Posts Tagged ‘hedge’

Can stocks hedge you from price inflation?

Tuesday, September 15th, 2009

Continuing from our previous article, should we buy stocks as a hedge against price inflation? The answer to this question is not so straightforward.

In normal circumstances, some stocks are a good hedge against the garden-variety types of price inflation (or even beat inflation spectacularly) because their earnings power can increase faster than the general rise in prices. But in times of hyperinflation, when the real economy deteriorates, it will be increasingly difficult to find such a business.

First, let’s take a look at the past from this research report,

The 1970s were a period of accelerating inflation and poor equity returns in the US. By December 1980, the federal funds rate stood at 20%, and the ten-year Treasury peaked at 15.3% in September 1981. From December 31, 1968 to December 31, 1981, the S&P 500 returned 1.28 % per annum in nominal terms and -6% in real returns. Put another way, a dollar invested in the US stock market at the end of 1968 twelve years later was worth roughly 45 cents in real terms.


In the US, there is substantial empirical evidence that high inflation is associated with a high equity risk premium and declining stock prices. Bodie (1976) found from 1953-1972 that common stocks were poor hedges against inflation. Cohn and Lessard (1980) also found that stock prices in many industrial countries are negatively related to nominal interest rates and inflation.

It is important to make the distinction between properly anticipated inflation, and unanticipated inflation. If inflation is correctly anticipated and if companies can in fact pass on costs of doing business, then nominal cash flows should be unaffected by a general increase in prices. However, as inflation rises, it tends to become more uncertain and a component of price increases may not be properly anticipated by firms. Blanchard (1993) found that ?an unexpected increase in inflation in year 0 leads to a sharp decrease in stock prices in that year.?

There are a couple of ways to see why price inflation and stock prices are negatively correlated:

  1. In times of high inflation, interest rates are high. Therefore, bonds may prove better value than stocks relatively.
  2. Investors demand higher returns from stocks to compensate against higher price inflation. The lower the price paid for stocks, the higher yield returned by the stocks and thus, the higher the returns on investments.

On the other hand, we have examples in history where hyperinflation do wonders for stock prices. For example, in 2007, Zimbabwe had the world’s best performing stock market- stocks actually rose faster than price inflation:

Zimbabwe Industrial Index up till 2007

Zimbabwe Industrial Index up till 2007

Despite these two seeming contradictory real-life examples, one thing is clear: everything else being equal, unexpected rise in price inflation will lead to compressed valuation of stocks due to a rise in discount rates used to value stocks. In other words, PE ratio can decrease (in the context of rising earnings) even though stock prices can still rise in nominal terms. In the case of the US stock market in the 1970s, this led to negative returns in real terms. But in Zimbabwe’s case, stocks actually had good positive returns in real terms. But make no mistake: as we quoted Marc Faber in our previous article, such positive returns are the result of rising speculative bubbles in the stock market abetted by the printing of money.

If you believe that the (1) US are going the path of Zimbabwe-style money printing and (2) the stock market hit record high due to speculation, does it mean that you should rush to buy any stocks as a hedge?

Here, you have to be careful. The dizzy heights of stock prices in the Zimbabwean stock market have a survivorship bias. With real GDP deteriorating and sky-rocketing unemployment in that country, we are sure many Zimbabwean public companies are dropping dead like flies. That means, there will be many stocks whose prices went to zero. If you happen to hold one of them, you will suffer loss in nominal terms in a hyper-inflationary environment.

Also, stellar stock market performance that are induced by money printing are, at the end of the day, bubbles. Bubbles can easily burst.

Thus, if you are considering holding stocks as a price inflation hedge, you will have to choose the stocks very carefully. The wrong choice will lead to (1) losses in real terms at the very least or (2) a possible wipe-out in the context of a highly dysfunctional economy.

Entrenched perception on the value of paper money

Monday, December 11th, 2006

Not long ago, we advised someone to buy gold as a hedge against inflation. That person?s reaction was, ?But gold prices had already doubled from a few years ago!?

As we think about that person?s reaction, we realised that people?s perception on the value of gold had changed immensely over the course of centuries. Two hundred years ago, people would rather trust gold much more than paper money. After all, paper money were just warehouse receipts for gold, which may well be forged or quantitatively inflated (this is, strictly speaking, fraud). Gold, on the other hand, had been selected by the free market over the course of centuries as the most reliable medium of money. It was considered far more reliable than paper because there was (and is) no way for anyone to easily inflate the supply of it at will (other than mining for it, which require significant time and effort).

