Inflation, stocks, TIPS, and gold

No one really understands "inflation", broad equity markets are for those who feel they must conform, TIPS are for the gullible, and gold is for those who have a deeper understanding of how the world really works.

Two stories in the mainstream media over the last two days make these points as clear as they've ever been (that is, to non-conformists who are not so easily duped).

On Monday, John F. Wasik of Bloomberg noted that the U.S. consumer price index is high testament to "the art of economic spin", though he comes up a little bit short in recommending reasonable alternatives, sailing right past the natural resource sector and opting for small-cap stocks instead.

Since wages, Social Security cost-of-living increases and some agency budgets are tied to it, the government has a vested interest in keeping it as low as possible.

Yet your real cost of living -- what you keep after taxes, medical bills, college expenses and other household costs -- is probably much higher than the 2 percent annual rate the government reported in July, showing a slight decline.
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One of the best ways to beat inflation is to own securities that hedge inflation risk and its many facets. Don't go out shopping for energy, health-care and gold stocks, though.

Think long-term and diversify. Over the last 80 years, large- and small-company stocks have beaten an average inflation rate of 4.3 percent, according to Ibbotson Associates, a Chicago-based research firm owned by Morningstar Inc.

Small stocks, generally companies with market values of less than $1 billion, averaged almost 13 percent annually since 1926, with large firms returning about 10 percent.

Since these two asset classes are among the most volatile investments, you can't expect those returns every year. During the Great Depression, small companies lost from 10 percent to 60 percent.

Questioning the government's inflation statistics is an important step in the right direction, but the recommended alternatives demonstrate once again that buying gold stocks (or, presumably, worse yet, the bullion itself) is still a non-conformist approach to investing in contemporary America.

As stated here many times before, when everyone wants gold and gold stocks - when natural resource investments are the conformist view - that's when you should start thinking about selling yours.

Even less aware of the realities in the financial world around him is Gregg Greenberg writing at TheStreet.com who derides gold as an investment because it doesn't pay a dividend.

Puh-lease.

Can we just get past that "doesn't pay a dividend" line for hard assets like precious metals? It was fine when tech stocks rose 20 or 200 percent a year and didn't pay a dividend, but when gold and silver rise 20 percent a year, then this "doesn't pay a dividend" issue becomes an impediment.

TIPS are not as good as gold when it comes to fighting inflation. In many respects, they are even better.

Treasury Inflation Protected Securities, or TIPS, are designed to protect investors from the erosion of purchasing power that rising inflation can cause. In an inflationary environment, TIPS, which pay a semiannual coupon, tend to outperform most traditional fixed-income investments, because their par value is adjusted to account for changes in the consumer price index.

For instance, if the CPI rises by 0.2%, the value of the TIPS bond would also climb by 0.2%. If the CPI were to decline, the bond's value would fall very little, because the government guarantees the original investment.

Gold, on the other hand, does not pay a dividend. Until it is sold, gold bullion just languishes in a safety deposit box, while the metal succumbs to the market's price swings. And despite its recent run up through the $720 mark, gold is not the all-encompassing, "pure play" answer to inflation many investors think it is.

Well, the whole idea of TIPS might be a whole lot more convincing if the return wasn't based on the increasingly dubious government version of "inflation". Anyone accepting government "protection" from government created "inflation" deserves what they get.

Given what Fed chief Ben Bernanke did last week, I'll take my rather large pile of gold coins sitting in a safe deposit box since early in this decade to anyone's TIPs any time for at least the next few years.

Based on where we now appear to be headed, in a few years an ounce of gold at $700 will seem as cheap as an ounce of gold at $300 seems today.