Summary 📈 Inflation eats up bond returns. Medium inflation helps businesses grow, negative/ high doesn't. Hedge w precious metals, REITs & TIPs. Be a lender in deflation.
In this section you'll learn how you may be wisely influenced by rising prices. Remember: all data is refers to the period before 1970.
You want to fight inflation, especially if you have a fixed dollar income.
Stocks on the other hand may fight the loss of purchasing power through dividends and price rises. They've consistently returned higher than bonds.
There must be some conditions in which bonds are better than stocks right? We'll discuss.
Graham first shares a table of US inflation from 1915-1970, and comments that inflation is on average 2.5%, but all in all it's hard to predict, let's say a reasonable investor would suggest 3% per annum.
What are the implications of inflation? It would eat up the returns of bonds. It would increase the 'value' of previous capital, in turn increasing the rate of earnings of previous capital, contributing to the total increase in capital return (old mixed with new).
When choosing a portfolio of stocks and bonds, decisions depend more the individual's experiences year to year and less on a perspective of a life's investment.
But, you can't count on DJIA earnings, there's no relationship between American business and prices (when looking at 5 year rate). Earnings rate had recently fallen at the time of writing as well (1950s-1970s). Also for this period, market value is well above book value. Another way of expressing this is saying that the price of a stock is many times earnings (times earnings/ earnings multiple or P/E ratio).
Graham's research notes a lack of any sign that inflation has affected per-share earnings. All large gains have come from the large growth of invested capital coming from reinvested profits
A little inflation is helpful to business profits. But the numbers show otherwise.
Figures indicate that the effect of inflation on earning power of common stock has limited, it hasn't even maintained the rate of earnings on the investment. Two reasons:
- wage rises exceed the gains in productivity
- need for huge amounts of capital, holding the ratio of sales to capital employed
Inflation hasn't really benefitted corporates and shareholders. Most striking is the growth of corporate debt between 1950-1969, which increased 5x while profits before tax just doubled. EBIT as a percent of debt decreased from 30% in 1950 to 13.2% in 1969. It's a problem.
Debt/EBITDA ratio is the comparison of financial borrowings and earnings before interest, taxes, depreciation and amortization. This is a very commonly used metric for estimating the business valuations. It is a good determinant of financial health and liquidity position of an entity. It is a measure of the ability of a company to pay off its debts.
The 11% growth in stocks has been accomplished by the large use of new debt (which costs ~4%). And if they didn't take out debt to finance this growth, the return on stock would have been even lower.
Graham discusses energy public utilities companies. The market considers them to be a chief victim of inflation, suffering from a large increase in the cost of borrowed money, and the inability to raise prices to consumers, but they haven't seen an increase in their raw material cost = a strong future strategic position. Then again, they are entitled by law to charge something that enables an adequate return on invested capital.
This all brings us back to the conclusion that the investor shouldn't expect more than 8% on a DJIA type stocks, purchased at 1971 price.
Remember, as John Morgan said, the stock market will fluctuate.
Be wary: real price increases take time, it took GE 25 years to record from the stock market crash of 1929.
The Dirty Secret About The 1929 Stock Market Crash
Somewhere along the line growing up, most of us have encountered the story behind "Black Tuesday" and "The Stock Market Crash of 1929." On October 28th of 1929, the Dow Jones Index dropped 12.82%. The next day, it dropped an additional 11.73%.
If the next bull market comes along, and you don't see that as a danger signal of an eventual fall, or not as a chance to cash in on profits, or as a justification of the inflation hypothesis and thus as a reason to keep on buying. "That way lies sorrow".
An Overview of Bull and Bear Markets
Almost every day in the investing world, you will hear the terms " bulls" and " bears" used to describe market conditions. Because the direction of the market is a major force affecting your portfolio, it's important that you know exactly what the terms signify and how each affects you.
Alternatives to stocks as inflation hedges
A common global strategy is to buy and hold gold. Luckily for Americans, this has been illegal since 1935.
In the 35 years 1937 to 1972 gold has from from $35 per ounce to $48 = 35% increase. All this time there has been no income return, and instead has incurred storage expense. It would have been better to put money into savings bank.
Price in 1985 = £265.76
Price in 2020 = £1356.73.
Rise = £1090.97 = 410% = 11.73% per annum
In the commentary: Peter L Bernstein says the opposite, and gold has shown a robust ability to outpace inflation. William Bernstein also agrees, pointing out that a tiny allocation to precious metals (2-5% dependent on age) doesn't hurt returns when the metals do poorly, but when metals do well, they do spectacularly.
Graham deems that "things" such as gold fail to protect the purchasing power of the dollar. Maybe other items like antiques advance in price in the market, but that's outside of his depth.
Property can be considered as inflation hedges, but again there can be serious pitfalls in location, price, sales process. Also not his field.
The prevailing advice from Chapter 1 remains. Don't put all your funds into one basket.
The more you depend on the income of your portfolio, the more you need to guard. Carry out insurance.
Inflation seems insignificant. In recent years inflation in the US has been around 1% annually. But it's not dead!
Inflation disillusions us. Wages go up and we're happy, even if the real wage hasn't.
Money Illusion Definition
Money illusion is an economic theory stating that people have a tendency to view their wealthand income in nominal dollar terms, rather than in real terms. In other words, it is assumed that people do not take into account the level of inflation in an economy, wrongly believing that a dollar is worth the same as it was the prior year.
It's important to assess your financial success post inflation! Some examples:
- 1973-1982 stagflation: prices went up from $100 (1973) to $230 (1982)
- Since 1960, 69% of the world's market economics have experiences a year of >25% inflation, destroying 53% of purchasing power.
- It's easier to pay debts though, it's good to be a lender during deflationary periods (the money you get back has stronger purchasing power)
Figure 2-1 shows:
- shows don't perform well in negative areas, or at high levels
- 20% of the 64 five year periods between 1926 to 2002, stocks didn't keep up with inflation 20% of the time 😯
Two inflation fighters:
- Real Estate Investment Trusts (REITS) are companies that collect rent from property. They do a good job of combating inflation.
- Treasury Inflation Protected Securities (TIPS), are US bonds that go up in value with inflation. Because the US treasuriy is backing them, they're safe from default. But, they are open to taxation, so put it into a 401(k) (or ISA for us UK people).