Inflation rate and other things your stock broker won’t talk about

It was all over the radio today (5/3/13) “stock market hit a new high because of a better than expected jobs report”. That is talking head BS. The market goes up when there are more buyers than sellers and NO ONE knows what is driving the buy decision. The vast majority of the market is professionally traded by institutional investors and banks who are not trading based on jobs reports. If the market is at an all time high, why aren’t you selling?  There is going to be a lot of profit taking in the very near future which means more sellers than buyers. If you have a buy and hold approach to stocks you are going to get creamed!!! That is an antiquated investment idea that your mutual fund sales person wants you to believe in so they can afford new shoes for their kids.

Here’s the short answer on my philosophy: ownership of publicly traded stocks should be for the wealthy and for sophisticated traders who have the time, team, risk tolerance, and intellectual resources to go from cash to asset and back to cash as the market indicates. The financial services industry through an obscene amount of marketing and the passing of ERISA laws have conned middle class Americans into believing that the stock market is an appropriate place for their money. The addition of mutual funds seems like a good way to make a risky investment for the wealthy sanitized for consumption by average Americans except for this hugely important point…. the value of mutual funds is not based on the performance of the underlying stocks owned by the mutual fund; the value of the mutual fund is based on what other investors and traders are willing to pay for shares of the mutual fund. Therefore mutual fund pricing works basically the same as a stock and thus is no safer or more appropriate for an unsophisticated investor than direct ownership of stocks. 

I’m not saying that you can’t make money buying stocks. I’m saying that a buy and hold strategy ABSOLUTELY WILL NOT WORK because their has been a fundamental shift in our economy and here it is… America *and other nations* are purchasing their own sovereign debt and thereby controlling the price of their bond market. Treasury rates are at an all time low (see chart below) because of artificial interference in the bond market (*due to bonds being purchased by the same governments that issue them).

Ultra conservative investors who should be in dividend paying assets like bonds cannot buy bonds because the bond yield is a fraction of the Fed’s target inflation rate thus bond purchasers are accepting a guaranteed loss of purchasing power.  Bond investors are being forced into at risk equities (stocks) in an attempt to create yield and preserve purchasing power.  Today’s 10 year US Treasury rate is 1.62% while the Fed is targeting a 2% inflation rate *source Wikipedia and the meeting minutes of the January 2012 US Federal Open Market Committee (aka the Federal Reserve).   To put this into as simple language as possible…  if you buy a $100 US Treasury and hold it ten years until maturity you will have LOST $4.70 of purchasing power. 

Inflation rate and things your stock broker won't talk about

Here is where anyone can predict the future for what happens next.

Bond rates will either go up or stay the same (they can’t go much lower than they are now).  If bond rates stay where they are, more and more low risk money that should be in the bond market will move to the stock market which will further drive up prices. As money leaves the bond market to chase yields in the stock market, governments will have to buy even more of their sovereign debt which ultimately results in a higher inflation rate.

(Side Note: governments buy their own debt using newly created money.  Inflation is a reflection of money supply times velocity.  Velocity is the rate at which money changes hands in the economy.   New money results in inflation unless velocity goes down.  We haven’t seen a high inflation rate recently because velocity is at an all time low at the same time money creation is at an all time high.) 

As the inflation rate increases from increased money supply or increased velocity, the effective nominal gains experienced in the stock market will get wiped out through inflation and taxes on paper profits. 

(Another side note using the above chart as an analogy:  If you buy a stock for $100 and ten years later sell it for $121.90 and the price of a widget inflated at exactly the same rate from $100 to $121.90, have you preserved your purchasing power?  NO!!!  Because you will owe taxes on the $21.90 profit before you can buy your widget.  $21.90 profit less 25% tax = $16.43   Thus your $100 purchasing power is still eroded even if you can invest the same as the inflation rate.  One obvious solution is investing in inflation friendly assets like real estate.)

If *or when* bond rates go up, existing bond holders will experience losses on the face value of their bonds (bond prices move inversely with bond rates). As bond rates trend up, the discount purchase rate on bonds will increase to compensate for the perceived rising interest rate risk (bond holders become losers again).  Let me say that again in English…. if you want to sell your US Treasury Bond before the maturity date, you’ll have to sell it for LESS than what you paid for it if the prevailing bond rate goes up (which it probably will).  An investor will pay less for a bond paying 1.6% interest than they will pay for a bond paying 2% interest.  If you buy a $100 bond today with a note rate of 1.6% and tomorrow the prevailing note rate is 2%, you’d have to sell your $100 bond for less than $100 to attract a buyer.

When bond yields become attractive enough for low risk investors (aka when you can buy US Treasuries that pay a rate of interest higher than the targeted inflation rate), there will be a massive transfer of wealth from the stock market to the bond market.  Remember, there is an incomprehensible amount of money currently in the stock market that doesn’t want to be there.   I’m not talking about mom & pop investors…. I’m talking about banks, pension funds, and huge family trusts. When higher rates in the bond market begin to draw money away from the stock markets there will be some massive price turbulence in the stock market (mutual funds included).  NO ONE  knows whether the stock market will be higher or lower in 20 years than it is today. What I can guarantee is that  (1) we will have more price volatility than we’ve ever seen (2) smart traders will make a fortune because they love volatility (remember a trader gets into and out of positions, an investor holds for passive income – CLICK HERE for my article on the difference between being an investor and a trader), (3)  investors who are following a buy and hold, dollar cost average, diversification strategy are going to have no control over the value of their portfolio and they will be taking HUGE risks without the correlating potential for upside.

Stock investing rules have changed.

If you want to summarize the problem in a nutshell… the average American doesn’t know the rules of stock investing have forever changed, yet they feel safe owning stocks and mutual funds because their television tells them “It is safe to buy mutual funds because everyone else does it.” Mutual fund sales people are taught to sell products to middle class Americans who are not traders and they don’t have the skill or ability to actively and intelligently move from cash to asset to cash.  Few mutual fund sales people and even fewer of their customers understand basic economics and how a targeted annual inflation rate of 2-3% combined with sovereign debt purchasing driving bond yields to zero has removed “risk free yield” from the investing equation which has been the historical basis for all investment decisions to date.  A target inflation rate combined with sovereign debt purchases have fundamentally changed the rules of the investing game and your mutual fund salesperson either doesn’t know or doesn’t care to tell you.  

The solution:  Buy income producing assets like positive cashflow real estate.   Start or invest in closely held companies that generate cashflow and whose value is based on real things like the physical assets they own and the profits they create.

david campbell blog photoIf you’d like to schedule a no cost investment strategy consultation with Professional Investor David Campbell to see how you can increase your investment yields while lowering your investment risk, CLICK HERE.

 

 

 

 

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