Value Stocks and Margin Loans as Inflation Hedges

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Park
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Value Stocks and Margin Loans as Inflation Hedges

Post by Park » Sat Jul 21, 2018 9:37 am

Some assets (TIPS, real estate, commodities etc.) are considered hedges against inflation. However, such assets may not hedge inflation in a taxable accounts, with TIPS being an example. Also, they tend to hedge the principal invested in the particular asset, but no more. Since it is unlikely that all of one's portfolio will be in inflation hedges, some of one's portfolio will be exposed to inflation risk.

What one wants is an asset that profits from inflation, and not just keeps up with it. Also, one wants this to be effective in a taxable account.

A loan with a fixed interest rate and a fixed return of principal could profit from inflation. An example would be a mortgage.

What other assets are either such loans or have such loans embedded in them?

There are companies that have such loans. Why not buy the stocks of such companies?

"Finally, tilting towards value stocks also provides a buffer against inflation, for the same reason a fixed-rate mortgage does: since value stocks are more highly leveraged than the market, they benefit when the real value of their fixed-rate obligations falls. Between 1975 and 1981, for example, the Fama-French U.S. Large Value/ Growth indexes returned 20.98%/ 12.15% on a nominal, annualized basis, while the Fama-French International (developed) Value/ Growth indexes returned 20.39%/ 13.15%. (Domestic inflation ran at 8.86% during those years.)"

Bernstein, William J. Deep Risk: How History Informs Portfolio Design (Investing for Adults Book 3) (p. 43). . Kindle Edition.

What about margin loans? The return of principal is fixed, but the interest rate is not. However, assume you're in a taxable account. If the interest is tax deductible and the relevant tax rate is appreciable (40% for example), then your aftertax interest rate may be considerably less than inflation.

Does this mean that I advocate margin loans? At present valuations, no.

However, consider recessions. Conventional wisdom is to own bonds, as they will help in a recession. That is certainly true in a deflationary recession, but less so in an inflationary recession. But margin loans in a taxable account might help an inflationary recession. And because it's a recession, valuations would less likely to be on the high side.

AlohaJoe
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Re: Value Stocks and Margin Loans as Inflation Hedges

Post by AlohaJoe » Sat Jul 21, 2018 9:39 am

Park wrote:
Sat Jul 21, 2018 9:37 am
But margin loans in a taxable account might help an inflationary recession. And because it's a recession, valuations would less likely to be on the high side.
This seems like a lot of hand waving. Why don't you at least do a backtest and share with us the results instead of saying "might"?

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whodidntante
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Re: Value Stocks and Margin Loans as Inflation Hedges

Post by whodidntante » Sat Jul 21, 2018 9:41 am

It's an interesting idea.

software
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Re: Value Stocks and Margin Loans as Inflation Hedges

Post by software » Sat Jul 21, 2018 9:46 am

I’m interested in this topic as well. I purposefully do not pay down my mortgage, since I consider it a low interest, non-callable inflation hedge.

The main issue I can see with margin loans is the risk of a crash causing you to have to sell low to cover the margin. I’ve never thought about value stocks during high inflation periods. I wonder if that is related to some of the value lag recently (low inflation period).

stlutz
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Re: Value Stocks and Margin Loans as Inflation Hedges

Post by stlutz » Sat Jul 21, 2018 10:46 am

The problem with margin loans is that the rate is variable. Inflation goes up and rates go up--you don't gain anything.

That contrasts with a 30 year fixed rate mortgage.

With stock selection, the problem with just using "value stocks" is that this group is composed of companies with a wide variety of other characteristics. Low price-to-book is not the same as high debt to equity.

I think what you are looking for are highly leveraged companies. But you would want to focus on ones with long-term debt. Short-term debt has the same problem as your margin loan. And the preferred measure is probably debt to the market value of equity as opposed to the book value of equity. The problem with this approach is that these stocks probably aren't as good of an investment absent high inflation.

In theory what you would want are options on CPI futures. Problem is that CPI futures don't exist.

The best real-life solution probably is to simply own some real estate, own some TIPS, but otherwise just deal with the fact that sustained higher inflation probably isn't going to be good for you. Trying to hedge a portfolio for high inflation has too high of a cost for all other economic scenarios.

subrosa
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Re: Value Stocks and Margin Loans as Inflation Hedges

Post by subrosa » Sat Jul 21, 2018 12:20 pm

I remember hearing something similar to this on a podcast from Dan Rasmussen who is at Verdad Capital; there is also a paper called “leveraged small value equities” by Brian Chingono, who apparently also works at verdad

At least it seemed similar to me at first glance; I might be missing something besides the specifics of using it In a Recession (maybe not the easiest time to get capital at cheap rates fixed).

I have no affiliation with either the group or strategy but It seems interesting. Verdad was discussed here at this thread I think viewtopic.php?t=242905#p3805525
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market timer
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Re: Value Stocks and Margin Loans as Inflation Hedges

Post by market timer » Sat Jul 21, 2018 10:01 pm

As others have noted, a margin loan is not a great way to benefit from inflation, because short term rates will tend to rise with the inflation rate. Ideally, you want to borrow long term at a fixed rate to buy an asset with cash flows that rise with inflation.

