INFLATION NATION Wise Investing In A Foolish Age

1. INFLATION NATIONWise Investing In A Foolish Age Tom Cammack, CFA, CPA Presentation to the CFA Society of Austin March 2010

2. The Time To Prepare Is Now 1

3. I. Introduction • Looking out over the next 5 years, do you believe deflation or inflation is the bigger concern? • The book has 3 Major Sections: • Return of the Stagflation Trap • A World of Funny Money: The Inflation Time Bomb • The Inflation Survival Guide • It may not occur in the short-term, but inflation will come • Caused by currency debasement rather than economic growth • The goal: maximize inflation-adjusted investment returns 2

4. Who Said It? • “Inflation is always and everywhere a monetary phenomenon.” 3

5. The Financial Tug-of-War • Deflation vs. Inflation 4

6. II. Return of the Stagflation Trap • Opposing Economic Philosophies: 5

7. What is the Stagflation Trap? • Stagflation: economic stagnation and inflation occur simultaneously 6

8. Causes of Stagnant Growth • Diminishing Impact of New Debt Growth: 7

9. Causes of Stagnant Growth (cont.) • Demographics – aging population • Rising Taxes • Excess Capacity/Productivity Enhancements • House Mortgage Resets: 8

10. Stagflation Implications • Negative real wage growth • Increased financial stress: especially the middle class & the elderly • Increase in crime rates • Financial stress on state and local governments • Social Unrest 9

11. Who Said It? • “By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some… The process engages all the hidden forces of economic law on the side of destruction, and it does it in a manner that not one man in a million can diagnose.” 10

12. III. A World of Funny Money: The Inflation Time Bomb • Up to this point, I agree with the deflationists. However, I part ways with them at this point because of the nature of our money. • What makes money “money”, anyway? • Recognized medium of exchange • Unit of account • A trustworthy store of value • Inflation: The Hidden Tax • Webster’s definition: a rise in the general price level; • Types: • Cost-push • Demand-pull • Currency debasement (bad) 11

13. The $100 Trillion Entitlement Black Hole • The current trend of government spending is clearly unsustainable. Just take a look at this chart: 12

14. Your Share of the Debt • This chart shows each household’s share of federal debt plus unfunded entitlements: 13

15. Who is Going to Fund This Mess? • Projected funding deficit this year: $400 - $700 billion! (projected supply vs. demand for Treasury bonds). The only solution I can see: monetization (Fed buying the Treasury debt). 14

16. What is the True Inflation Rate? • To me, this is not an easy answer, for the USA or for other countries. Most governments are incentivized to report low inflation rates (COLA adjustments). For the U.S., the calculation methodology has changed so much over the years that I question comparing current results to historical numbers. • For reference purposes, I use the information on www.shadowstats.com to see what the current reported CPI rate would be using the old calculation methodologies. My own personal conclusion from researching this matter is that CPI is understated by approximately 5%. I am well aware that Wall Street and most investors only look at the government (BLS) reported CPI numbers. 15

17. What is the True Inflation Rate? (cont.) • The graph below shows the difference between the current calculation methodology for CPI and the result that you would get using the 1980 calculation methodology: 16

18. The Importance of Real Interest Rates • Simple calculation: • Nominal interest rate – Inflation rate = Real interest rate • If the result is positive, money should retain its function as a store of value, and vice versa. My personal opinion is that most asset price bubbles can be tied to periods of negative real interest rates. Here is a chart showing the real interest rate chart for the USA over time (using reported CPI): 17

19. Who Said It? • “But then the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy that will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against “real” goods, no matter whether he needs them or not, no matter how much money he has to pay for them.” 18

20. Currency Debasement Inflation • Inflation is the loss of purchasing power of money. Here is a chart showing the purchasing power of the U.S. dollar going back to the year the Federal Reserve Bank was established (1913): 19

21. Currency Debasement Inflation (page 2) • Factors to consider when looking at monetary statistics: money supply and money velocity. See the charts below: 20

22. Currency Debasement Inflation (page 3) • Can a determined Central Bank turn deflation into inflation? • According to Ben Bernanke, the answer to this question is a resounding “yes”! Here is his famous quote from November 2002: “Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or by even credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning.” Ben Bernanke speech: “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” November 2002 21

23. Currency Debasement Inflation (page 4) • Conclusions I draw from the Bernanke speech: • Japan didn’t try hard enough to get out of their deflation; • You can bypass the banks if you need to; • Velocity and inflation will go up when people see that you intend to continually debase the currency. • What will cause velocity to increase? • Healthy economy with sound bank loan growth; • Forced or unsound loan growth; • Capital flight (people fleeing the currency). • Common arguments from the deflationists: • Japan – 20+ years economic stagnation • U.S. Fed – Paul Volcker 22

