Playing the Inflation Game

Is inflation a threat?  Find the answer by looking at the historical performance of commodity prices, the US dollar, gold, and economic conditions.

On New Year’s eve 2004, the US Dollar Index hit a nine-year low of 80.53, a level of dollar weakness that had been seen only twice before in the past 30 years. Two months later, the Commodity Research Bureau Index (CRB) hit new multiyear highs and continued to move up from there. The basket of commodities and the dollar had been at simultaneous, opposite extremes only once before in recent memory and that was in November 1980.

While the US Dollar Index recovered going into 2005, commodity prices continued to rise. The CRB Index (recently renamed the Continuous Commodity Index) hit 336.56 on September 1, just short of the all-time high of 337.60 hit on November 20, 1980. In September 2005, gold was hovering around a 17-year high. (See Figure 1.) 

During both periods, gold and oil prices were also at or near either all-time or multiyear highs. But there was one pivotal difference: the federal funds rate was 3.75% this time around, while the last time the dollar and commodity prices were at opposite ends of the scale (in 1980), it was approaching 20%.

Given the number of similarities between the late 1970s and recent times, can understanding what happened to the markets after 1980 help us anticipate what to expect today?  And if so, what impact will dramatically lower interest rates today have on commodities and gold prices going forward?  In the current volatile markets, what is the best way to play the inflation game?

HEADING BACK TO THE FUTURE
The stock market hit an 11-year low in 1974, paving the way for strong economic growth and a bull market.  As interest rates fell, the new bull began. As it turned out, 1975 was a good year, but it would also be the last year the US experienced a positive trade balance, with a $12.4 billion surplus. Appropriately, singer Vicki Sue Robinson’s release "Turn the Beat Around," became a hit in 1976, later becoming a signature anthem as the disco era was born.

In 1976 Democrat Jimmy Carter took over the Oval Office from the Republicans and -based on the historic record- fighting inflation was obviously not a priority. As Carter’s term neared its close in January 1980, the price of gold peaked at $875 in New York after rising rapidly in the preceding year. In July 1980, the dollar hit a new low. By November’s Election Day, commodity prices hit a new all-time high; so did interest rates as the Federal Reserve fought in vain to keep a lid on inflation. But then in a classic example of overkill, the fed funds rate hit 19% in July. Overall, 1980 saw the prime lending rate rise above 21%.

Skyrocketing demand compounded by the weak dollar pushed oil over $40/bbl (inflation-adjusted equivalent of $90 today). The economy was firmly caught between crushing interest rates and the strangling energy costs. By the time Ronald Reagan was inaugurated in 1981, the economy was on its knees and heading for recession. The Dow Jones Industrial Average (DJIA) peaked in April 1981 at 1030.

The resulting economic impact had a global effect. In early 1982 Mexico devalued the peso by 30% to fight the economic slide.  Shortly thereafter, Mexico’s oil market collapsed and banks were nationalized, following one of the most powerful economic meltdowns in that nation’s in history. 

By July 1982, the DJIA had dropped 22%. By November, bubbling real estate prices in a number of areas of the US and Canada plummeted by as much as 50% as homeowners already struggling to pay payments on 18%- plus mortgages also lost their jobs.  The effects were even more devastating in Mexico; mortgage rates compounded by runaway inflation climbed to near-triple digits at their peak.

By early 1983, the US prime rate had declined back to 10.5%, gold prices eased to around $350 by year-end, and oil was back below $30/bbl. The economic meltdown was over and the excesses of extreme high commodity and asset prices- as well as record levels of private debt- had been purged from the system. As it was, 1983 marked the first year of the longest bull market in history… one that would last 17 years (See figure 2.).  

DIFFERENT INFLATION MUSIC, SAME INFLATION TUNE
Fast-forward to the new millennium.  Disco has been replaced by hip-hop, but is the inflation picture all that different? While no two periods in history are ever identical, the investor or analysts cannot afford to ignore the past.  History repeats itself, and the key is in knowing what to look for.

The US economy is still the envy of the world, which means foreign income will continue to flood the US stock markets. It also means that in a rising interest rate environment, foreigners will continue to buy other US dollar-denominated assets like bonds and mortgages, since the dollar will do well as long as rates (and yields) rise. This adds inflationary pressure. It also creates an unusual situation in which the dollar and gold can rise together. (See Figure 3.)

What is the real rate of inflation in America? The Federal Reserve would have us believe that the Consumer Price Index (CPI) is a good indicator. The CPI does not include food or fuel prices, two of the largest expenses to consumers. However, the core CPI does not really include housing prices or food or fuel prices, two of the largest expenses to consumers.  Even though they aren’t listed on the CPI, all these things cost more than five years ago- in excess of 100% more in the case of fuel and homes in certain housing markets.

