Don't Forget About Inflation

03/08/2013 9:00 am EST

Focus: STRATEGIES

James Stack

President, Stack Financial Management

The bull market still has legs, but it’s not too early to begin thinking about inflation’s effect on your portfolio, writes Jim Stack of InvesTech Research.

In a maturing bull market, it’s important to be vigilant for signs of rising inflation and a tightening monetary policy.

Odds are almost certain that we’re now in the latter half, if not the final third, of the bull's lifespan. So, in watching for potential inflationary pressures to emerge, there are several important tools that can serve as an early warning system.
 
The ISM “Prices Paid” Index signals when manufacturers are paying higher prices for their inputs or supplies. This index is currently sitting about in the middle of the long-term range, and well below the 70 threshold that would indicate high inflationary pressures.

Economic Cycle Research Institute’s (ECRI) Future Inflation Gauge is designed to measure underlying inflationary pressures and predict turning points in the US inflation cycle. It has slowly risen over the past 12 to 18 months to a four-year high. Yet it is still below pre-recession levels, and according to ECRI is not an issue at this time.

Of greater concern is the recent trend in the CRB Spot Commodity Price Index, which measures changes in the pricing of industrial materials at the earliest stages of the supply chain. Commodity prices are showing signs of renewed strength.

While there’s little evidence of inflationary pressures right now, it’s not too early to think about how to add some protection in your portfolio.

Looking back at eight inflationary periods over the past 63 years since 1950, we selected periods when the 12-month rate of change in the CPI increased by more than two percentage points before subsiding. In ranking these industries, we found that a sector pattern emerged.

Energy was by far the best hedge, beating the broader Index in at least 75% of the inflationary periods analyzed. Materials also typically outperformed the broader Index, with gold, metals, mining, and paper products companies offering good protection, although chemical and container manufacturers lagged.

Surprisingly, a number of Industrial groups also proved resilient. Industrial machinery, electrical equipment, and aerospace manufacturers averaged close to 10% annualized growth. Airlines and trucking were generally among the weakest segments. These sectors on the whole appeared to hold up well, or even benefit, during inflationary times.

Conversely, looking at the worst performing sectors...Consumer Discretionary groups were the most susceptible to rising inflation, as buyers cut back on higher-priced items. The Utilities and Telecom stocks also offered little protection, as companies in these capital-intensive sectors are particularly vulnerable to rising borrowing costs.

About 30% of our sector ETF allocation is in the top inflation hedge groups (Energy, Materials, and Industrials), with half of our recent additions in these sectors. Meanwhile, less than 10% of our ETF positions are held in Consumer Discretionary, Utilities, and Telecom funds. Outside our ETF positions, 6% is invested in foreign funds not directly affected by US inflation.

We’re comfortable with this allocation as long as inflationary pressures remain subdued. However, we’ll be watching inflation gauges closely, and will likely shift more out of the vulnerable Consumer Discretionary sector and into the better hedges if such action is warranted.

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