Inflation has been nearly nonexistent for years, which allowed the Federal Reserve to prolong its historic monetary program. And even as the Fed has begun raising rates, officials are pointing to benign pricing pressures as a reason to hold rates lower for longer.
There may be more to the inflation story than the market realizes, though. A report from the Bureau of Labor Statistics (BLS) showed a surprising trend hidden in the details.
Not only is inflation potentially rising faster than headlines suggest, but researchers have found investors may not understand the real effect on stocks. Thankfully, today’s trade could offer investors protection from this “inflation illusion.”
Inflation Isn’t as Tame as it Appears
The BLS reported incredibly weak consumer price growth of just 0.7% over the 12 months through December, but a closer look at the data presents a different picture.
The general level of inflation was restrained by a whopping 12.6% decline in energy prices. But the core inflation reading, which excludes volatile food and energy prices, has been rising steadily, increasing 2.1% over the past 12 months.
Not only is core CPI much higher, but there have been some big increases in key components. For instance, the December report showed prices for medical services increased by 2.9% over the past year, while those for keeping a roof over your head, known as the shelter index, shot up 3.2%.
Finally, we can make the argument that while core CPI is supposed to strip out energy prices, they still have an impact on the number. The huge drop in energy prices means a cheaper production process and workers with one less argument for higher wages. So a rebound in energy prices could add to the already-building inflation momentum.
Investors are More at Risk Than They Know
While it’s commonly thought that stocks offer decent protection against inflation because companies can raise prices, historical data proves otherwise. Research by and based on Nobel laureate Robert Shiller has shown that, historically, an inflation surprise is negative for investors due to lower dividends and stock returns after adjusting for higher prices.
A 2004 paper by John Campbell and Tuomo Vuolteenaho for the National Bureau of Economic Research showed investors are at risk from an “inflation illusion,” meaning they don’t account for the effects of rising prices on stock returns.
With inflation stealthily moving higher and many investors not fully comprehending the risk of lower stock returns, it’s time to start looking at how to profit from this trend.
Gold is the Go-To Inflation Hedge
Few assets have a better track record for beating inflation than gold. For decades, returns on the yellow metal have easily beaten inflation and returns on the 3-month Treasury bill, a common measure for holding cash. And gold’s 10-year average return has even beaten that of the S&P 500.
Besides buying the actual metal, individuals can participate in the sector by purchasing shares of gold miners.
Goldcorp (NYSE: GG) has one of the strongest balance sheets in the group with just 22% of its market cap in debt at the end of the third quarter. Only Agnico Eagle Mines (NYSE: AEM) had a smaller debt percentage, while Goldcorp’s largest competitors average 47%.
On Dec. 4, Goldcorp announced CEO Chuck Jeannes would retire in April. While uncertainty around the CEO transition seems to have investors on edge, Jeannes’ successor, David Garofalo, is a strong replacement. He previously served as CEO of Hudbay Minerals (NYSE: HBM) and, before that, was CFO at Agnico Eagle for more than a decade.
On top of that, Goldcorp just completed development of two major mines and will benefit from lower capital spending costs over the next couple of years. Management forecasted capital expenditures for 2015 will be between $1.2 billion and $1.3 billion, a savings of as much as $1 billion from the prior year.
Not only did investment spending decrease last year, but revenue is projected to have increased for the first time in three years. Management estimated 2015 sales of $5.1 billion to $5.5 billion — an increase of at least 13% over 2014 sales — thanks to production growth of 15% to 25%.
However, analysts’ estimates are for sales of just $4.4 billion in 2015, with a decline to $4.3 billion this year. When the miner releases earnings on Feb. 25, higher-than-expected revenues and a strong outlook could serve as a catalyst for the stock.
Boost Inflation Protection With This Income Strategy
In addition to investing in gold-related stocks, traders can gain even more protection with a simple income strategy known as a covered call.
By purchasing shares of GG and then immediately selling a call option against the position, we can bring in extra income that boosts our return and offers downside protection. (If you’re not familiar with how a covered call works or need a refresher, watch this 90-second training video now.)
With GG trading at $12.42 at the time of this writing, we can buy 100 shares and simultaneously sell one GG July 14 Call, which is trading around $1.05 ($105 per contract) for a net cost of $11.37 per share.
If Goldcorp closes above the $14 strike price at expiration on July 15, our shares will be sold for that price. In this case, we will make $1.58 in capital gains, plus the $1.05 we received for selling the calls and the $0.12 in monthly dividend payments.
That’s good for a total return of $2.75 per share and represents a profit of 24.2% over our cost basis of $11.37. Since we’d earn that in five and a half months, it works out to an annualized gain of 54%.
If shares do not move up following the earnings announcement in late February, stronger cash flow and the April CEO transition could turn investor sentiment higher. Meanwhile, building inflationary pressures should send gold prices up and investors flocking to miners like Goldcorp.
Note: A covered call strategy may be the perfect solution to inflation eating away at your portfolio. It’s the easiest way to squeeze bigger returns out of the stocks you already own. In fact, you can use it with almost any stock currently sitting in your portfolio as long as you hold at least 100 shares.
To find out how you could pocket $795 in the next 48 hours — and earn up to $3,000 a month from covered calls — follow this link.