24. Currency Debasement Inflation (page 5) • Beware of the Deflation head-fake (we may be here now!) • Weimar Republic – Germany • Beneficiaries of inflation: • Federal government (on two fronts – liabilities and taxes) • State and local governments • Underfunded pension plans • Debt-laden consumers and businesses • Inflation victims: • Savers and lenders 23

25. Who Said It? • “To preserve [the] independence [of the people], we must not let our rulers load us with perpetual debt. We must make our election between economy and liberty, or profusion and servitude. If we run into such debts that we must be taxed in our meat and in our drink, in our necessaries and our comforts, in our labors and our amusements, for our callings and our creeds, as the people of England are, our people, like them, must come to labor sixteen hours in the twenty-four, give the earnings of fifteen of these to the government for their debts and daily expenses, and the sixteenth being insufficient to afford us bread, we must live, as they do now, on oatmeal and potatoes, have no time to think, no means of calling the mismanagers to account, but be glad to obtain subsistence by hiring ourselves to rivet their chains on the necks of our fellow-sufferers.” 24

26. IV. Inflation Survival Guide • How will inflation impact you? The diagram shown below gives a general rule of thumb of how assets respond under various rates of inflation: 25

27. Build A Solid Foundation • Many investors skip building a solid foundation. I believe this is a serious mistake. Below is a diagram that shows my opinion of how a solid investment process should work. At he base is savings and financial insurance assets such as gold and silver. From there, an investor should focus on cash flow investments, then capital gain (growth) investments, and speculative investments should come last. 26

28. Investing In Gold & Silver • Going forward, I expect gold and silver to continue to do quite well. Continuing with the solid foundation theme, here is how I recommend investors approach investing in this sector. You could also use this approach for investing any commodity-related industry (such as energy). 27

29. Diversification Benefit of Precious Metals • This chart shows the diversification benefits of precious metals compared to other asset classes. 28

30. Building Wealth In The New Age of Volatility • It may be advantageous to have investment strategies that take advantage of volatility (because I believe it is sure to rise). 29

31. Focus on Inflation-Adjusted Returns • Our goal is for investment returns to outpace inflation and taxes. The following chart shows the Dow and the inflation-adjusted Dow going back to 1900. The average return is 6.5% excluding inflation and is about 3.4% inflation-adjusted (government-reported CPI). 30

32. Thematic Investing • If you believe, as I do, that inflation will be a problem going forward, then some investments should do better than others. Inflation-fighting investments that should do well in this environment include the categories shown below. The book has a list of ETFs for most of these various categories. • Precious metals – gold, silver, and platinum • Energy and clean energy • Food and water • Infrastructure • Emerging markets • Basic materials • Defense and personal security • Certain types of real estate (such as farmland) 31

33. One Example: Investing In Water • Clean drinking water is in short supply in many parts of the world. In addition, water infrastructure, like highway infrastructure, is in a state of disrepair in many areas. I believe there will be an increasing trend to privatize water resources because most local governments do not have the financial resources needed to upgrade their facilities. American Water Works (AWK) is the largest water utility in the U.S. The chart below compares cost of water in the U.S. with other countries. There is also a global water ETF – ticker PIO. 32

34. Is My House A Good Inflation Hedge? • Sometimes “yes”; sometimes “no”. 33

35. Concluding Thoughts: The Flood Is Coming • Can disaster be avoided? Perhaps, if we: • Dramatically cut government spending. This requires a recognition that we can no longer afford the “welfare state” form of government. • Reach agreement with the people regarding unfunded liabilities (entitlements) – these must be significantly reduced. • People must insist on honest government. Have term limits. Politicians must “re-earn” voter’s trust. • Maintain positive real interest rates and show commitment to this policy. If this is not done, investors will continue to seek alternative “stores of value.” See the example of copper on the next page. 34

36. Copper Price Drivers 35

37. Concluding Thoughts (cont.) • Since the beginning of the financial crisis in 2007, the primary accomplishment of the U.S. government and the Fed has been to shift debt and risky assets from the private sector to the public sector (taxpayers). Problems have not been solved, only delayed. • The next crisis can occur at any time. History shows that once a currency loses its function as a store of value, it will also cease to function as a medium of exchange. With this in mind, I offer the following advice: • Don’t let the rat race kill you; • Don’t let the funny money destroy you; • Live frugally; • Save and invest wisely now; • Don’t let disaster preparedness consume you; • Help others along the way. 36

38. Two More Quotes • “$100 placed at 7% interest compounded quarterly for 200 years will increase to more than $100,000,000 – by which time it will be worth nothing.” Robert A. Heinlein – Time Enough for Love – copyright 1974 • “Mainstream economics insists money is a veil over real activity, a mere medium of exchange. Our analysis begs to differ. Money changes everything. Perhaps the time has arrived when we need to openly consider changing the nature of money – the way it is created and the way it is managed – in order to reduce the odds of entertaining such glaring financial imbalances as have been set loose in recent years.” Rob Parenteau, editor, The Richebacher Letter, March 2010 37

39. Embrace Reality! 38