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The White Elephant That Could Destroy Your Portfolio, Part I

by: Graham Summers May 23, 2008 | about stocks: TIP / WIP    

Graham Summers

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The financial crisis has recently made talking heads of several heavy hitters in the investment community. Most notable amongst them is Warren Buffett, who now appears on TV almost every other day offering his sage insight to where we are in the crisis.

Buffett, as he commonly states in public, is not a “macro” guy. And I’m sure he appreciates the opportunity to impress with his insights and draw attention away from his recent embarrassment— losing nearly $1 billion in derivatives trading after famously calling derivatives “weapons of mass destruction.”

However, to me, a far more significant character has recently joined the financial media roundtable. Unlike Buffett, he’s very much a macro guy. And he understands the Federal Reserve and its actions better than anyone: He was the last decent Fed Chairman we’ve had in 30+ years.

I’m talking about Paul Volcker.

For those of you who are unfamiliar with Volcker, he served as Fed Chairman from 1979 to 1987. Volcker came in when the US was experiencing the worst inflation since the Civil war and left when the Fed experienced the worst protests and political backlash since the Great Depression.

Simply put, Volcker kicked off a serious recession in order to slay inflation. From an objective standpoint, his decision made economic sense, but it was a political death knell. Volcker’s clearly aware of the fact, joking that the “greatest strategic error” in his life was not the recession, but taking his wife fly-fishing in Maine for their honeymoon.

Our country has long struggled because people make political decisions differently from economic decisions. Volcker’s decision to impose a temporary set-back — a recession — to stop a problem that could easily result in the long-term destruction of Americans’ quality of life — inflation — is a perfect example of this discrepancy. It stands in sharp contrast to later Fed Chairmen Alan Greenspan and Ben Bernanke’s decisions to stave off a recession at the expense of the dollar.

So to see Paul Volcker speaking to Congress and hinting that the Federal Reserve is screwing up, is a BIG deal. Unlike his successors, Volcker understands economics. And it’s clear he now has a better understanding of political backlash: His criticism is expressed more via hints and insinuations than outright accusations.

And what is Volcker’s real concern? His old arch-nemesis, and the white elephant in the living room of the financial media, inflation.

The mainstream financial media has talked our heads off about “bottoms,” GDP growth, recessions and other news items. Amazingly, inflation, which is currently in the double digits (more on this later), hardly gets any mention. When it does, it’s the usual blather that it’s “better” or “worse than expected.”

A far more informative approach — and one that would be much more helpful to investors — would be to stop discussing inflation relative to expectations and start talking about inflation relative to reality. The Fed has changed its measure of inflation twice in the last 30 years; both times it chose to become more lenient. In fact, if you measured inflation today as you did when Volcker was Fed Chairman, you’d find inflation was in the double-digits.

As you can see, the Fed’s current measure of inflation is beyond inaccurate; it’s outright fraudulent. In fact it’s so bad that both Paul Volcker and members of the Philadelphia Federal Reserve bank have publicly stated it is not the “best predictor of total inflation.” You know things are bad when even current members of the Fed are beginning to admit their measures are somewhat inaccurate.

If you haven’t taken steps to protect your portfolio from inflation, you need to do so immediately. I’ll explain how in Tuesday’s essay (financial markets will be closed Monday in observance of Memorial Day).

PS. You can see Paul Volcker’s recent testimony to Congress and his interview with Charlie Rose here and here.

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This article has 60 comments:

  •  
    May 23 02:53 PM
    Is there no way for us citizens to effectively convey to Washington folks-in-charge that if they don't start measuring and reporting inflation accurately, and quit such baldfaced lying, they're risking a revolt, perhaps a modern reenactment of the Boston Tea Party?
    Reply
  •  
    May 23 03:00 PM
    Why not just personally profit from the inevitable? I'm not a gold bug, but right now gold and silver make a whole lot more sense than throwing money into financials, retail, airlines, etc. I was shocked in November when Bernanke cut the first time. If you think the Lehman bail-out (oops, gave that one away...) will take the financial system to the brink, there's always SKF, SDS, etc.
    Reply
  •  
    May 23 03:00 PM
    wow...you really know how to do DD...

