Our Strategy for Beating Inflation

Since March 2020, I have been largely confined indoors due to lockdowns and quarantines. 

Now that my family is vaccinated and restrictions are lifting, we felt safe venturing outside for the first time in over a year. 

So last weekend, I took my partner and daughter to visit friends in the historic city of Gettysburg, Pennsylvania. 

Gettysburg is the site of one of the most violent, chaotic battles that occurred during the American Civil War, in 1863. 

So many people died in the fields around the city that the battlefield was converted into a cemetery, so the bodies could be buried where they lie. 

Visiting that city, I was struck by something amazing.

I have to tell you…

While I was there amidst the battlefields and graves…

I could see America coming back to life. 

Many storefronts and offices had gone out of business during the lockdown. Almost every single one of them had workers prepping to reopen. 

Almost every shop — from artisanal soap boutiques to the Taco Bell — had a “Help Wanted” sign posted at the entrance. 

And out in the streets musicians played while people walked around — most of them wearing masks — shopping, eating at restaurants, talking and laughing. 

If you’ve been trapped inside by the pandemic for months, like I was, I’m sure you can imagine how shocking it was to be out, around other people, and feel less afraid.

What I experienced in Gettysburg is happening all around America.

The number of vaccinated people has topped 130 million — 39.3% of the popultation. 

Even though it is unlikely the U.S. will ever reach herd immunity, and we will likely always have to deal with new strains and outbreaks of SARS-CoV-2…

People are eagerly getting outside and trying to make the best of the “New Normal” way of life. 

That means folks are spending money in local markets…

And that means companies are starting to see their revenue — which was devastated by the pandemic — start trending up again.

Does that mean the market bubble is over?

Longtime readers know that one of my goals for my readers is for them to buy great stocks, average down costs, and reinvest the dividend income from these stocks to gradually compound your way to wealth. 

With that goal in mind, it might seem like the Grand (Re)opening of America is good news for the stocks in our portfolio. 

Indeed, Of the 457 constituents in the S&P 500 that have reported earnings to date for Q1 2021, 87.1% have reported earnings above analyst expectations. This compares to a long-term average of 65%.

So far, the earnings growth rate for the S&P 500 is 51.9%. If 51.9% is the actual growth rate for the quarter, it will mark the highest year-over-year earnings growth rate reported by the index since Q1 2010 (55.4%).

In recent issues of one of my newsletters, when I have talked about the market being in the bubble, what I have been describing is the gap between the price of assets (the blue line above is the price S&P 500 index) and their fundamentals, such as earnings expectations (the black line in the chart above).

But as you can see in the chart, even though earnings are rapidly recovering…

There is still a huge gap between the price of the market and the underlying earnings of the companies in the market. 

So there is still concern that, even though the U.S. is exiting the pandemic recession, the price of stocks might rapidly decline to “reconnect” with earnings trends. 

And right now, there’s a great deal of fear that high inflation will be the pin that pops the current market bubble. 

How Inflation Can Crush the Investor’s Returns

The Congressional Budget Office expects a multi-trillion-dollar government deficit in 2021. This would be the first instance of consecutive double-digit deficit years since World War II. 

Covid-fuelled quantitative easing has also led the Federal Reserve’s balance sheet to nearly double in size. 

And at the same time, the U.S. money supply has grown at a 26% annualized rate since February 2020, when the Fed began trying to save financial institutions by pumping the market full of liquidity (i.e., money). 

As I wrote to subscribers recently, excessive inflation is bad for an economy because the cost of everything — from milk to gas to lumber — goes up faster than wages increase. People simply can’t afford things, and so businesses lose revenue. 

If this gets extremely bad, it can become a hyperinflationary spiral that can destroy an economy, like Zimbabwe or Venezuela. 

And since U.S. inflation in April went up 4.2%, everyone is concerned about how this will affect stock prices going forward. 

In the last month, I have done hundreds of hours of research into the markets at risk from high valuations and inflation right now. 

One of the best resources I’ve found is a newly published research paper titled “The Best Strategies for Inflationary Times.”

The researchers analyzed “inflation regimes” in the U.S., U.K., and Japan over the past 95 years to answer the question: “What passive and dynamic investments have historically tended to do well (or poorly) in environments of high and rising inflation?”

The chart above, from the research report, shows the percentage increase in the US headline Consumer Price Index (CPI) basket over the trailing 12-month period. The pink shaded areas show inflationary regimes. The red rectangles at the bottom of the chart are periods when the US economy was in recession. The data are monthly, from 1926 to March 2021.

To quote the authors: 

“Neither equities nor bonds perform well in real terms during inflationary regimes… In reality, equities suffer from the less stable economic climate, and costs tend to rise with inflation more than output prices…  Smaller companies perform poorly in inflationary regimes… Larger companies are more suited to reacting to these conditions, given that they are more likely to have the necessary infrastructure to make such adaptations seamlessly.”

Ultimately, the researchers found that the overall market dropped -7% on average during high inflation periods. 

But high quality and value stocks, like those I recommend to subscribers, tended to exit unscathed…

The average returns for a typical “value stock” during inflation was -1%...

And the average returns for a typical “quality stock” during inflation was 3%. 

This tells you something important, and should also put your mind at ease…

The big, dominant companies tend to survive during inflationary periods.

And since investors become fearful at these times, subscribers can use any stock price drops or market volatility as an opportunity. 

Let me show you what I mean.

How to Turn Inflation Fears into Higher Returns

I write often about an index called the VIX, or “Volatility Index.” 

The VIX is essentially a measure of how much fear and uncertainty is in the market. It’s pretty simple: VIX up? Investors and option traders expect trouble in the future. VIX down? Investors expect the market to go higher. 

Many traders use the VIX to speculate—buying as the VIX goes down and selling as the VIX goes up. 

But this is an almost guaranteed way to lose money. 

Take a look at this chart comparing the VIX with the 1 year returns of five of the stocks we’ve traded in our alert: 

Notice how when the VIX (the dark blue line) spikes, the our stocks dip a bit? 

After the VIX calms down, though, our stocks continue trending up. 

Because we follow what’s called a “contrarian strategy,” we like to buy more of our stocks when they go down in price. 

This allows us to average down our costs, increase our effective dividend yield, and accumulate wealth over the long term. 

But here’s the interesting thing…

When the VIX goes up… 

So too do the cash payouts for selling put options on our stocks. 

That means that, when everyone is afraid of inflation and bubbles and it looks like the market is about to crash…

Our options strategy gives you the power to hedge your portfolio against these large macroeconomic forces. 

That’s going to be especially important in the years moving forward, since I anticipate that we will be seeing years of suboptimal or even negative market returns.