Faced with a spiraling crisis of confidence, European leaders finally took the so-called "nuclear option" this week and unveiled a $1 trillion package to ease fears of sovereign defaults. The measure seems to have worked: Yields on sovereign bonds in troubled countries like Greece, Spain and Portugal have declined dramatically, and fears of contagion seem to be on hold for the time being.
But investors are now scrambling to take cover from the prospect of inflation, the metaphorical radiation that will likely accompany Europe's response. Indeed, the Continent's new-found liquidity only adds to inflationary pressures around the world. While traditional inflation hedges like gold have been the big winner thus far, investors would be wise to seek cover in stocks as well.
Screaming Demand, but Is Gold Secure?
As gold prices soar amid reports of screaming demand, it's tempting for investors to pile into this crowded trade. But despite its seeming security, investors should recognize the risks that accompany the volatile metal. Traders looking to beat the market over defined horizons may profit greatly from gold-related instruments. Investors looking to fund chunks of retirement or college educations could be burned just as easily, however.
Stocks, on the other hand, could be a less recognized and more reliable bet among inflationary conditions. The same pressures driving prices higher tend to boost earnings. Indeed, with projections for next year's earnings rising to near all-time highs, the stock market may well be absorbing inflationary pressures already. And not only do high-quality large cap names perform the best amid inflation, they also provide an element of security that gold can't.
Gold prices, after all, are prone to dramatic swings and for good reasons. Unlike stocks or bonds, gold has no expected income stream to aid in determining a reasonable valuation. And with little economic utility, unlike silver or copper, demand is also remarkably tough to gauge.
Indeed, gold's distinguishing virtue is that it's very difficult to produce more of it, and that limits supply. Of course, there's a value to that. But investors should be aware they're buying into an investment with roughly the same characteristics as a Rembrandt or Monet rather than the bedrock of true value the metal is often paraded as.
Stocks as a Safe Harbor
Yet the prospects of inflation are real, and Europe is just the latest continent to join the party. The Chinese economy continues to show signs of dangerous overheating amid soaring property prices. The Reserve Bank of India has already embarked on a series of interest rate hikes to ease pressures.
The situation in some South American countries like Venezuela and Argentina is downright scary. Prices are spiking, and the lack of credible government data if further fueling inflationary expectations.
The situation in the U.S., though, is likely to be much tamer. And history suggests that the stock market could rally further even if inflation doubled from current levels.
The "sweet spot" for stocks tends to be when inflation comes in between 1% and 2%, research from State Street Global Advisors shows. Stocks tend to command a multiple of about 18 times forward earnings -- well above today's 14, despite inflation at around 2.3% as of March -- in situations like the present.
But even with inflation rates about 6%, stocks tended to be priced at a multiple of about 15 times earnings. That means stocks could provide a safe harbor for quite some time.
Of course, valuing stocks is a highly inexact process. Commonly used gauges like earnings estimates for the next year could easily be too high or too low. But that still easily trumps gold, where valuations are largely just an article of faith.
Basics of Diversification
Learn one of the fundamental concepts of building a portfolio.View Course »