Economist Robert Higgs comments in the following piece about the prospect of inflation in 2009 and beyond:

The Fed versus the Banks: Who Will Blink First?

I have never been inclined toward touting doomsday financial scenarios. I raise the possibility now only because, as I consider the situation portrayed in the graph of excess reserves linked above, I am unable to foresee how the Fed and the Treasury can navigate through these treacherous waters – waters that their own previous actions have whipped to a foam – without creating terrible financial and economic harm. If the dollar survives the ministrations of Bernanke, Paulson, Bush, and the Obama gang, its survival will be something of a miracle.

Earlier in 2008 inflation fears were the bogeyman. Oil was at $150 a barrel (it’s now $40). Gold hit $1000 an ounce (it’s now in the $800′s). And the Dollar was at record lows against the Euro and other world currencies (it recovered greatly). The markets were sure that inflation was coming on strong. 

Ahhh, but Fall 2008 came and so did the popping of the Real Estate bubble. This caused a massive destruction of paper wealth that rippled through the financial markets taking out many large banks. By December, Long Term bonds (a powerful deflation shield) swapped places with gold, commodities and other inflation hedges for being the winning asset of the year. The US Dollar shot up in value at a rate never seen against the Euro. Deflation was on everyone’s mind and Long Term bonds proved their mettle as they powered ahead with 30-40% gains. This boost erased almost all market losses in the Permanent Portfolio strategy during the October/November stock crash.

Who would have thought that we’d start 2008 with the prospect of inflation only to end the year with our illustrious central bankers scrambling to prevent an all out deflation? The markets are like that though. Moody. Random. Unpredictable. 

But what should we do now?

Stick to the plan.

If you follow the Permanent Portfolio strategy you’ve probably done OK so far considering how bad the markets are. Perhaps you’re down only a couple percent compared to the 40% loss in the general markets. You dodged a bullet and may be feeling pretty good, but don’t get complacent!

During this time as stocks swooned your Long Term bonds have soared. You are probably finding that your bond allocation is now at or above your rebalancing bands in the portfolio. They could likely be 30, 35 or even 40% of your allocation. Yet, your stocks may have fallen by 40% and could be only 15% or so of your portfolio.

That’s not good. It’s now time to rebalance. 

If you are overweight on your bonds in the portfolio (e.g. they exceed 30-35% of your holdings), you should consider selling them down to 25% and using the proceeds to bulk up the other parts of your portfolio that are below the 25% allocation band (such as your stocks, cash and gold).

For those thinking their bonds have done great and don’t intend to rebalance, all I can say is be careful. It’s tough to sell a winning asset, but at any time your bond gains could be eroded as interest rates whipsaw upwards. If economist Higgs is right, the inflation we see could be quite bad. Instead of 30-40% profits in your bonds, you could be staring at 30-40% losses or worse. 

By not rebalancing, you may miss out on large gains in your other assets by having too much of your money tied up in your current winners. Imagine missing out on a 20%, 30% or higher gain next year in stocks if the markets recover and things work out. 

YES, I know that sounds impossible right now. But it’s happened before and YES it usually does it after a bad market crash.

Gains like I just mentioned happened after the early 1970′s recession (1975 +37%, 1976 +24%), after the recession in the early 1980′s (1982 +21%, 1983 +22%), after the early 1990′s recession (1991 +31%), after the early 2000′s Internet bust (2003 +29%) and they even happened during the 1930′s Great Depression (1933 +54%, 1935 +47%, 1936 +34%, 1938 +31%).

Virtually nobody during these years was predicting a big bull market would happen right in the middle of those bad economies. Yet, they did. If you find your stocks are up +40% next year that’s great. You’ll be selling off those profits to buy your new losers. That’s the essence of rebalancing. Same for any gains in your gold or even more gains in your bonds. If the markets turn against this year’s winner at least you’ll know you took those profits off the table and put them somewhere more productive before they had a chance to vanish. 

This is not a prediction (I don’t do predictions). Just a reminder that the markets do crazy and unpredictable things so you need to own all of the Permanent Portfolio assets and not try to guess what may happen. Be unemotional about rebalancing out of winners to buy your losers. 

One final note is that taxable investors may want to take the time to do a tax loss harvest on stock funds that are underwater before the end of the year. You can use these losses to offset their taxable gains going forward. If you don’t have any losses to take, it may make sense to wait until 2009 to take the Long Term bond gains to defer the taxes until next year. Talk to your accountant to see what option makes sense. Investors in tax-deferred retirement plans don’t need to worry about this. 

