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Finding Beauty Within the Inflationary Beast

By Daniel Amerman, CFA

August 24, 2007

In this article we will meet a ravenous Beast that goes by the name of Substantial Inflation, and find out just how difficult it is to keep this Beast from shredding our investment portfolios and consuming our real net worth. Next, we’re going to find out how the exact same inflationary conditions which create the Beast, also simultaneously and necessarily create a ravishing Beauty. An easily available Beauty with a most desirable figure, for she generates after-tax and after-inflation benefits that are equivalent to a conventional investment earning 27% per year. As we continue to mangle our fairy tale metaphors, we will find out what happens when Beauty pairs up with a Golden Prince, and how our portfolios can live happily ever after.

Let’s start with the Beast, and a question – what if real inflation is 10% or more? Some people might say this is a very good question for the next several years, when we look at such issues as the budget and trade deficits, or paying for promises made to Boomers. Other people (such as John Williams of Shadowstats.com) might say it is a good question for today, when we take into account real price changes in such categories as energy, food and health care. There are numerous discussions of the reasons to fear inflation elsewhere, in this article we will instead take some quick looks at possible solutions.

The Ravaging Beast:

10% / (100% – 40%) = 16.7%

The simple equation above is a picture of the Beast, and it is an ugly Beast indeed. The equation calculates the investment return we have to earn in order to merely stay even with inflation. Not really make any money, just run in place and keep our wealth worth the same in inflation-adjusted terms. The simplest way to view this return is to say that if the value of our money declines 10% each year because of inflation, then we must earn 10% per year just to keep up. Unfortunately, in today’s investment environment there are no widely available ways to earn anything close to a ten percent risk-free yield.

The full situation is much worse. Because the relationship between inflation and taxation is one of the more unfair aspects of life. Government policies create inflation. That inflation creates the illusion of income. The illusion of income is then fully taxed by the government. So our illusory 10% yield, that is really just keeping pace with inflation, is taxed by the government with most forms of investments. If our combined state and federal marginal tax bracket is 40%, then we lose 4% of our yield, meaning our after-tax yield is only 6%. So even an investment yielding 10%, in an environment of 10% inflation, would only be locking in a 4% annual loss in real purchasing power terms.

This brings us back to our Beast equation above. To stay even with 10% inflation, we have to earn an after-tax yield of 10 percent. So we divide inflation by one minus our marginal tax rate, and find that it takes a 16.7% rate of return to stay even with 10% inflation. As an example, if we invest $100,000, then we lose $10,000 (which is 10%) of the real value of the principal amount of our investment to inflation the first year. We must earn $16,700 in income, which is taxed at a rate of 40%, meaning taxes take $6,700 of our earning. Ten thousand dollars of lost purchasing power, plus $16,700 in nominal income, less $6,700 in taxes all add up to zero, meaning we truly do have earn almost 17% to just tread water and maintain the purchasing power of our savings!

Where, exactly, do you invest today to earn a 17% rate of return? With dividend ratios below 2%, and ten-year US Treasury bond rates below 5%? Inflation truly is a Beast, particularly when in markets where inflation is not priced into the yield levels, as is the current case.

A Tantalizing Beauty:

[-6.5% X (100% – 40%)] + 10% = 6.1%

To uncover the alluring Beauty that can be found within the inflationary Beast, let’s put some numbers to the equation above. Once again, we will assume that inflation is 10%. This time, we will then assume that you have borrowed $100,000 at a 6.5% interest rate (approximately the cost of a 30-year fixed rate mortgage). This means that you pay $6,500 in interest payments for the year. However, 10% inflation has reduced the principal value of what you owe by 10%, from $100,000 down to $90,000 in real dollars, meaning in economic terms you have experienced a $10,000 gain over that year. Subtract the $6,500 you paid in interest from the $10,000 of economic gain, and you are ahead $3,500. However, the $6,500 interest expense is deductible against current income, which at a marginal combined rate of 40%, is equal to a $2,600 reduction in taxes paid. So, we start with a $10,000 economic gain from inflation reducing the real principal value of our debt, subtract $6,500 in interest payment expense, add $2,600 in tax savings, and we are ahead by $6,100.

