for those who seek regular income and still hope to preserve capital is becoming a more difficult endeavour by the day.  Yes, there are stocks that pay great dividends and have appreciated in the last few months by as much as 50% – 60% or more.  But that’s no guarantee that those same issues won’t fall into the dumpster tomorrow and trade lower by 50% – 60% for years to come.  And even if the dividend remains safe, what profit can one expect from such an investment over the long term?

No question, these are trying times.  One has to plan for inflation – even hyperinflation – going forward.  One has to consider the possibility of continued upheaval in the financial system when that inflation hits.  And one has always to expect the unexpected: that it may, in fact, be some sort of deflationary bust that next afflicts the world economy, brought on by … who knows what?  There are still any number of miscalculations governments and their central bank wunderkinds can make (no, they haven’t yet exhausted their store of reckless monetary jabs yet).

So consider the following scenario: you buy a bond, and with inflation you lose as interest rates rise.  In a hyperinflationary situation, you can watch the market deliver your head on a platter.

If you’re a stockholder, on the other hand, your stocks may rise as the CPI heats up – if you’re in the right sector.  But how to determine in advance what the right sector will be?  Think Weimar Germany, 1920’s.  And what were people doing with their “money” in those years?  Buying only necessities.

So where to invest?  Where’s the sure thing?  Rice stocks?  Bread makers? 

Not bad ideas. 

But here’s another one.

There exists an investment that was built specifically to take advantage of an inflationary environment.  And for the time being it’s without question one of the best places to invest.  Not talking about gold here, though gold is without a doubt where smart investors will put funds in anticipation of inflation. 

Not talking about TIPs either.  There’s a certain safety in owning an inflation indexed bond, that’s for sure.  And one issued by the Federal Government probably feels safe.  But TIPs can net you a negative return in a deflationary environment, and moreover, the CPI is a lie, and that’s what the payout on these instruments is tied to. 

Manipulating the Consumer Price Index

The CPI is regularly being revised by the Bureau of Labor Statistics, and experimental indexes are routinely being offered as a more “accurate” measure of inflation (read: one that better suits the interests of big government and its big spending habits).  Just ask yourself why official sources always quote the CPI without the so-called “volatile” food and energy components – as if that reading were a more accurate rendering of the average American’s experience of inflation.  Since when did we stop buying food and driving cars?  In the end, do you want an investment that’s linked to a manipulable metric?
 
For those interested in a more accurate CPI, I highly recommend John Williams’ shadowstats.com website.  There, you’ll find a bevy of provocative data on just about every major government issued economic statistic.

But Back to the Issue at Hand

That said, maybe you couldn’t care less about real CPI rates and quibbling over a percentage point or three here or there.  Still, are you comfortable investing funds with the same corrupt hooligans who brought you this monetary mess in the first place?  Would it not be preferable to put your cash with Wall Street’s hooligans, who at the very least have a profit motive behind their foolishness – and whom the government will likely bail out in a pinch?

Given the choice…

The Residual Investment Report’s Bi-Monthly Recommendation

The item we’re recommending in this issue of the Residual Investment Report is a security that tracks another, parallel measure of inflation: interest rates.  And while interest rates are not a direct proxy for the cost of goods and services, certainly at the short end, central banks do use interest rates to coerce populations to either spend or save.  That means that short term rates will follow the broad wave of prices as they inflate and deflate.

Here’s Reason To Fear

Because of recent government and central bank activity, we now have grounds to expect a meaningful surge in consumer prices, and with it a concurrent rise in short term interest rates.

Look here:

The above chart ran in a recent Wall Street Journal article penned by economist Arthur Laffer, called, Get Ready for Inflation and Higher Interest Rates – The unprecedented expansion of the money supply could make the ’70s look benign.  Had the piece been written by a Journal staffer we likely would have written it off as ‘more of the same.’  But Laffer’s work on taxation rates and a man’s motivation to work (which, incidentally, should be mandatory reading for very politician who takes office in this country) convinced us to take a peek. 

His chart shows us very clearly that at the drop of a hat the Fed completely switched its generations-old policy of being America’s inflation-fighter to that of a deflation-fighter.  The Bernanke Fed’s expansion in the money supply was, in Laffer’s words, “the largest increase in the past 50 years by a factor of 10,” and one that will result in

…even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

If you remember the 1970’s, you’ll probably remember this:

You’ll also remember that gold climbed from $35 an ounce to $850, says Laffer, and that “the U.S. Dollar collapsed.”

What Laffer makes clear in this article is that the Federal Reserve will find it extraordinarily difficult to “mop up” all these excess dollars sloshing about the system without causing other, foreseeable and unforeseeable negative consequences.  Indeed, he says it’s impossible for anyone to forecast the ultimate results of such a wild stab into the monetary night.  

Interest Rates Begin to Tell the Tale

Here’s how the bond market has reacted to all of the above mentioned stimulus in the last six months:

In a half year, the yield on the benchmark ten year Treasury has roughly doubled.  To put it succinctly, bondholders have gotten whacked.

But if you were invested here:

You are a happy man today.

Morgan Stanley’s floating rate, preferred shares (series A) pay investors the three month U.S. Dollar Libor rate plus 0.70% – and never less than 4.00%.  At present they trade for $14.69 and pay a very healthy 6.88% annually. 

The issue is callable on or after July 15th, 2011 at $25.00 but has no stated maturity.  It’s rated Baa1 by Moodys and BBB by S&P. 

The beauty of this floating rate preferred is that it moves in tandem with interest rates!  You outperform TIPs by a longshot in both inflationary and deflationary environments.  Moreover, you have an opportunity to lock in at nearly seven percent annually just for the effort.  And if you’re called away in the summer of 2011 – you have a 70% gain waiting for you – along with all the collected interest payments.  And all that within a two year time frame.

That’s what we call upside.

The Residual Income Report recommends immediate purchase of Morgan Stanley’s Floating Rate Depositary Shares, Series A Preferred (MS.PR.A:NYSE) for all accounts.

Then go buy a farm.

Matt McAbby
Analyst, Residual Income Report