Even though commodity prices are very near where they in 1980, in lieu of an unexpected economic meltdown, there is room for prices to move significantly higher, especially considering that real interest rates (fed funds rate minus the real rate of inflation) sit at less than 1% when energy and food are included.

With a new Fed Chairman on deck who has publicly declared that deflation can’t occur while governments have printing presses, the tacit political motivation for inflation is clear:  it’s a way of paying off government debt with cheaper future dollars.  Inflation is also a superstitious way of raising taxes without having to go through Congress or alerting those who must pay them.  As inflation drives the value of goods and incomes higher, tax revenues rise.  Is it any wonder that the amount of goods and services purchased for $1 in 1914 (one year after the formation of the Federal Reserve and two years before income taxation began in the United States) now costs $20 (see Figure 4)? 

Few would argue that deflation is desirable, but are statistics such as those provided by the CPI giving us the true inflation story?  Real assets such as commodities, homes, and other goods that have intrinsic value and are not easily reproduced have jumped in price far more than core inflation figures would indicate- and are likely to continue doing so, given the access to cheap money.

Can gold return to the halcyon days of late 1979 and early 1980, when it hit $800 an ounce? Only time will tell, but it certainly has more room to run, given the current environment.  As Darrell Jobman, senior market analyst for the TradingEducation.com website commented:      “Those who witnessed gold’s meteoric rise in the late 1970s and early 1980s never believed it could happen then either. No one had ever experienced gold prices anywhere near that range before. Given current commodity prices and historically low interest rates, especially on long end of the [yield] curve, inflation potentially still has a lot of room left to run. At least this time around, it would not be the first time gold prices went ballistic.”

SHOW ME THE MONEY
How does someone make money with this information? Buying gold or a gold exchange traded fund (ETF) are two possible methods, but buying and holding anything in current volatile markets is a risky proposition at best. The buy and hold investor is betting that during the period that he or she owns gold, the dominant trend will be up. If someone owns the precious metal for three years, the trend must remain essentially up for that period. If gold moves up for 18 months and then down for 18 months, the B&H investor makes no money. Trading and setting tight stops in case you are wrong is a better option. Let’s compare the two strategies.

Looking at the chart of gold in Figure 3, the investor who bought gold in early 1983 at $500/oz, is still underwater, while the trader playing the trends lasting anywhere from three months to five years has made a good profit.

Let’s look at a recent trading example. Figure 5 shows a daily chart of gold with buy and sell signals. Between May and December 2005 there are six trades, with the last signal to buy (B3) generated and confirmed on VantagePoint as of November 11, 2005.  The less aggressive trader might instead have used the late October sell signal as a place to take profits while waiting for the next opportunity to buy.

Let’s assume the buy & holder bought gold on June 20 (at the left side of Figure 5, marked with a blue arrow) when it was selling for $445.90. As of October 31, gold closed at $466.90. That is a profit (not including the cost of commission) of $21, assuming the investor sold his position on Halloween. 

Having made the first trade by selling short on June 29 at $444.50 (S1), the trader sold his or her position and went short an equal position. At B1 the short trade was covered at $431.80 and a new long position taken. At S2, the position was sold at $433.00 and a new short position taken. This position was covered on B2 and a new long position purchased at $448.60. This position was sold at S3 at $474.60. Total profit (not including commission), including one sizable loss of $15.60 is $43.80. 

Figure 5 uses a relatively basic system of technical indicators (with the exception of the intermarket predictive moving average and neural network indicator) and shows that by using a system of oscillators, moving averages, and careful eyeballing, the trader can make money in volatile markets and capturing profits when the market changes.   The only time a buy & hold strategy beats the trader is in a sustained long term uptrend, which occurs less than 20% of the time.

PLAYING YOUR HISTORY CARD
Looking at the price of commodities, the US dollar, and current economic situation tells us that--compared to the last time these conditions occurred-- inflation is a serious threat. While history may never repeat itself identically, similar conditions generally have similar outcomes. However, interest rates are very different this time around, suggesting that the inflation train is just beginning to get going in earnest.

There are a number of commodities that will benefit from inflation, and the most likely leader will continue to be gold. Instead of using complex indicators/systems, a trader playing the inflation game need only buy weakness and sell strength when price hits a plateau to lock in profits. Consistency, having a good charting program, and sticking to a proven game plan are the best strategies for success.

Matt Blackman, market analyst for www.TradingEducation.com, is a technical trader, author, reviewer, keynote speaker.  He is a Market Technicians Association (MTA) affiliate, a Canadian Society of Technical Analysts member, and is enrolled in the Chartered Market Technicians (CMT) program.

Reprinted from Working-Money.com.
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