Saturday, February 13, 2010

What does a Year Supply of Food, a 72 Hour Emergency Kit, and Stocks Have in Common?

The value of the dollar may be one of the most talked about issues on Wall Street, and in Political Circles on Main Street. What does a "weak dollar" mean for the US and for it's citizens.

For American companies, it's fabulous. It means that the rest of the world can buy our goods for less. That usually means that, as a country, we will sell more goods because they are more competitive internationally. There are many more consumers outside the US than inside of it. If we are to prosper as a country, we will have to export and in large amounts. As international companies convert foreign currency back into US dollars, they get more for their money on account of the exchange rate; especially if the US dollar has weakened from the time they sold the goods and collected payment.

How does this all relate to inflation? Inflation occurs when your dollar buys less in the future than it does today. Many people feel like the act of printing money by the Federal Reserve Bank is what leads to inflation. That is just simply not the case. Just because money is created, does not mean that it will find it's way into the hands of those who will spend it. We hear all the time about how we face hyper inflation if we keep interest rates at zero for an extended period of time. But, we also hear how banks are not least not to sketchy lenders. Without lending that not so "easy money" to borrowers, there is little risk that inflation gets out of control.

So, how does inflation really happen? Say you buy a house for $150,000. Just two years later you hear about someone desperate to buy a house in your area, and he/she is willing to pay top, top dollar for that house. You personally find out who it is and have them over for dinner. You offer to sell them your home and all of your furniture for $175,000 because you agree to move out in 10 days. Now, all of a sudden, when real estate agents run comparables of your market and find out that a house just sold for $10,000 to $15,000 over every home in that market is "worth" more money. When the next buyer pays $170,000 for a similar home, inflation is born. See, inflation happens when someone is willing to pay "too much" for something and then all similar sales follow suit.

If I wanted to buy a Toyota Prius in 2004 when the 2nd Generation Prius (2005) Prius came out, there were literally waiting lists in California to buy that car. People were actually buying the car and then reselling it if they were able to get the HOV Lane sticker (that allowed you to drive your Prius in the HOV lane by yourself in California). People were paying OVER the sticker price for a Toyota Prius in 2004 and 2005. All of a sudden, this car was experiencing inflation and it had nothing to do with the Feds printing money. When someone "pays up" for something, inflation is born.

So, the next time someone insists that the Fed is printing money, you ask them where you can get yours, because until that money gets in the hands of those who will spend it, you will not see inflation. In this environment, the Federal Reserve is much more worried about deflation. That's where no one has money to spend and there are all sorts of things to buy. You may hear the term "slack in the economy". That means we have much more production capacity than demand and it causes producers to sell their goods for less just to generate cash to stay in business. A deflationary spiral is MUCH worse than inflation. They say inflation is too many dollars chasing too few goods. You know what that's called in economics? It's called demand. Regardless of how it happens, when people want something and they are willing to pay more than the next person...inflation is born.

So, what do you do when inflation strikes? I can tell you what you do not want to do, and that's own bonds that have lower interest rates or are going to mature shortly. Without having a much longer duration or an above average interest rate, you could see your bond price get whacked, hard, in order to bring the yield in line with the market's interest rate.

Lets take a look at Zimbabwe's situation in which they experienced hyperinflation:

Highest Monthly Inflation Rates in History Country Month with highest inflation rate Highest monthly inflation rate Equivalent daily inflation rate Time required for prices to double
Hungary July 1946 1.30 x 1016% 195% 15.6 hours
Zimbabwe Mid-November 2008 (latest measurable) 79,600,000,000% 98.0% 24.7 hours
Yugoslavia January 1994 313,000,000% 64.6% 1.4 days
Germany October 1923 29,500% 20.9% 3.7 days
Greece November 1944 11,300% 17.1% 4.5 days
China May 1949 4,210% 13.4% 5.6 days

Source: Prof. Steve H. Hanke, February 5, 2009.

This compares Hungary, Zimbabwe, Yugoslavia, Germany, Greece, and China. Besides Zimbabwe, only Yugoslavia's inflation is in recent memory. Hungary, Greece, and China were all in the 1940s and Germany's inflation was in the 1920s. The data above shows you the country of inflation, the date experienced, the highest monthly inflation rate, the inflation seen on a daily basis, and the time it took prices to double. In just over 24 hours, prices doubled in Zimbabwe for a month.

So, what do you hold when inflation hits? If the answer isn't bonds, it certainly isn't the currency itself. What is left to hold?

That's right, you're looking at the Zimbabwe Industrial Index over the period of 12 months. Stocks themselves, are the way to fight inflation...or at least keep pace with it. See, when you buy a banana for $1 today and inflation is 5% over the next year, that banana will cost you $1.05 the next year. Imagine you hold IBM at $120 and inflation sets in at 5% and at the end of the year, your IBM stock is worth $126. What if hyper inflation sets in and inflation goes up 100% over the course of the year? Your IBM stock goes from $120 to $240. When inflation sets in, it's really everything that goes up...but it's only because someone is willing to pay it.

If the President came on TV and said: "Do NOT pay more for a gallon of milk than $3.50," and people listened...we would not see inflation in the price of goods. Just because something happens geopolitically or economically, does NOT mean that people have to pay that price. The supermarket tries to take advantage of the fear, and they mark the goods up. As soon as someone pays that price, it causes a panic and people rush to spend their hard earned dollars on goods that cost too much. Inflation is more about a lack of discipline that it is about some macroeconomic force pushing the cost of goods to unreasonable levels. It just takes one undisciplined person to make that purchase, and now everyone else seems to be willing to say "that's the new price." That is how inflation is born. If you wanted to sell a loaf of bread for $10 today, very few people would pay it. If you said that we will all be snowed in for 2 weeks under 8 feet of snow...I bet the grocery store could get $10/loaf of bread to the highest bidder. Someone with money, who waited too long to go grocery shopping will end up paying that price for bread and then everyone else will be worried they might have to go without, and then they pay that insane price...inflation is born.

If everyone went to the store together and said, we refuse to pay more than $4...and the store wouldn't sell it at that price, everyone should walk away. When the store realizes that no one will pay that price, what happens? They have to lower the price until demand appears. See, inflation is really about supply and demand, not prices and the availability of money. We call it inflation and deflation, but it's really simple. If someone will pay a certain price for it, that's what it cost. It's purely driven by demand. If the demand isn't there, the price will fall. If the demand is there, prices will rise. Instead of acting independently of each other, consumers should really act together to get a favorable price for their goods. Hmmmm, sounds familiar, how about Walmart*? They are the single largest consumer in the world and they determine the prices for many of the worlds goods. Why? Because they control demand.

What do you do to make sure you're in a position never to "have" to pay up for something? How about save money out of each paycheck so that you can buy goods an an opportunistic time like a sale or with a coupon? Invest in stocks with dependable dividends that will grow over time with good business models and great cash flow. Keep a 72-hour kit so that when disaster strikes, you don't have to run to the store to buy basic goods because you have them. Keep a years supply of food and rotate it so that you're not "forced" to buy food during a time of panic at unreasonable prices. If Zimbabwe taught us anything about how to handle inflation, it's that stocks should do just fine.

You don't have to take our word for it. If you want to read more about the state of the economy and how the US is recovering, our friend James Altucher has a great article in The Huffington Post. You can read his article here: "Why Ron Paul is Wrong"

Don't forget to leave your comments, we'd love to see a brisk conversation about this topic! :-)

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