INFLATION NATIONWise Investing in a Foolish Age (2010)

1

I. Introduction� The question that inspired the book: I.O.U.S.A. documentary film

and the live panel response.

� The goal of this book: to help save and invest wisely now

� The book has 3 Major Sections:

� Return of the Stagflation Trap� Return of the Stagflation Trap

� A World of Funny Money: The Inflation Time Bomb

� The Inflation Survival Guide

� It may not occur in the short-term, but inflation will come

� Caused by currency debasement rather than economic growth

� The goal: maximize inflation-adjusted investment returns

2

Who Said It?

� “Inflation is always and everywhere a monetary phenomenon.”

(Milton Friedman)

3

The Financial Tug-of-War

� Deflation vs. Inflation

4

II. Return of the Stagflation Trap

� Opposing Economic Philosophies:

5

What is the Stagflation Trap?

� Stagflation: economic stagnation and inflation occur simultaneously

6

Causes of Stagnant Growth

� Diminishing Impact of New Debt Growth:

7

Causes of Stagnant Growth (cont.)

� Demographics – aging population

� Rising Taxes

� Excess Capacity/Productivity Enhancements

� House Mortgage Resets:

8

Stagflation Implications

� Negative real wage growth

� Increased financial stress: especially the middle class & the elderly

� Increase in crime rates

� Financial stress on state and local governments

� Social Unrest

9

Who Said It?

� “By a continuous process of inflation, governments can confiscate,

secretly and unobserved, an important part of the wealth of their

citizens. By this method, they not only confiscate, but they

confiscate arbitrarily; and while the process impoverishes many, it

actually enriches some… The process engages all the hidden forces

of economic law on the side of destruction, and it does it in a of economic law on the side of destruction, and it does it in a

manner that not one man in a million can diagnose.”

(John Maynard Keynes, 1920)

10

III. A World of Funny Money: The

Inflation Time Bomb� Up to this point, I agree with the deflationists. However, I part ways

with them at this point because of the nature of our money.

� What makes money “money”, anyway?

� Recognized medium of exchange

� Unit of account

� A trustworthy store of value� A trustworthy store of value

� Inflation: The Hidden Tax

� Webster’s definition: a rise in the general price level; my

definition: loss of purchasing power of the currency

� Types:

� Cost-push & Demand-pull

� Currency debasement (bad)

11

The $100 Trillion Entitlement Black Hole

� The current trend of government spending is clearly unsustainable.

Just take a look at this chart:

12

Your Share of the Debt

� This chart shows each household’s share of federal debt plus

unfunded entitlements:

13

Who is Going to Fund This Mess?

� Projected funding deficit this year: $400 - $700 billion! (projected

supply vs. demand for Treasury bonds). The only solution I can see:

monetization (Fed buying the Treasury debt).

14

What is the True Inflation Rate?

� To me, this is not an easy answer, for the USA or for other

countries. Most governments are incentivized to report low

inflation rates (COLA adjustments). For the U.S., the calculation

methodology has changed so much over the years that I question

comparing current results to historical numbers.

� For reference purposes, I use the information on

www.shadowstats.com to see what the current reported CPI rate

would be using the old calculation methodologies. My own personal

conclusion from researching this matter is that CPI is understated by

approximately 3-5%. I am well aware that Wall Street and most

investors only look at the government (BLS) reported CPI numbers.

15

What is the True Inflation Rate? (cont.)

� The graph below shows the difference between the current

calculation methodology for CPI and the result that you would get

using the 1980 calculation methodology (from ShadowStats.com):

16

The Importance of Real Interest Rates

� Simple calculation:

� Nominal interest rate – Inflation rate = Real interest rate

� If the result is positive, money should retain its function as a store

of value, and vice versa. My personal opinion is that most asset

price bubbles can be tied to periods of negative real interest rates.

