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22-May-08

CNBC Bonus Bucks Trivia: What did Goldman Sachs’ Abby Joseph Cohen call a “pretty good hedge against inflation”?

Holding Rationale for GLD.

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What did Goldman Sachs’ Abby Joseph Cohen call a “pretty good hedge against inflation”?

“We think that equities in general tend to be a pretty good hedge against inflation,” she said. “Equities and shares do well in a period of moderate inflation.”

A comparison of our tax returns would no doubt indicate that Abby’s opinion is more highly valued than mine. Nonetheless, I will give mine here.

First, what does she mean by “moderate inflation?” Stocks have tended to do well over time, and inflation has been moderate over time, so I suppose that is all correct. Meaningless, but correct.

Typically, to be considered an inflation hedge, an asset’s returns should be highly correlated with inflation rates. Alternatively, if the asset returns preserve purchasing power over time it can be considered inflation resistant.

Equities do seem to cover the second criteria. According to Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series), “companies’ earnings tend to increase with inflation, whereas payments on conventional bonds are fixed in nominal terms. [However…] corporate income taxes and capital gains tax rates typically are not inflation indexed.” Also, the earnings multiple is inversely related to inflation in the same way that bond prices are (a higher discount rate).

As a result of these conflicting signals, “the very-long run real return on stocks in the United States has been relatively insensitive to realized inflation rates.” (Emphasis added.) Equities are not so much a hedge against inflation as an asset class that does not fare as poorly as some others. Furthermore, they have a negative correlation (ibid p. 526) with unexpected inflation (such as we are seeing today).

Commodities, by contrast, and particularly storable commodities directly related to economic activity, have a positive relation to unexpected inflation. Energy, and to a lesser degree precious metals, are true inflation hedges. Is it then any wonder that such commodities are doing well now, and equities aren’t? Whether this will continue is a function of where inflation goes from here, not a function of equities being a “pretty good hedge against inflation.”

Another asset class that has typically been a good inflation hedge is real estate - and raw land in particular. However, in light of the current economic situation the past may not prove to be a reliable indicator in this case.

Disclosure: At time of publication William Trent is long oil (USO) and gold (GLD) through ETFs.

Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.