Hedge Against Inflation With ETFs
Thirty years ago, President Ford sported a button with the initials "W.I.N.," short for "whip inflation now." Nowadays, investors looking to fight inflation might try a different acronym: ETF, for exchange-traded fund.
With oil hitting multiyear highs, bond yields climbing and the dollar faltering, many investors are worrying that we could soon see a '70s-style flashback in U.S. stocks. The disco days weren't kind to stock-market investors -- the
Dow Jones Industrial Average
was stuck below 1,000 from 1974 to 1982 -- and the mere mention of that era is enough to give some people hives.
What's missing from this throwback scenario, for now, is inflation. Rising prices crippled U.S. economic growth during the '70s, as the consumer price index averaged an annual 7.4% gain during the decade.
So far in the current cycle, inflation has remained tame. The CPI posted a less-than-3% rise in the 12 months through the January 2005 report. Still, investors leery of rising prices might want to consider hedging their portfolios using ETFs and, in particular, Select Sector SPDRs.
Like most ETFs, the Select Sector SPDRs are not "actively managed" by traditional methods. Each Select Sector SPDR is designed to closely track the price performance and dividend yield of a particular sector of the
S&P 500
(before annual expenses of 0.28%). The combined companies of the nine Select Sector indices represent all of the companies in the S&P 500.
One potential strategy is to overweight the SPDRs representing the market's five "inflation-friendly" sectors:
Consumer Staples SPDR
(XLP) - Get Report
,
Energy SPDR
(XLE) - Get Report
,
Health Care SPDR
(XLV) - Get Report
,
Materials SPDR
(XLB) - Get Report
and
Utilities SPDR
(XLU) - Get Report
.
After all, market data show that the threat of inflation pushes investors toward more defensive sectors of the market -- even though inflation in small doses isn't necessarily bad for stocks.
A recent study by S&P found that over the past 35 years, the S&P 500 posted its strongest advances during periods of modest increases in inflation (2% to 3.9%), but fell sharply when the CPI's rate of annual change rose above 4%.
"We believe, therefore, that the market may welcome a touch of inflation -- but not too much -- since slightly rising inflation implies that the economy is growing and producers are able to boost earnings through price increases," writes Sam Stovall, S&P's chief investment strategist.
Over the three-and-a-half decades tracked by S&P, the six times in which inflation rose beyond the 4% threshold were 1972-74, 1976-77, 1978-80, 1983-84, 1986-87 and 1988-90. S&P's data showed the S&P 500 index declined an average of 3% during these phases.
In those periods, the energy components of the S&P jumped an average of 27%, while the financials fell 12% on average.
Other outperforming sectors were consumer staples (+2%), health care (+10%), materials (+12%) and utilities (+3%).
Conversely, investors may decide to reduce their positions in the inflation-sensitive sectors:
Consumer Discretionary SPDR
(XLY) - Get Report
,
Financial SPDR
(XLF) - Get Report
,
Industrial SPDR
(XLI) - Get Report
and
Technology SPDR
(XLK) - Get Report
.
Indeed, other sectors that had a rocky time when prices rose included consumer discretionary (-10%), industrials (-4%) and information technology (-1%).
Aggressive investors might also try to profit by selling short these names. Short-sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.
Nevertheless, S&P's Stovall is careful to warn investors to treat history as a guide, but not gospel.
"What worked in the past may not necessarily be successful in the future," says Stovall.