    Buffett DID NOT loose 1 Billion in derivatives last quarter (it was just accounting)...because those contracts cannot be called early...and they are LONG TERM contracts...specifical... PUT OPTIONS he sold on indexes with terms of 15-20 years...

    You really think the SP500, DAX, etc. will be lower in 15-20 years? Those contracts are as close as you can get to receiving free money in the market.
    Reply
  •  
    May 23 05:01 PM
    Fed Director,Ben Bernanke, and company will not raise interest rates in an election year, especially with a weak Republican candidate and his party already heading into the toilet. Nor, does the director want to be accused of killing the GOP's chance of a victory at the polls. Which a raising of rates would certainly do.
    So, why not have the real estate depression break the back of inflation this year and right through 2012? The Fed can't do much to prevent the loss of family wealth anyway. If it means sacrificing John McCain and the GOP in the process, those are the breaks.
    Bernanke doesn't have to raise Fed rates. All he has to do is simply wait for Bush's depression to take hold and do the Fed's dirty work for him.
    Reply
  •  
    May 23 07:52 PM
    inflation relative to reality - absolutely well put. and this will indeed be the Greenspan/Bernanke/Bus... recession - I can't bring myself to say the d word yet.
    Reply
  •  
    May 23 08:25 PM
    We would be far better off without the Federal Reserve. It serves only two purposes.

    1) Supply the Federal Government with money so it can avoid raising taxes. This is obviously a cheat unless you believe in something from nothing.

    2) Back up the fractional reserve banking cartel in this country which allows the banks to create "money from thin air" thereby allowing them to steal via inflation. The inflation and contraction of the money supply is also the chief cause of the banking cycle.

    Central banking is a con. It is a cynical way to exploit the masses.
    It also contains the seeds of its own destruction. It would be worth a depression if a stake was driven through this abomination's heart.
    Reply
  •  
    May 23 08:47 PM
    No chart!
    Reply
  •  
    May 23 10:56 PM
    I'm not a fan of Uncle Ben Bernanke or the Federal Reserve, but just once I'd like to see any of the posters flapping their gums be put in charge for a yeat... just to see how badly they can screw things up.

    Talk is cheap.
    Reply
  •  
    May 23 11:11 PM
    I love the idealist comments on how it is worth a DEPRESSION to stop inflation.

    Folks, inflation sucks, but bread lines suck worse.

    Reply
  •  
    May 23 11:48 PM
    BxCapricorn, i agree with you, but the only problem with investing in commodities is that you get taxed on your gains, similar to investing in stocks. Why should citizens be taxed by the federal government for trying to hedge against government induced devaluation of the currency? The current system doesn't make much sense.
    Reply
  •  
    May 24 12:30 AM
    The current system is designed to allow the bankers to profit tremendously off of all Americans. The Federal Reserve purposefully has a policy of inflation. This helps the politicians and themselves. First they profit by increasing the Federal govts debt. Because of the constant inflation the average American is forced to either deposit their paper money in a bank, by stocks, bonds, US treasuries (destroyed by inflation), mutual funds, etc.... With each of these forms of investment the bankers take their cut. The morality of bankers charging interest on loans in the first place is that they take on risk and therefore should be able to profit. However are the established system won't allow banks to fail so where is the risk. Imagine everyone purchased all goods with only credit cards. The credit card companies would then get a cut of everything. The current system allows the banks to get a cut of everything because they issue the money, control its value forcing you to make them the stewarts of your money, and then taking a cut for doing so. Its crazy if you think about it.
    Reply
  •  
    May 24 05:23 AM
    That is exactly why people turn to oil as the substitute of dollar.
    The real crisis may be ahead when:
    1. the housing crisis spread into the credit card area as the inflation worsen.
    2. Most Oil countries refuses dollar.
    Reply
  •  
    May 24 07:06 AM
    The looming inflation crunch is a theme I've addressed many times on my finance blog, and indeed the wise comments of Paul Volcker on the issue. The bizarre (and self serving) changes made to the CPI calculation methodology under Clinton (such as the highly imaginative hedonic pricing) are now coming home to roost and we could face a credibility crisis for US stats in the next few months, with dire implications for the dollar and US bonds. The emperor, if not quite naked, is wearing very tattered rags...
    Reply
  •  
    May 24 09:07 AM
    nothing will change as long as the stadiums are full of the beer swilling crowds."let them eat cake" said emperor bush or maybe it was a long ago queen.sadly little ethics,morals etc. is the norm of the times.you cant believe anybody anywhere(well maybe buffett).
    Reply
  •  
    May 24 09:43 AM
    jcrash,

