Investing in Uncertain Times - Part 2

“Divide your fortune into four equal parts: stocks, real estate, bonds and gold. Be prepared to lose on one of them most of the time. During inflation, you will lose on bonds and win on gold and real estate, during deflation, you lose on real estate and win on bonds, while your stocks will see you through both periods, though in a mixed fashion. Whenever performance differences cause a major imbalance, rebalance your fortunes back to the four equal parts.”

In this post I will discuss the other part of Jacob Fugger’s investment approach, i.e. investing in real assets (gold and real estate).

In 1981 I read a book called “When your Money Fails” (I still have it in my library) which talked about, the move to a cashless society (credit cards, debit cards, bar coding etc) but more importantly, the US government printing of lots of money and the high inflation it would cause. As we all know the inflation rate rose to about 12% and interest rates skyrocketed to a high of 21 percent and many people lost their jobs and homes as a result.

Fast forward to August 2007, the global debt bubble burst and in order to prevent deflation, which is more serious than inflation, the US government started printing more money, lots of it, since the primary tool for fighting deflation is inflation. This ultimately means higher taxes, higher interest rates and of course higher inflation.

Today it’s February 2010 and I have just finished reading the book “Conspiracy of the Rich – the 8 new rules of money” by Robert Kiyosaki. The whole world is in a financial crisis, the US government is printing even more money and could pretty soon quite possibly be “technically bankrupt”. The difference between 1981 and 2009/10 is that we now live in a global economy, where the economies of the world are interlinked and therefore many countries around the world are in financial crisis today.

In order to try and make sense of this current economic crisis we need to go back in time and learn of some of changes in the financial rules that led us to this current economic situation.

In 1913 the creation of the Federal Reserve System granted the world’s ultra rich the power to control the money supply of the United States. Once the Fed was in place, there were two sets of rules when it came to money: One set of rules for people who work for money, and another set of rules for the rich who print money. Many people don’t know that the Federal Reserve is not federal, it is not a government institution and has no reserves. It is a banking cartel the same way OPEC is an oil cartel. The creation of the Federal Reserve was basically a license to print money. The other reason why the Fed was created was to protect the biggest banks from failing by providing liquidity to those banks when they are in financial trouble, which essentially protected the wealth of the rich, not the taxpayers. We have seen this just recently with the bailout of some of the biggest U.S. banks and insurance companies using taxpayer money.

In 1944, the Bretton Woods Agreement created the World Bank and the International Monetary Fund. This agreement replicated the Federal Reserve system globally and in effect installed the US dollar as the reserve currency of the world. This meant that all currencies worldwide were now essentially backed by the US dollar, which was pegged to gold. As long as the US dollar was pegged to gold, the world economy would be stable.

In 1971, President Richard Nixon changed the rules of money: Without the approval of Congress, he severed the U.S. dollar's relationship with gold by taking it off the gold standard. He made this unilateral decision during a quietly held two-day meeting on Minot Island in Maine, without consulting his State Department or the international monetary system.

President Nixon changed the rules because foreign countries being paid in U.S. dollars grew skeptical because the U.S. Treasury was printing more and more money to cover its debts and they began exchanging their dollars directly for gold in earnest, depleting most of the U.S. gold reserves. Before this rule change one could exchange a $5 dollar bill for a $5 piece of gold. When a currency is backed by a hard currency, there is a built in discipline and the government cannot manipulate the currency. Since 1971 the US government has been using deficit budgets/spending to stimulate their economy however: Deficit spending = Inflation = Currency debasement.

Deficit spending requires governments to print additional dollars to finance the deficits. Think of it in this way: If a family had an income of $50,000 but they spent $55,000 so they borrowed the $5,000 and paid the interest. The following year their income was $54,000 but they spent $60,000, so they borrowed $6,000 and paid the interest on the old deficit of $5,000. If they continued to do this for a prolonged period of time they would get to a point where they can’t service their debt and they would go bankrupt.

In order to further understand the effects of today’s financial crisis, it is also important to understand the relationship between the U.S. government, the Federal Reserve System.

It took 84 years from 1913 to 2007 to put $827 billion into circulation. Since 2007, the year the subprime mess rocked the world, the Fed has essentially doubled the previous eighty four years worth of currency supply, by increasing the base money in circulation to roughly $1.7 trillion – and they are still printing money. What this means is that there will be inflation in essential items such as food and energy and there will also be inflation in every country that trades with the United States because the central banks of those countries will be forced to print more money to keep their currency competitive with the US dollar.

In addition, there will be an increase in government controls and taxes to cover the increase in debt. We have already seen this in President Obama’s recent budget which calls for $1 trillion in tax increases and a cut to domestic spending programs. The U.S government’s budget calls for a cumulative deficit from the fiscal year 2011 to 2020 that would add a whopping $8.5 trillion to the federal deficit, pushing the debt as a percentage of GDP up to 77%. Let us just hope that the economy does not go into hyper inflation.

So how do we apply Jacob Fugger’s advice to our modern day financial environment?

“…During inflation, you will lose on bonds and win on gold and real estate…”

Based on what I explained above and the current economic state that most countries around the world are in, we going to enter into a period of high inflation and investors should be positioning their portfolios in assets that will benefit from this.

In the past 2 years we have seen the value of real estate in the United States fall to a point where today houses are selling for far below their replacement value. There are many cities in the US where the majority of the homes are rented and not owned by the people living in them. For example, Rochester NY and Memphis TN. This combination of cheap houses and a large pool of renters is good news for cash flow seeking real estate investors.

Investors should therefore focus on purchasing and holding rental real estate with positive cash flow which will provide a two fold benefit . Appreciation in value and an increase in rental income due to rising inflation.

In addition, you should consider adding Gold and silver investments as a hedge against a devaluing currency. Gold and Silver Exchange Traded funds are a good way to do so.

I believe that Jacob Fugger would be proud to know that his common sense approach to investing still makes sense today 485 years after his passing.