The numbers above are an example of turning adversity into opportunity. Are interest rates far too low compared to the risks to the dollar, both domestically and internationally? Then instead of complaining about the low asset yields, we lock in low costs, and go short the dollar on a long-term and tax-advantaged basis, as one component of an overall asset/liability management strategy.

(Talking about debt as “Beauty” may seem absurd while the subprime debacle and accompanying credit crunch continue to grow, however, keep in mind that comparing overleveraged hedge funds to a contrarian debt strategy is akin to comparing matter and anti-matter. Contrarian debt strategies with leverage factors far below market norms are designed to thrive in the conditions of economic turmoil that collapse speculative borrowings and markets, as described in the report “Commercial Property Balance Point: Achieve Deep Protection From Economic Turmoil While Turning Inflation Into Wealth”, linked at the end of this article.)

Beauty’s Abundant Attractions

For comparison’s sake, how much would we need to earn using a normal, fully taxable investment in order to equal Beauty’s 6.1% annual after-tax, after-inflation gain? We use our Beast equation from above, and find out that in order to earn $6,100 in real terms, we would need to earn $26,833 in nominal terms. That is, we invest $100,000, inflation costs us $10,000 of the value of our investment, we earn $26,833, we subtract 40% taxes of $10,733, and we end up with a real gain of $6,100.

[26.8% X (100% - 40%)] – 10% = 6.1%

So, if inflation averages10% over let’s say, the next ten years, then we would have to actually realize pre-tax gains of almost 27% per year from our investment portfolio, to experience the same economic benefit of a 6.1% after-tax and inflation return, that we would from borrowing at current market, long-term, fixed mortgage rates of around 6.5%. That’s amazing – but absolutely true.

Now, where precisely, can we invest today for a 27% annual rate of return over the next ten years? The conventional answer used to be investing in a hedge fund that has leveraged up for its investments in subprime mortgage derivative securities, pay annual management fees of 20% plus of our earnings, and cross our fingers and hope that nothing of any magnitude goes wrong with the financial system, or the hedge fund’s guesses. While quite lucrative for the hedge funds while it lasted, that one turned out not to work so well.

The Golden Prince

It is extraordinarily difficult to reliably earn a 17% or 27% rate by purchasing dollar denominated investments. The simple solution to this quandary is – you don’t try to beat an impossible game. You don’t try to beat the dollar on it’s own terms in a game that is stacked against you, you pivot around instead, and play a different game. You buy tangible assets, whose value does not erode with dollar.

A proven winner in difficult times is to pair Beauty up with her Golden Prince. As covered in the article “The Great Game, Gold Arbitrage & Three Little Pigs” (available in the archives of this site and/or the author’s website), during the last prolonged period of major inflation in the United States, investing in gold was lucratively profitable as investors fled dollar-denominated assets. Being the short the dollar in the form of home mortgages was also highly profitable for millions of average American households (old-fashioned fixed-rate mortgages, extended to employed people with good credit histories and real equity in their homes). The combination of being simultaneously long precious metals and short the dollar was much more powerful than either strategy alone, and turned sustained inflation from a wealth destroyer to a potent wealth creator, as wealth was systematically redistributed from dollar holders to gold holders even as it was also being redistributed from creditors to debtors. This strategy can also be used with other precious metals, as well as selected other raw materials, with energy having particular potential for the construction of a “Reality Hedge”.

An alternative strategy is to set up an inflation hedge that generates a cash flow that both pays your interest payments, and rises with inflation. When the Balance Point between wealth preservation and wealth creation is found for commercial and rental properties, then hedges can be constructed to both safely withstand even severe bouts of economic turmoil, while still maintaining the ability to deliver cash flow that grows at a faster rate than the rate of inflation.