    What I should have said is that if we have a depression or hyperinflation or stagflation let's know who is to blame. But strictly speaking, central banking is responsible for a lot of misery. WWII for instance was caused by the Great Depression. Here is what Uncle Ben has to say about that:

    "I would like to say to Milton [Friedman] and Anna [Jacobson Schwartz] regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

    50 million people were killed in WWII.
    Reply
  •  
    May 24 11:55 AM
    Back in 1933 the small book "Sacrifice or Chaos" suggested that in the U S we all agree to reduce all dollar denominated obligations by some agreed per cent, say 50%. A $5,000 insurance policy would then become a $2,500 policy; a $10,000 mortgage would become a debt of $5,000 and so on. There was, of course, the impairment of contracts problem (strictly then just applied to states).

    Never happened, of course - foolish idea, to devalue debt!

    So, what have we done to debt obligations over the years? Well, we have worked things out so that the dollars in which they are denominated are reduced in value (and a lot more than 50% since 1933!).

    The merits of those procedures (effectively constantly devaluing debt obligations) gave rise to a new and burgeoning class of entrepreneurs, today our "political class."

    The procedures made (and make) it possible for them to use debt creation (at all levels of governments) to fund (by bribing the public with its own money) the increases in their aggregate powers and influence (which has proven better than plowin').

    There is no easy escape, and as long as there are periodic surges in relative productivity increases, all costs will be covered over time. That is, so long as we are able to create more with less efforts, which is quite different from just trying to get more with less effort.

    Gee! And it's not Sunday yet.
    Reply
  •  
    May 24 02:00 PM
    The assumption here is that, if the Fed's methods were correct, it could measure inflation. But I think that real inflation has gone under the wire of official methods of measuring it. For example, the handle of a standard broom was wooden and of a certain length and thickness a few years ago; now it is both thinner and shorter, or may be of flimsier plastic.

    But it might be listed as being the same product. In order to get a product of the same value now one would have to pay much more. The shift from metal and wood to plastic has accompanied this but is not the cause of it.
    Reply
  •  
    May 24 02:32 PM
    Volcker is right, but few listen. I've called for an investigation of the BLS, starting with the Commissioner that Bush appointed in 2007, to no avail. No spine in this country. Gutless academia and media, are all intimidated, fearing an IRS audit, loss of livelihood, or access. Volcker, Steiglitz, Rogers, you can count courage on one hand.

    With Treasuries & CDs earning 4% max, and gold no sure bet (Fed can knock down with sales by IMF & underweighting in GSCI as ordered by Sec. Paulson and simultaneous buying of our own Treasuries to support the dollar) Anyone watching how they hit the 10-year ($TNX)each time at 3.92%? That's our own Treasury/Fed buying our own bonds, making sure the 4% doesn't get pierced.
    SDS, negative-correlated etfs are fine but your timing has to be right, the Big Boyz at the trading desks know the short interest, they will burn you when it's highest, by releasing a "better than expected" report, burning you in the premarket.
    Reply
  •  
    May 24 02:36 PM
    Didn't Buffet comment in support of Moody's, and their obvious "computer error" coverup?
    Reply
  •  
    May 24 04:44 PM
    historically, the election year is a good year for stocks .. the year after elections are not so great. Would be a good study to see how all these Inflation manipulations will affect 2009 stock market returns ..
    Reply
  •  
    May 24 05:46 PM
    If Graham (and many others) are right that the Fed is seriously understating inflation, that would impact the returns on the TIPS ETFs. For that reason, I've added the two TIPS ETFs' tickers as tags to this article.
    Reply
  •  
    May 24 06:05 PM
    The Federal Reserve and the Banks are Gangsters and Banksters. When you cut interest rates from 5% to 2% you do the following to people who have worked and saved all their lives: There is $2.69 trillion sitting in just money market accounts at 2%. The Fed took away $80.7 billion in one year's time with that cut. This does not count the money just sitting in passbook savings. They did this to save the damn Wall Street big shots and the bankers who lent money to those that could never pay it back. As far as I'm concerned, the Govt. is our worst enemy. The Fed Reserve is not federal at all. It is time for us angry White Men to cling to our guns and keep our powder dry.
    Reply
  •  
    May 24 07:33 PM
    Borgie One,