Terry Coxon, co-creator of the Permanent Portfolio, discusses the possibility of high inflation as the US economy stagnates. Is it possible? Sure. The Fed is biased towards creating inflation because that’s what they were designed to do. Their worst fear is deflation because their tools are so limited. In my opinion, they will continue to try to inflate the dollar to force people to spend money. They’ll worry about the inflation it causes later.

Will it work? Hard to say. It didn’t work in Japan for the past 20 years and may not work here. Economics is just as much about psychology as anything else. If people don’t want to spend money and take on new debt it’s hard to force them to.

People often wonder why the Permanent Portfolio holds a 25% gold allocation at all times. After all, isn’t gold a zero real return asset? Well, this is the reason. If bad inflation comes the other components of the portfolio will do poorly, but the gold will react so strongly that it’s likely all the other losses will be overcome. But what about a deflationary situation and these predictions of inflation are wrong? Well, the portfolio holds 25% in Long Term Treasury bonds which will do very well under that scenario.

An article in Forbes magazine tries to make the case for devaluing the dollar by 40% to help out the economy:

Why not attack the situation in a manner that will benefit most everyone, an approach that has been successful before and, when compared to the current course, has little downside? Here it is. Stand back. World currencies should be devalued overnight.

The Forbes article is riddled with errors about inflation and the gold standard that I won’t address in this post. The short of it is that devaluing the dollar by 40% won’t do anything at all except force the prices of everything else in the market up by 40% overnight as businesses move to protect themselves. It would also drive interest rates on loans through the roof, put many companies into bankruptcy, wipe out huge portions of savings of the average American and make a bad economy much, much worse. 

So what if? After all, this is Forbes Magazine discussing the idea so someone thinks it’s good. How would you want to position your finances if the threat of a massive inflation to solve our problems came to pass? 

For severe inflation you want to be in gold, commodities, and other tangible assets. Real estate may also be another option, but is not a very liquid investment which causes its own problems. 

You want to be out of long and intermediate term bonds and cash which will rapidly lose value. In the long-run stocks should beat inflation. However, in the short-run stocks will do poorly during high inflation as businesses have a hard time adjusting to rapidly increasing prices. Short term government bonds and money market funds may tread water OK but won’t be profitable. Treasury Inflation Protected Securities (TIPS) may also tread water again without much profit. Then again, risks could show up in this situation that would even effect these bond holders dramatically. 

The true worst-case inflation scenarios includes things like price, wage, capital and exchange controls which always are tried when governments are scrambling to prop up their currencies. These actions are all tremendously bad news for an economy. If you ever hear high-ranking politicians openly talking about doing such things you should be prepared to move quickly to protect your money by shifting it into tangible goods, hard assets, or moving it into another currency (preferably in a foreign bank) if possible. Even this is not foolproof as governments would likely put up blockades to trap as many people as possible before a serious devaluation would occur. 

But this is all worst-case scenario. Does it happen in real life? 

Well, in Argentina before they devalued the peso in 2001 they implemented capital and exchange controls. These controls forced citizens to repatriate foreign funds, froze all bank accounts, limited how much money could be removed at any one time, and converted all domestically held accounts in Euros and Dollars into the Peso before they did the devaluation. The Argentinean peso lost about 80% of its value shortly thereafter, decimating the life savings of their citizens. Nice huh? 

Just because the US Dollar is the reserve currency doesn’t rule out the use of high inflation to try to solve economic problems either. The question is, can it happen here? Well, it almost did. The decade of the 1970′s wasn’t bad just because of Disco. It also saw double digit inflation with the prime rate over 20% by 1980. It also saw price and wage controls, shortages of oil and other staples due to these controls, and a destruction in the standard of living for working and retired Americans on fixed income as the value of the dollar sank by 50%. So this type of scenario has happened even in the US and was only averted after a very painful recession that capped off 15 years of flat stock market returns. The next time it occurs we may not be so lucky.

This is all an extreme situation, but it’s always a good idea to consider how to deal with problems you think are unlikely right now. For this reason, I think all investment portfolios should hold some percentage of their allocation in hard assets as insurance in case a bad inflationary situation unfolds. More on that in the future.