Here is a chart showing the real interest rate chart for the USA over Here is a chart showing the real interest rate chart for the USA over

time (using reported CPI):

17

Gold & Commodities Are Used As A Store Of Value When

Real Interest Rates Are Negative

� Gold vs. Real T-Bill Interest Rate:

Monthly Data 3/31/1968 - 3/31/2010

GoldGold Gain/Annum When:

Gain/ %

Real T-Bill Yield Is: Annum of Time

1.2 and Above -2. 0 48. 6

Between 0.2 and 1.2 14. 8 17. 9

* 0.2 and Below 21. 3 33. 5

240

300

360

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480

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660

720

780

840

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960

1020

1080

1140

240

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420

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540

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660

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780

840

900

960

1020

1080

1140

Gold vs Real T-Bill Yield

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(DAVIS74)

60

120

180

240

60

120

180

240

Real T-Bill Yield

3/31/2010 = -2.2%

High Real Yields

Low Real Yields

Low Opportunity Cost

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

1970 1975 1980 1985 1990 1995 2000 2005 2010

Copyright 2010 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. . www.ndr.com/vendorinfo/ . For data vendor disclaimers refer to www.ndr.com/copyright.htmlSee NDR Disclaimer at

The Copper Example: Copper Price Drivers

Price Drivers – dollars/pound November 2009

Weak U.S. dollar $0.30

Energy prices 0.15

China trade balance 0.15

Supply/demand/inventory 1.80

Total Fundamentals $2.40

Commodity Trading Accounts (CTAs) $0.30

Hedge Funds 0.38

Index Funds 0.26

Total Fund Influence $0.94 (28% of the price!)

LME cash price $3.34

Source: CRU – Commodity Metals Management Company

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Commodity Price Changes Over The Past Year

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Who Said It?

� “But then the masses wake up. They become suddenly aware of the

fact that inflation is a deliberate policy that will go on endlessly. A

breakdown occurs. The crack-up boom appears. Everybody is

anxious to swap his money against “real” goods, no matter whether

he needs them or not, no matter how much money he has to pay

for them.” for them.”

(Ludwig von Mises, 1953)

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Currency Debasement Inflation

� Inflation is the loss of purchasing power of money. Here is a chart

showing the purchasing power of the U.S. dollar going back to the

year the Federal Reserve Bank was established (1913):

22

Currency Debasement Inflation (page 2)

� Factors to consider when looking at monetary statistics: money

supply and money velocity. See the charts below:

23

Currency Debasement Inflation (page 3)

� Can a determined Central Bank turn deflation into inflation?

� According to Ben Bernanke, the answer to this question is a

resounding “yes”! Here is his famous quote from November 2002:

“Like gold, U.S. dollars have value only to the extent that they are strictly limited in

supply. But the U.S. government has a technology, called a printing press (or, today, its

electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at

essentially no cost. By increasing the number of U.S. dollars in circulation, or by even essentially no cost. By increasing the number of U.S. dollars in circulation, or by even

credibly threatening to do so, the U.S. government can also reduce the value of a

dollar in terms of goods and services, which is equivalent to raising the prices in dollars

of those goods and services. We conclude that, under a paper-money system, a

determined government can always generate higher spending and hence positive

inflation.

The conclusion that deflation is always reversible under a fiat money system follows

from basic economic reasoning.” Ben Bernanke speech: “Deflation: Making Sure ‘It’

Doesn’t Happen Here,” November 2002

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Currency Debasement Inflation (page 4)

� Conclusions I draw from the Bernanke speech:

� Japan didn’t try hard enough to get out of its deflation;

� You can bypass the banks if you need to;

� Velocity and inflation will go up when people see that you intend

to continually debase the currency.

� What can cause velocity to increase?� What can cause velocity to increase?

� Healthy economy with sound bank loan growth;

� Forced or unsound loan growth;

� Capital flight (people fleeing the currency).

� Common arguments from the deflationists:

� Japan – 20+ years economic stagnation

� U.S. Fed – Paul Volcker

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Currency Debasement Inflation (page 5)

� Beware of the Deflation head-fake (we may be here now!)

� Weimar Republic – Germany

� Beneficiaries of inflation:

� Federal government (on two fronts – liabilities and taxes)

� State and local governments� State and local governments

� Underfunded pension plans

� Debt-laden consumers and businesses

� Inflation victims:

� Savers and lenders

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Who Said It?