    If you want to understand exactly how the banks steal via inflation by CREATING money I strongly suggest The Mystery of Banking by Murray Rothbard. It is available for free at:

    mises.org/Books/myster...

    The public at large has been looted since at least 1694 when the Bank of England was established to fund Charles II. Depressions, wars, and misery can be laid at the feet of banksters. They are just sophisticated counterfeiters.
    Reply
  •  
    May 24 07:55 PM
    Here's good proof of how the Fed has been loaning investment banks and RESCUING THE MARKET FROM ANY PLUNGE. Facts are here, look at the money. Will the Plunge Team act again, increasing the TAF even more before next options expiration? NO FREE MARKET, FOLKS!
    www.financialsense.com...
    Reply
  •  
    May 24 08:22 PM
    >Folks, inflation sucks, but bread lines suck worse.<

    And the Fed has practically guaranteed we'll have both.
    Reply
  •  
    May 24 10:26 PM
    Not being honest about inflation is only a very small sad part of the socio-economic equation of what we will be facing when considering that current times ARE different this time around.

    Transitioning of the energy sector accompanied with higher energy costs may be one aspect that everyone is talking about - n o w
    . . . but what about the food sector? Being aware that just the poor of China and India are gaining ground in the food chain gives way to understanding there will be an increase level of competition for the basic food groups . . . even before considering the negative impact of mandating corn being be used to partially fuel our transportation needs.

    Meaning . . . costs for energy A N D food are likely to ratchet up and not be so cheap for quite a long period of time . . . or at least within the majority of my lifetime and yours.
    Reply
  •  
    May 24 11:22 PM
    Has the humanity been better off since 1694?

    Or do you prefer to live in the world before 1694?
    Reply
  •  
    May 24 11:32 PM
    I'll bite, why did you draw a line at 1694 and not 1752 or 1812 or some other point?
    Reply
  •  
    May 25 03:29 AM
    We all know that food and fuel are rising and these ae two staples which we require for our surival and lifestyle. The idea of lowering interest rates until housing stabalizes might be 2-5 years off. In the end inflation will have to rise faster and faster until houses look cheap. This mess looks much worse than the tech bubble. The problem is all the cheap money went after commodities. It may be awhile before cheap money goes back to the housing industry. In the meantime core inflation (which I might add means nothing to an aging population rises) real inflation will have to rise higher and higher.
    Reply
  •  
    May 25 03:32 AM
    Mr. Summers: You say, "In fact, if you measured inflation today as you did when Volcker was Fed Chairman, you’d find inflation was in the double-digits." You supply a chart, but do not identify the different methods. Please supply the different methods so we can evaluate for ourselves. By the way one method "pre 1983" indicates one of the changes was made during the Volker Chairmanship. So since the article lauds him, was the change for the better or worse, whatever it was? Again please identify the methods and sources for the data used in the chart.
    Reply
  •  
    May 25 04:26 AM
    how we got into this mess or banking in a nutshell

    "What do bankers do?"

    Well, they take your money and lend it out
    then make some more and lend it too.

    "Make some more!? Surely you jest;
    t' would take a printing press!"

    Au contraire mon freir,
    they make it from thin-air.

    "they make it from thin-air!?
    But that's dishonest, absurd!"

    Yes, hence the Fed Reserve.
    Reply
  •  
    May 25 06:19 AM
    Dear poet sam, Reading your posts is a waste of my time. We need solutions. What happened in 1694 is meaningless. The Federal Reserve Board is not going to be shut down anytime soon. Banks do have a reason to exist but they must be properly and fairly operated.

