Are Commodities the Answer for Inflation?

Inflation is the hangover that comes from an expanding money supply and an overheating economy.  Our money supply has grown exponentially over the past year and the global economy is far from overheating.  Investors are scared that inflation is likely to happen and eventually it will.   There is a food fight between prominent economists about whether or not we’re going to see a surge in inflation sooner rather than later.  Its’ a fascinating discourse, but I’m leaning toward the camp that it’s unlikely to happen soon.   When global economic growth rebounds, it’s time to pay attention.

The Federal Reserve was very artful in the means it used to shore up our financial system.   It dropped the Fed Funds rate to 0% and used other measures (massively expanding its balance sheet) to inject liquidity into our financial system.  It wasn’t an overnight success but it did prevent a global financial meltdown.

Investors are understandably concerned that the Fed is going to have to start mopping up the ocean of liquidity it unleashed upon our financial system to prevent inflation from getting out of hand.  The Fed’s success in accomplishing this will determine whether we have the doomsday stagflation scenario that all the television commercial purveyors of gold are expounding or a boring cyclical recovery along the lines of our historical experience.

Some investors, who are very concerned about inflation, and  in the belief that they are being safe, are piling into gold and commodities.  Gold is a very emotional asset class.  It has industrial uses but fear is a big driver of its price.  Fear is a horrible motivator for financial decisions.  Overall commodities prices are being distorted by the same market forces.  Commodities prices rise because people expect economic growth to happen, or because they are scared, or because they are speculating on a combination of the two. 

I don’t mind a little bit of gold or commodities in the mix, but I consider them speculative and volatile, so I wouldn’t put a huge chunk of a portfolio in them.  The Gold SPDR (GLD) has a three year return of 14.41% and a standard deviations of 20.69.  Considering the market conditions of the last three years that was pretty spectacular.  But I think the likelihood we’ll see the same performance over the next three years isn’t that high.  

We can use the average rate of return and the standard deviation to create a normal distribution, or a range of likely returns (to learn more about this fascinating statistical concept,  please read my blog post “50% of the Time That Works All the Time” dated April 16,2009).  Sixty-seven percent of the time (or two out of three years) the Gold SPDR’s likely range of returns fall somewhere between -6.28% (14.41% – 20.69%) and 35.10% (14.41% + 20.69%).    I think going forward we’ll see that normal distribution curve take a shift to the left.  If the standard deviation remains about the same the downside range of likely returns for gold could be lower than -6%.  Of course, there is a one in three chance that the return will fall below -6% or above 35% anyway.  Professional traders and speculators leave hapless individual investors holding the bag with commodities every time.  Folks that chased returns and bought gold when it was close to $1,000 per ounce know exactly what I’m taking about.

A small percentage of commodities are a part of the solution to hedge against future inflation, but it is not the silver bullet.  Investors would be better off in the long run being broadly diversified in stocks and bonds (and a dab of commodities) than gambling with their life savings by putting a large percentage of their portfolio in commodities and speculating about the direction of the market or the impact of inflation.  I prefer owning companies that profit from commodities like Freeport McMoran or Exxon Mobile (both of which are present in broad market and sector index funds) rather than owning the commodities themselves.

The global economy is cyclical.  It always has been and always will be.  Being positioned to participate in the recovery, when it happens, is the most prudent thing to do.  Since March 9, we’ve seen a 30% to 40% recovery that millions of investors completely missed.  Now they’re wondering if the train has left the station without them.  What should they do?  The answer is to reinvest their cash allocated to the stock market a little each month (via index mutual funds) for the next year or so to get fully invested again.

The fewer moves one makes, the more likely one is not to have made the wrong one.  Get properly diversified and ride it out.  We are much closer to the end of the recession than the beginning.

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