� “To preserve [the] independence [of the people], we must not let

our rulers load us with perpetual debt. We must make our election

between economy and liberty, or profusion and servitude. If we run

into such debts that we must be taxed in our meat and in our drink,

in our necessaries and our comforts, in our labors and our

amusements, for our callings and our creeds, as the people of

England are, our people, like them, must come to labor sixteen England are, our people, like them, must come to labor sixteen

hours in the twenty-four, give the earnings of fifteen of these to the

government for their debts and daily expenses, and the sixteenth

being insufficient to afford us bread, we must live, as they do now,

on oatmeal and potatoes, have no time to think, no means of calling

the mismanagers to account, but be glad to obtain subsistence by

hiring ourselves to rivet their chains on the necks of our fellow-

sufferers.” (Thomas Jefferson, 1816)

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IV. Inflation Survival Guide

� How will inflation impact you? The diagram shown below gives a

general rule of thumb of how assets respond under various rates of

inflation:

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Build A Solid Foundation

� Many investors skip building a solid foundation. I believe this is a

serious mistake. Below is a diagram that shows my opinion of how a

solid investment process should work. At the base is savings and

financial insurance assets such as gold and silver.

From there, an investor should

focus on cash flow investments,

then capital gain (growth)then capital gain (growth)

investments, and

speculative investments

should come last.

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Investing In Gold & Silver

� Going forward, I expect gold and silver to continue to do quite well.

I believe silver will outperform gold. Continuing with the solid

foundation theme, here is how I recommend investors approach

investing in this sector. You could also use this approach for

investing any commodity-related industry (such as energy).

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Diversification Benefit of Gold & Commodities

-0.02

-0.04

-0.03

0.05

0.03

S&P 500

BarCap US High Yield

BarCap US Credit

BarCap US Tsy Agg

BarCap 1-3 month T-bills

Chart: 5-year weekly return correlation on key assets and gold (US$)

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0.49

0.35

0.01

0.18

-0.01

-0.06

-0.02

-1.0 -0.5 0.0 0.5 1.0

DJ UBS Comdty Index

Brent crude oil (US$/bbl)

Dow Jones Wilshire REITs

MSCI World ex US

Russell 3000

DJ Industrial Average

S&P 500

Source: Global Insight, Barclays Capital, WGC Data ending 26 March 2010

Whilst every effort has been made to ensure the accuracy of all information used in this document, the WGC cannot guarantee such accuracy;nor does the WGC accept responsibility for any losses or damages arising directly, or indirectly, from the use of this document. This report is intended for information purposes only, and is not and should not be construed as a solicitation to buy or sell gold or any gold-related product.

Building Wealth In The New Age of Volatility

� It may be advantageous to have investment strategies that take

advantage of volatility (because I believe it is sure to rise).

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Focus on Inflation-Adjusted Returns

� Our goal is for investment returns to outpace inflation and taxes.

The following chart shows the Dow and the inflation-adjusted Dow

going back to 1900. The average return is 6.5% excluding inflation

and is about 3.4% inflation-adjusted (government-reported CPI –

before taxes).

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Thematic Investing

� If you believe, as I do, that inflation will be a problem going

forward, then some investments should do better than others.

Inflation-fighting investments that should do well in this

environment include the categories shown below. The book has a

list of ETFs for most of these various categories.

� Precious metals – gold, silver, and platinum

� Energy and clean energy

� Food and water� Food and water

� Infrastructure

� Emerging markets

� Basic materials

� Defense and personal security

� Certain types of real estate (such as farmland)

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One Example: Investing In Water

� Clean drinking water is in short supply in many parts of the world. In

addition, water infrastructure, like highway infrastructure, is in a

state of disrepair in many areas. I believe there will be an increasing

trend to privatize water resources because most local governments

do not have the financial resources needed to upgrade their

facilities. American Water Works (AWK) is the largest water utility in

the U.S. The chart below compares cost of water in the U.S. with

other countries. There is alsoother countries. There is also

a global water ETF – ticker PIO.

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Is My House A Good Inflation Hedge?

� Sometimes “yes”; sometimes “no”.

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Short-Term: Deflation Will Be A Powerful Force

� Just take a look at this graph of M-3 money supply growth (re-

constructed per ShadowStats):

37

A World In Transition: Wealth, Power & Influence Are Being

Transferred From The West (G7) To The East

� Greece is currently the hot topic. Prediction: the next 10 years will

contain one currency and bond market crisis after another. Here is

Bill Gross’s “Ring of Fire”:

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Government Debt is Exploding!