    So you see, your solutions are BS.

    I hope that the author of this article doesn't tell us to buy gold next Tuesday. I do not think that having gold is wise and if everyone would stop buying gold the price would drop. Also, if there continues to be a world cartel/monopoly called OPEC then we will all pay more for energy. I am not in favor of price controls but when some people in the US are struggling to pay for food, heat and housing, something must be done.

    Perhaps, the first thing to do is spend your money wisely or don't buy anything you don't need.

    The second thing to do is conserve energy.

    The third thing to do is speak out against fraud in government and in business.

    The fourth thing to do is get serious and get an education so you know what you are talking about.
    Reply
  •  
    May 25 08:17 AM
    Volker is a hero.
    Reply
  •  
    May 25 08:52 AM
    USA punters are way too passive and way too credulous and the press is no help.
    ( This kind of article is helpful but has a tiny audience)
    The government, the military, commerce, the Church and the press have disgraced themselves repeatedly.
    Where is the OUTRAGE after a decade of fraud, deceit and violence perpetrated on the US people and the peoples of the World?

    If not enough poeple understand, and then express their outrage, then they will continue to get the government and institutions they deserve.


    Reply
  •  
    May 25 09:42 AM
    e tu boubou... and poetSam, Central banks should be added to the axis of evil. "Sympathy for the Devil" "Please allow me to introduce myself, I'm a Banker of wealth and taste..."
    Curious though, people still want to live long and prosper. So SA founder, David Jackson, and others give advice on how to make the most out of these times.
    Reply
  •  
    May 25 09:54 AM
    "The fourth thing to do is get serious and get an education so you know what you are talking about." jjason

    The Mystery of Banking by Murray Rothbard is available for free at:

    mises.org/Books/myster...



    mises.org/Books/myster...
    Reply
  •  
    May 25 11:28 AM
    The Annualized Inflation Rate chart that was inadvertently omitted from the original post has been added.
    Reply
  •  
    May 25 01:44 PM
    Austrian economist Hayek explains that recessions are peroids of "creative destruction", i.e. a time when capital, labor, and resources are redirected so that what is produced conforms with what is wanted and needed. Changes in technology, fashion, demographics etc. mean the economy must continuously adapt to new demands. When businesses do not adapt quickly enough the gap between what is supplied and what is demanded grows. A recession is a period of readjustment when people are forced to adapt to the new economy.

    Foolishly trying to avoid small recessions, the federal government used Keynesian economics to maintain the status quo. Today, the cumulative effect is a federal debt of nearly $10 trillion. This is a measure of how much change needs to take place to realign the economy with what is needed. The fear people feel for the future is the realization that we have become a nation of rackets - businesses of questionable or negative value - but we must soon earn our way competing with Asians used to a lower standard of linving.

    If all this wasn't enough, we find we live in interesting, changing times. Oil is at peak, the global climate is changing, the internet has shrunk the world. So great change is at hand and the the passage into the new world will be painful.

    It is unfair to blame central bankers who find themselves caught between a rock and a hard place and realize they must always choose between the lesser of two evils.

    Personally, I think the federal government should default on its debt obligations. This would be very painful to all, but less painful than the water torture of trying to maintain the fiction that it will be paid off or debasing the currency to monetize the debt. Sovereign debt would finally get the repuation it deserves. Governments around the world would not be able to run deficits and make mischief.
    Reply
  •  
    May 25 01:55 PM
    boubou, if anyone gets too OUTRAGED, they will find a new home in our massive prison system. Sure you can be upset, but you can't actually do anything that would make a difference. There will never be enough folks that would coordinate together and take these high risks. I choose to try getting by the best I can, play by the rules, and stay "free".
    Reply
  •  
    May 25 02:26 PM
    "It is unfair to blame central bankers who find themselves caught between a rock and a hard place and realize they must always choose between the lesser of two evils." walleke

    That is very forgiving of you but the central bankers BUILT the kitchen they are now sweating in. Let them disassemble the monster they have built as Jim Rodgers suggests. But other than that you make some very good points as would be expected of someone who knows Austrian economics. I will quote Ron Paul,

    "The proble