If you want to do this in a brokerage account, shorting long term Treasuries can be thought of as borrowing long term. Given how low interest rates are right now, and the low spread between short term and long term rates, this isn't such a bad idea right now. As for buying assets that rise with inflation, I'd look at commodities, like gold and oil.

Another method that I think is likely to pay off is buying low-income rentals with high rental yields. This would be my preferred method if I were retiring early.

Theoretical
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Re: Value Stocks and Margin Loans as Inflation Hedges

Post by Theoretical » Sat Jul 21, 2018 10:20 pm

I think that Managed futures funds could do extremely well in the 1970s inflationary spike situation, one because the majority of the collateral is in ultrashort cash-type instruments, and two because in a bad inflationary spot, you could see some major trends develop in currencies, commodities, and (negatively) bond futures. For the same reason, even long-only commodities futures will do better in an inflationary cycle because the collateral is already getting them there.

Margin loans aren't going to get you there due to the floating or near-floating rates. Bill Bernstein considers value stocks to have some inflationary hedging aspects, and I think the deep value funds also have that going for them. Junk bonds have some benefits too because inflation makes the fixed payments easier to make, potentially improving the creditworthiness to boot.

But Bernstein's remarkable contribution to this discussion is the compelling picture of unhedged international stocks in an inflationary situation from his book Deep Risk.

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aj76er
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Re: Value Stocks and Margin Loans as Inflation Hedges

Post by aj76er » Sun Jul 22, 2018 11:58 am

Inflation can be due to a number of things. If it is localized due to money supply issues, then unhedged foreign equities seen like a good hedge. However if inflation is due to a global phenomenon, like an energy crisis or environmental issue, then global equities could all go down together.
"Buy-and-hold, long-term, all-market-index strategies, implemented at rock-bottom cost, are the surest of all routes to the accumulation of wealth" - John C. Bogle

Valuethinker
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Re: Value Stocks and Margin Loans as Inflation Hedges

Post by Valuethinker » Mon Jul 23, 2018 11:09 am

subrosa wrote:
Sat Jul 21, 2018 12:20 pm
I remember hearing something similar to this on a podcast from Dan Rasmussen who is at Verdad Capital; there is also a paper called “leveraged small value equities” by Brian Chingono, who apparently also works at verdad

At least it seemed similar to me at first glance; I might be missing something besides the specifics of using it In a Recession (maybe not the easiest time to get capital at cheap rates fixed).

I have no affiliation with either the group or strategy but It seems interesting. Verdad was discussed here at this thread I think viewtopic.php?t=242905#p3805525
One should google "Bonfire of the quants" and/ or read the Scott Patterson book "The Quants".

This should give one a certain... caution ... regarding leveraged portfolios of small value equities. There is the possibility of being wiped out.

Remember the Crowded Trade.

asif408
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Re: Value Stocks and Margin Loans as Inflation Hedges

Post by asif408 » Mon Jul 23, 2018 12:07 pm

IIRC, from the Bill Bernstein book you quoted regarding value stocks, stocks of commodity producers are also a hedge against inflation, as well as international diversification. So it seems if you agree with his views you would want to make sure you have adequate international diversification, a tilt toward value stocks overseas and at home, and a maybe some smaller positions in the stocks of commodities producers.

As long as you stick to broad market index type funds with low turnover, you should do fine holding these in a taxable account. For example, I hold some international funds and an energy fund in a taxable account, and the turnover for both funds is very low annually.

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Re: Value Stocks and Margin Loans as Inflation Hedges

Post by ThrustVectoring » Mon Jul 23, 2018 10:36 pm

market timer wrote:
Sat Jul 21, 2018 10:01 pm

If you want to do this in a brokerage account, shorting long term Treasuries can be thought of as borrowing long term. Given how low interest rates are right now, and the low spread between short term and long term rates, this isn't such a bad idea right now. As for buying assets that rise with inflation, I'd look at commodities, like gold and oil.
Treasury futures are an extraordinarily thick and efficient market, too. Plus you have favorable tax treatment on futures contracts - 60% long-term and 40% short-term capital gains, rather than the ordinary income of the underlying bond coupons.

There's also fundamental reasons to believe that 30-year treasuries will tend to be overpriced - the bet-against-beta factor predicts that efficient ways of getting factor exposure (eg, duration) will be over-crowded due to liquidity constraints among market participants. The portfolio that exploits this aims at getting zero duration through going long short-term treasury futures (the two-year one, most likely) and shorting long-term futures (mostly the 30-year) to get a market-neutral portfolio. As a small bonus, margin requirements can be lower than taking those positions independently, too.
Current portfolio: 60% VTI / 40% VXUS

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whodidntante
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Re: Value Stocks and Margin Loans as Inflation Hedges

Post by whodidntante » Mon Jul 23, 2018 10:53 pm

market timer wrote:
Sat Jul 21, 2018 10:01 pm
shorting long term Treasuries can be thought of as borrowing long term.
That's pretty far from "is the same as."

I tried shorting long-term treasuries in the hedge fund contest. They wouldn't let me. :beer

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