Inflation, interest rates and taxes should all rise significantly in the future and to take advantage of this, you need to:

  1. Put some of your money into high-quality value stocks — or more specifically, fundamentally solid undervalued stocks. Even in the worst times, value stocks minimize your risk. In inflationary times, they can really get a big jolt upwards (at least for a period of time). If they cease to be value stocks after a big run up, sell them. As long as they remain fundamentally sound and undervalued, keep them.
  2. Pay off debt not backed by appreciating assets as soon as you can (use this low-interest environment to pay off as much loan principal as you can. Interest rates won’t stay this low forever and when they rise, it will probably be in a very big way).
  3. Start thinking about how you can minimize your tax burden right now. As taxes increase over time, any savings you make today will be compounded in the future.

Protect your portfolio during good times and bad

I know, I know, I’m hedging a bit by not defining exactly what I mean when I say, “the future.” And the reason is because I don’t know.

But I can take a guess.

And that guess would be anywhere from 2 to 10 years (sorry, I can’t narrow that range any further for you). As a consequence of this, stocks should also rise for a time before doing something else (which, again, I don’t know what that something else is).

Of course the big question you might be asking is, “why?”

To answer, I’ll use the U.S.A. as an example, but for the most part what I’m about to say applies to all the world’s economies – at least the major ones.

The Federal Reserve…

In the U.S., there is an institution called the Federal Reserve (or the “Fed”) which serves as the central banking system. You’ve probably heard quite a bit about the Fed and its current Chairman, Ben Bernanke, recently. Other countries have their own version of the Fed.

As with most central banks, the Fed has the ability to adjust interest rates and the license to print money. It therefore has control of inflation. Unlike many central banks, however, the Fed is not a government entity. It is actually a banking cartel controlled by private interests (but that is a topic for another time).

The Commercial Banks…

The commercial banks are another participant and play an important role in the economy beyond what you might expect. These banks actually create new money every day. Of course there is a limit to how much money they can create and this limit is governed by the reserves they must legally hold (this is known as “Fractional Reserve Banking”).

According to Wikipedia…

“Fractional-reserve banking is the banking practice in which banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand. Fractional reserve banking necessarily occurs when banks lend out any fraction of the funds received from demand deposits. This practice is universal in modern banking.”

The upshot of this is that there is much more money in circulation than actually exists in reality.

How the Economy is Controlled…

When the central bank wants to stimulate the economy, it can do a couple of things: lower interest rates or use quantatative easing.

Generally it will manipulate interest rates. But sometimes, such as in today’s environment, interest rates are so low, they can’t be further lowered. So quantatative easing comes into play.

Again, according to Wikipedia, quantatative easing is described as…

“In practical terms, the central bank purchases financial assets, including treasuries and corporate bonds, from financial institutions (such as banks) using money it has created ex nihilo (out of nothing). This process is called open market operations. The creation of this new money is supposed to seed the increase in the overall money supply through deposit multiplication by encouraging lending by these institutions and reducing the cost of borrowing, thereby stimulating the economy.”

Note the term, “deposit multiplication.” It’s very important and is defined as the inverse of the reserve requirement (i.e. m = 1 / R; where m is the multiplier and R is the reserve ratio).

So if someone deposits $100 into a banking system with a reserve ratio of 10%, then that initial $100 deposit can theoretically be expanded to $1000 (i.e. 1 / 0.10 * $100).

In practice, however, this level is never reached because banks generally keep more reserves than the bare minimum required by law and there is a currency drain component (where people keep some money in cash).

However we don’t have to take these effects into account to understand why we’ll see monster increases in inflation, interest rates and taxes.

The Money Supply…

According to economist Art Laffer, “The percentage increase in the monetary base [for 2008 and 2009] is the largest increase in the past 50 years by a factor of 10. It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless.”

But forget about all the indirect, ten-dollar words Laffer is using.

In plain direct English, the government, through the Fed and commercial banks, has more than doubled the entire money supply in about one year. Think about it. In 2008, there was about half as much money in the system as there is now.

As any beginning economics student will tell you, when there is more money chasing fewer goods and services, prices will rise.

In this case, the money supply has increased dramatically and so prices should rise dramatically, assuming output doesn’t grow to match the expanded monetary base – which at this point in time seems unlikely to happen.

Inflation…

When prices rise, we call that inflation. The thing is, the new money doesn’t immediately affect prices because it takes some time to work its way through the system. How much time? That’s hard to say, but most experts agree it is somewhere between 2 and 10 years – hence my guess earlier.

So significant inflation pressure in the next 2 to 10 years is almost a given (unless something miraculous happens and economic output increases dramatically). That’s the first piece of the puzzle.

Onward.

Today, most governments like to see inflation hovering around 2% annually. We definitely don’t want deflation (which is very bad, but again, best left for another discussion), but we don’t want runaway inflation either (remember our old friend ruler-for-life Mugabe and Zimbabwe?).

Rising Interest Rates…

So in an attempt to control inflation, the Fed will be forced to raise interest rates (however it can’t just jack up rates willy nilly, so inflation will rise, then rates will catch up but inflation will rise some more and so on and so on).

I mean, realistically rates will have to rise regardless of inflation because they are historically way too low.

Therefore, in all probability, interest rates will rise, and significantly so. Timeframe? 2 to 10 years. That’s the second piece of the puzzle.

Rising Taxes…

Third piece: Taxes will rise.

Why?

Because governments simply can’t borrow like there’s no tomorrow, print money out of thin air and have commercial banks multiply it without having to pay the piper somewhere down the road (recall that paper money is actually debt and has been since President Nixon removed it from the gold standard in 1971).

And how does a government in debt up to its eyeballs pay the piper when the bill comes due?

Simple. It taxes its citizens. And the current tax base will not be enough to meet its obligations.

So either there will have to be more citizens paying taxes (not likely because as the baby boomers start to retire, the tax base will actually shrink unless a significant number of taxpaying immigrants arrive very quickly) or taxes will have to increase.

Furthermore, as the dollar declines relative to other currencies (which it will as more people flee from a currency guaranteed by a government with huge debts), more dollars will be needed to service and repay debts denominated in foreign currencies.

Value Stocks Should Do Well…

Add these things together and it should be clear that some stocks will also rise for a time.

That’s because when inflation occurs, stock prices generally go up, at least at first – but at some point prices stop following inflation up as people become scared. When that point occurs is anybody’s guess.

Of course if you’re going to be in the stock market during such an uncertain time, you’d do well to only invest in high quality value stocks that have a built-in margin of safety.

Keep in mind that nothing is 100% certain. However if you logically look at history and some cause and effect scenarios, it should be obvious that what I’ve just described is highly probable — and as such, you would do well to position your portfolio accordingly.

 

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