Inflation may be on the horizon. Hedges, anyone?
Inflation may be subdued today, but the debate over inflation is anything but tame. Pessimists, such as hedge-fund manager Julian Robertson of Tiger Management, say rampant inflation is a looming threat. "I ask anyone to give me an example of an economy beefed up by huge amounts of fiscal and monetary stimulus that did not inflate tremendously when the economy improved," he recently told us.</br></br>Optimists such as David Herro, co-manager of the Oakmark International fund, disagree. "The global economy is soft, and there's excess capacity, so I believe inflation is still preventable," Herro says.</br></br>The debate over gold, considered an excellent inflation hedge by some, is equally lively. Top investors, such as Paulson & Co.'s John Paulson and Greenlight Capital's David Einhorn, placed big bets on gold in 2009. Einhorn explained his rationale at the recent Value Investing Congress: "Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely."</br></br>At the same conference, Bill Ackman of Pershing Square Capital Management said he avoids gold because it is "a greater-fool investment." In other words, making money on the yellow metal is less a function of a rise in its fundamental value and more a function of finding someone who is willing to pay you more for it. Tiger's Robertson describes his aversion to gold similarly: "It's less a supply-demand situation and more a psychological one -- better a psychiatrist to invest in gold than me."</br></br>Because inflation hasn't afflicted America in some 30 years, it's worth reviewing what rising prices might mean for stock investors. In a 1977 article on the subject in Fortune, Warren Buffett went to great lengths to disabuse shareholders of the notion that they could skate through inflationary times unscathed. He wrote that companies have little ability to improve returns on capital when inflation is high, so investors aren't willing to pay as much for each dollar of corporate earnings. The subpar 5.2 percent annualized return for the Standard & Poor's 500-stock index from 1973 through the end of 1981, a span during which inflation rates often hit double digits, provides ample support for that argument (adjusted for inflation, stock returns were negative).