Today, people?s entrenched perceptions are completely different. Somehow, by some strange reason, paper currency (with today?s technology, they can exist in the form of digital information) is mistakenly seen to be the more reliable store of value. It has come to the point that even the value of gold is measured in terms of paper currency. As we said before in How is inflation sabotaging our ability to measure the value of things?, how can we measure the value of something by using a yardstick that is as elastic as paper currency?

Now, since the gold prices had doubled from a few years ago, will it be subjected to the law of gravity and return to where it was? There is nothing to prevent gold from obeying (or disobeying) this ?law? but fundamentally, if this ever happen, the market will be behaving even more irrationally that it is right now. Think about it: if the quantity of paper currency (including credit, money substitutes, deposits, etc) is growing at a rate that far outstrips the rate of increase in the quantity of gold by a colossal margin, then the fundamental value of paper money relative to gold has to continue to fall significantly. Today, gold prices still far undervalue the fundamental worth of gold.

If we consider the way central banks around the world are grossly inflating the supply of paper currencies, we cannot help but feel that it is more risky to hold cash in the long run.

The ABCs of hedging

Wednesday, December 6th, 2006

One of the claptraps that we get to see nowadays is ?Hedge Funds.? According to the Encarta dictionary, the word ?hedge? is defined as: ?a means of protection against something, especially a means of guarding against financial loss.? A ?hedge fund? was originally meant for managed funds that employ hedging to protect against any market downturn and perhaps even profiting from it. Today, there are many funds that call themselves ?hedge funds? even though in reality, they do not hedge at all. Those fund managers are more akin to gamblers betting on anything that they can get their hands on, often using huge amount of borrowed money and derivatives to magnify their punts. In addition, unlike the conventional gamblers in the casino, those gamblers are usually absolved from personal losses if they lose their bets. Instead, it is often those poor investors who entrusted their money to those scoundrels who have to pay the price. Worse still, if those gamblers won their bet, they will often be the first to carve out a slice of their winnings. Thus, if you should decide to entrust your wealth to a hedge fund, please make sure the fund manager is not a gambler in disguise and that the fund does indeed hedge. There are too many quacks, swindlers and cheats in the financial industry waiting to devour your money.

Now, as a private investor, how do you hedge your portfolio? In other words, how do you reduce the risk of potentially significant losses in your portfolio?

The most well-known and basic technique is diversification, which is spreading out your investments across different stocks, industry, asset classes and so on. Unfortunately, this technique has major limitations. Firstly, though diversification reduces your risk, it also reduces your chances of making big gains. It is possible to over-diversify, which will result in mediocre returns over the long term. Secondly, diversification will not protect you against major economic catastrophe when deflationary forces wipe out the value of almost every class of investment. Thus, for investors after atypical excellence, diversification is not the most favoured method of hedging because they would rather reduce risks by increasing and improving their skills, knowledge and understanding then by scattering their eggs over many baskets. The best investors would rather concentrate their investments on the ones that they understand intimately than to spread out their investments to make up for lack of understanding. In other words, diversification is a very blunt tool for hedging.

What is the more precise strategy for hedging? For long-term value investors, there is this ?war-gaming? approach. Military planners often go through war games where they work out the outcome of all the possible scenarios and develop strategies to specifically counter each of the unfavourable outcomes. The same can be applied to investing. This risk management approach will determine how you structure your portfolio. Given each of the economic what-if scenarios, what are your plans to ensure that your portfolio will survive and perhaps even thrive? For example, what are your plans for your investments if oil prices sky rocket? What happens if the US dollar collapses? What if the global economic imbalances unwind disorderly? For you to be able to evaluate the ?war-gaming? scenarios, you would need to understand both global and local economic conditions. That is why in this publication, we often delve into economics, which some novice investors mistakenly believe is irrelevant and is the ?job? of the government.

Then there are the more tactical approaches for hedging, which is more relevant for short-term traders but nonetheless can be adapted for long-term investors as well. The most basic of these is the stop-loss. It is a tool mainly used by trader to pre-define the price which they will exit their position regardless of what their emotions tell them in the heat of the battle. Stop-loss does not prevent you from making a loss?they let you pre-define your potential loss before you enter the trade. For those more advanced traders, there are more powerful tools for hedging using derivatives. For example, delta-neutral option strategies allow you to potentially profit from all kinds of short-term market situations and limit your losses to pre-defined levels should you turn out to be wrong.

There are a lot more to hedging and risk management than we can say in this article. We hope this will be a good starting point for you.