"Joey Grapes" asks a good question,

and we answer it

A revival of inflation (increases in prices of goods paid by consumers) would certainly be a threat to investors. For many of those who follow the markets regularly and have some sense of economic history, this is a foregone conclusion.  In our opinion, we will have high inflation, but when it will occur is difficult to predict.  That makes preparing for it much tougher, as being early to invest in a big trend can cost you a lot of money. 

But make no mistake about it: when it happens, it will likely be a secular event. That is, the inflation era will be several years in length, it won't just come and go. It took a long time to leverage up the global economy, and we think it will take a long time to reverse that damage. One very likely outcome is rising prices on nearly everything we spend money on.

Recently, I received a great question from a seasoned advisor nicknamed "Joey Grapes" (owing to his enthusiasm for wine) who entrusts some of his clients' money to us. It was a question that should be on all investors' minds, but he asked first so he gets the credit.  We are happy to devote this response to him. The legendary Joey Grapes simply asked how I would position our mutual fund during an inflationary period. Here is what I told him in response:

One thing we try not to do is make generalizations. For instance, we have been "expecting" inflation in the US for some time, but it is certainly not showing up in the numbers. Just as this market cycle (down and up) since late 2007 has been atypical of "traditional" market cycles, we won't be surprised if the first inflation cycle we see in nearly 30 years, when it arrives, does not follow the expected script.

Understand that while consumers fear the impact of inflation on their lifestyles, it is not what investment managers should be concerned with. Instead, we should focus on inflation EXPECTATIONS, since when inflation actually arrives, some of the opportunity to take advantage of it for your investors has already slipped away. Owning funds that short both US Treasuries and High Yield Bonds is one way to pursue this. Gold is another, since it is viewed by many as an alternative to the world's hard currencies. In other words, when the US Dollar, Yen, Euro, and other currencies suffer from inflation in their underlying economies, their currencies are sort of "juiced." That bogs down their potential for profit if it is suspected that such inflation can negatively impact their economy's growth. Gold has historically been a useful alternative.

Other ways to fight the inflation fear-factor is to use TIPS. We have not done so yet, but that is exactly what they are built for. That said, what if we feel the impact of inflation more than the government's CPI statistic implies? This has been the case many times. CPI is a flawed indicator of price pressures, so again, each specific market environment demands a unique strategy.

Another decision we must make is whether stocks will be a good inflation-fighter. At times inflation is good for the stock market, as it increases the nominal value of whatever goods are sold in the economy. That may also help attract asset flow from foreign economies.

Sometimes the threat of inflation is bad news for the stock market. That has a lot to do with world investors' opinion on the overall state of our economy. For instance, despite the rise in our domestic stock market since March, the US Dollar suffered a large decline in 2009. To many, that looked like the rest of the world expressing their disapproval over policy in Washington and the fear of a secular decline in the success of our economy. They may be looking ahead to a period of "stagflation."

If that concern continued, we might consider a wager against the US Dollar as a way to profit from a perception of US weakness whose root cause is the bubbling up of...you guessed it...inflation.

Similarly, inflation is not just a US issue. We attempt to observe the threat of inflation pressures around the world. In particular, there is a strong correlation between international bond rates and inflation.  In other words, global bond investors want to buy bonds in currencies that are strong, and sometimes the presence of moderate inflation (say, 3%-5%) is viewed as a positive. We have not often treaded in global bonds, but that is certainly a possibility in the future. That would be a decision based on a combination of the aforementioned relationships between currencies, as well as inflation expectations around the world. This is where we, as a fund-of-funds manager, defer to the expertise of the underlying mutual fund managers we know and select. That includes those who invest in medium-to-long-term bonds around the world, as well as funds that invest in short-term bonds across the globe (the equivalent of what the US Government issues as T-Bills) to access the currency's appreciation as well as the income from short-term rates in those countries.

All of these are ways to potentially react to investment concerns either due to, or derived from, inflation expectations. Importantly, as with any move we make in any portfolio, we view positions taken to exploit or hedge inflation as a risk-reward assessment within the overall portfolio, not a decision made in isolation.

To summarize: Inflation, like so many other issues to investors, is more of a hurdle than a problem. We can afford to view it that way because of the flexible strategies we manage, and our ability to adapt to major changes in market conditions.  We believe that having a flexible investment toolbox, which includes the ability to use the short side of the market and employ alternative styles, is a key ingredient to battle through tough economic environments.  Our goal is to deliver a durable portfolio that enables investors and financial advisors to weather whatever market conditions we may all encounter, and thus help our dear friends like Joey Grapes sit back, relax and enjoy their fine wine.

 If you have something you'd like us to answer, bring it on!  Email your questions and we'll answer them directly to you or in GreenThought$, whichever you prefer.

Adapted from the forthcoming book "The Flexible Investing Playbook - Asset Allocation for Long-Term Success" by Robert A. Isbitts, to be published by John Wiley & Sons, Inc.