Get ready for stagflation

If I was 100% confident in my abilities to see the future my preparation would be better. I’ve been preaching economic slowdown for months and also worried about rising commodity prices causing ripples in the industrial sector. But trends never develop as quick as I become alarmed. So I’ve stayed invested in stocks defensively while moving a decent amount of capital to short term governments, money markets, puts, and wrote covered calls on many stocks.

The “market” is concentrating on whether the Fed is doing a good job of avoiding recession and hasn’t seriously focused on inflation. It’s only a matter of time before inflation becomes the second reason why stock prices will be under pressure.

Lots of investors flee to bond funds during stock downturns. Avoid all but the shortest types. AVanguard short term treasury fund has returned me 7 1/2% over the last 6 months as investors fled stocks and rates fell. That type of fund will likely continue to do fine as the Fed lowers short rates. But watch out for all other types of bonds as inflation and a slowing economy scare overseas buyers. They will demand greater yield to stay invested and bond prices will decline. Inflation is about to make the Fed’s mission very difficult.

So what am I doing to deflect the effects of inflation? A little gold, a little bet on a strengthening dollar as rates rise, and an inverse long term bond fund that increases in value as rates go up whereas a normal bond fund goes down as rates rise. This is kind of squirrely since it uses derivatives and I have not been kind to people that buy products they don’t understand and I haven’t investigated all of the counterparties involved. But we’re not talking about a large sum of money so i view it as an experiment.

I’ve also lowered my expectations for 2008 to maintaining capital. If I’m worth the same at the end of December 2008 as I had at the end of 2007, the year will be successful. Given the state of stocks and bonds, the huge runs already in commodities and emerging markets, and the weaknesses in the credit markets, we’re going to have a very challenging twelve months. Heres to breaking even.