Another potentially attractive option is to borrow domestically in dollars, and invest the money in selected overseas properties, giving what amounts to triple protection against inflation. For individuals of sufficient means, there is no need to select any one approach. A diversified approach with a portfolio allocated among multiple contrarian assets, while simultaneously shorting the dollar on a long term and tax-advantaged basis, using fixed-rate debts contained behind legal firewalls (call it having Beauty sign a pre-nup), can offer the lowest risk way to opportunistically turn dollar turmoil into increased real net worth.

Living Happily Ever After

Inflation is not a destruction of wealth, but a redistribution of real wealth, and whether you prosper with inflation or it is your wealth that is being redistributed – can be a matter of approach and attitude. If you approach your net worth using the low inflation paradigm of the 1990s and early 2000s, then after-inflation returns become a minor footnote to your decisions, that you sometimes calculate after the real decision making is done. Works great during times of low inflation, but if you take this approach in preparing for inflationary times – you better be pulling in some very high returns, or you’ll be losing net worth while paying taxes for the privilege.

Another perspective is that of accepting that the value of money is variable and not fixed, as your starting point for investment decisions. This mindset prepares you to sidestep investment traps, and to instead identify and exploit the accompanying opportunities.

With the first approach, we say the dollar is overpriced, and your best protection strategy is to use up your dollars today to pay down your debts with the most expensive dollars possible, so you can be safe from having to repay those debts with cheap dollars later. You then hunker down and try to hold onto your remaining symbols (dollars) with both hands to ride out the storm. This a is fairly conventional approach to preparing for turmoil, and at its (unspoken) core, this strategy assumes that the dollar’ nature is to be a fixed reservoir of value, and that inflation is a episodic threat to this natural order.

Our alternative approach is to say that the dollar is overpriced, and current low long-term fixed interest rates don’t reflect current risks to the dollar. Therefore, you borrow valuable dollars, use them to acquire real assets, let the storm blow, pay off your debts with dollars that are worth quarters, dimes or pennies – and keep the real assets. This strategy is based on a mindset which accepts that the value of a dollar is variable, it has been variable every year of our lives, the fixed value of a dollar is and always has been illusory, and there are powerful reasons to believe that the value of the dollar will be the most variable it has been in our lifetimes over the coming years.

The choice is yours, but do be sure and make the choice, and then take action. For without a wall to withstand the ravaging Beast, or a plan to enjoy Beauty’s charms when paired with a Golden or propertied Prince – then should substantial inflation return, all you will do is lose the value of your dollars. Also keep in mind that Beauty is notoriously fickle, and much of her current historically attractive charms could diminish by next month, next quarter, or next year – if you don’t lock in before then.

As we are currently seeing with the subprime debacle, debt can be ruinous – but this doesn’t make all debt “bad”. Debt can be prudent and lucrative, or foolhardy and reckless – the difference is in the specifics. Kind of like some stocks can make you a millionaire, others will financially destroy you, it’s all in the specifics – except the differences between good and bad debt are more objective and understandable. At a minimum, individuals should carefully research the issues through their personal reading, and for many people, the services of a financial professional with expertise in such matters is highly recommended.

“Commercial Property Balance Point: Achieve Deep Protection From Economic Turmoil While Turning Inflation Into Wealth” is a free 46 page report about a powerful new optimization technique for using debt within a balanced contrarian wealth preservation and creation strategy, and is available for download at the website linked below. Using simple examples which are illustrated by numerous graphs, the report shows how to successfully weather turbulent markets, credit crunches, soaring interest rates and a plunging dollar, even while simultaneously turning inflation into personal wealth and increased safety. While focusing on real estate, some of the same principles can be applied to other asset classes as well. You can also sign up for a free mini-course on how to use inflation to redistribute wealth for your personal benefit.

Daniel R. Amerman is a futurist and financial consultant with a unique approach to helping individuals and organizations prepare for and profit from an upcoming time of generational change and likely financial turmoil. He is a Chartered Financial Analyst and former investment banker, with MBA and BSBA degrees in finance and over 20 years of financial experience.

Contact Information:

Dan Amerman

Website: http://mortgagesecretpower.com/

E-mail: mail@the-great-retirement-experiment.com

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