Country 2010 Projected FiscalBalance as a % of GDP

Projected Increase in Public Debt/ GDP – 30

Years (Baseline Projection)

France -8.6 400%

Germany -5.3 300%

Italy -5.4 200%

Japan -8.2 300%Japan -8.2 300%

U.K. -13.3 500%

USA -10.7 400%

Greece -9.8 400%

Asia -3.5

Central Europe -4.4

Latin America

Source: BIS Working Papers, March 2010

-2.4

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Not Only A U.S. Problem: Gold vs. Major Currencies

Daily Data 12/02/1986 - 4/26/2010

Gold in Japanese Yen (x 100)

Scale Right

300

375

450

525

600

675

750

825

900

975

1050

Gold in Euros 450

500

550

600

650

700

750

800

850

720

Gold in Terms of Foreign Currencies

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(AA422)

Gold in Euros

Scale Left

250

300

350

400

450

Gold in British Pounds

Scale Right

200

240

280

320

360

400

440

480

520

560

600

640

680

720

Gold in Canadian Dollars

Scale Left450

525

600

675

750

825

900

975

1050

1125

1200

1991

1996

2001

2006

Copyright 2010 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. . www.ndr.com/vendorinfo/ . For data vendor disclaimers refer to www.ndr.com/copyright.htmlSee NDR Disclaimer at

The “Inflation Trade”

� Implications of Wealth & Power Transfer & Rising Inflation:

� Stocks: Emerging Markets > Developed Markets

� Currencies: Positive Real Rates > Negative Real Rates

� Real Assets > Financial Assets

� Bonds: Emerging Markets > Developed Markets and Developed

Market Corporate (Investment Grade) > Developed Market

Sovereign Debt

� Commodities: Structurally short supply (copper, platinum, silver)

> Excess capacity (aluminum)

41

S&P Sector Correlation With CPI

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Concluding Thoughts: The Flood Is Coming

� Can disaster be avoided? Perhaps, if we:

� Dramatically cut government spending. This requires a

recognition that we can no longer afford the “welfare state”

form of government.

� Reach agreement with the people regarding unfunded liabilities

(entitlements) – these must be significantly reduced.(entitlements) – these must be significantly reduced.

� People must insist on honest government. Have term limits.

Politicians must “re-earn” voter’s trust.

� Maintain positive real interest rates and show commitment to

this policy. If this is not done, investors will continue to seek

alternative “stores of value.”

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Concluding Thoughts (cont.)

� Since the beginning of the financial crisis in 2007, the primary

accomplishment of the U.S. government and the Fed has been to

shift debt and risky assets from the private sector to the public

sector (taxpayers). Problems have not been solved, only delayed.

� The next crisis can occur at any time. History shows that once a

currency loses its function as a store of value, it will also cease to

function as a medium of exchange. With this in mind, I offer the function as a medium of exchange. With this in mind, I offer the

following advice:

� Don’t let the rat race kill you;

� Don’t let the funny money destroy you;

� Live frugally;

� Save and invest wisely now;

� Don’t let disaster preparedness consume you;

� Help others along the way.

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Two More Quotes

� “$100 placed at 7% interest compounded quarterly for 200 years

will increase to more than $100,000,000 – by which time it will be

worth nothing.” Robert A. Heinlein – Time Enough for Love –

copyright 1974

� “You can’t solve a debt crisis with more debt. Ask Greece in about 6-

12 months, as the “fixes” are temporary. Things go along until there

is a loss of confidence in the bond market, and then all hell breaks is a loss of confidence in the bond market, and then all hell breaks

loose. When is that? Who knows? But it is not ten years away, and

probably not five. Rates skyrocket and the currency takes a hit…I

think we avoid it, as there will be a growing backlash at the polls

against government deficits. But then, I am an optimist. If you think

politicians cannot muster the will to make the cuts, then bet on the

disaster scenario. Think gold and hard assets and foreign assets and

absolute-return funds.” John Mauldin, “Is This a Recovery?,” April

2, 2010

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Embrace Reality!

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It’s Going To Be One Heck Of A Ride!

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