Summary:
Economist article explaining why owning shares is no shield against the scourge of inflation. The conventional wisdom is that in times of inflation bond markets suffer and equity markets prosper (inflation in prices means profits up for companies). There are limits to the levels of inflations under which this rule holds: the sweet spot for stockmarkets is when inflation is between 2% and 4%. When inflation falls out of the bottom end of that range, the economy is normally flirting with recession and deflation, and stockmarket valuations start to deteriorate sharply. In 1970s, employers were unable to keep lid on wage costs, which meant their margins took a double hit from rising raw materials and labour costs. This time round, workers in the developed world have less bargaining power. However, if workers see their real wages fall at the same time as the credit crunch is construing their ability to borrow, consumer demand will suffer. Whichever way the inflation scare plays out, profits are sure to take a hit and stockmarkets will be retreating accordingly. (Published: 03/07/0)
Notes:
- in times of inflation
- normally: bad for bond markets, good for equity markets
- bonds:
- bad because value of most bonds fixed in nominal terms
- bonds are a nominal asset
- shares:
- good because inflation is a rice in the price of goods and services
- businesses make those goods and services
- revenues should keep pace in real terms with prices
- shares a hedge against inflationary pressure
- equities are a real asset
- current inflation: bonds do well, shares deteriorating
- bonds:
- bond market has held up well because investors have perceived them as being low-risk
- instead, investors have taken out their feats on the stockmarket
- most recent period of high inflation: 1966-81
- real returns for US shares fell 0.1%/year
- fell 1.3%/year between 1973-81
- gold: earning an annual 10.9% in real terms between 1966 and 1981
- much better inflation hedge
- why have shares been such a flimsy hedge?
- profits did manage to keep pace with prices
- business profits rose (marginally) in real terms during 1970s in both US and Britain
- but: simply keeping up with cantering inflation was not really good enough
- as a share of GDP, US business profits fell from 12.2% in 1965 to 6.4% in 1982
- never touched that low again
- rose steadily to reach temporary peak of 10.5% of GDP in 1997
- then dropped sharply during the dotcom bust to 7.6% in 2001
- rose again to 11.8% in 2006
- investors reacted to this long profits cycle by adjusting the stockmarket rating
- in 1970s, shares were savagely downgraded
- p/e ratios fell to single-digit levels
- explains stockmarket's dismal performance
- 1982-2000 long bull market
- investors enjoyed the twin pleasures of soaring profits and expanding p/e multiples
- culminated in the dotcom buble
- 2003-2007 stockmarket rally
- because of profits growth, not 1990s style surge in multiples
- shares now look a lot more attractively valued than they did in 1000
- based on trailing p/e ratios
- better to look at trailing, rather than prospective, earnings, because profit forecasts are still ludicrously high: investors are expecting a 20% rise in US earnings next year
- problem is not the ratios, but the earnings
- if profits fall as a share of GDP all the way back to their 1982 low (or even to their 2001 nadir), share prices will suffer
- valuation measures that adjust for this, by using a ten-year average for profits, make shares look a lot less appealing
- main questions: why did profits do so badly in 1970s? and are those conditions like to repeat themselves?
- high inflation wrought enormous economic damage
- GDP growth, interest rates and company profits made more volatile
- contrast: 1982-2000 bull-market coincided with the "great moderation" in economics
- sweet spot for stockmarket is when inflation is between 2% and 4%
- when inflation falls out of the bottom end of that range, the economy is normally flirting with recession and deflation
- when inflation rises above 4%, and particularly when it reaches 6%, stockmarket valuations start to deteriorate sharply
- in 1970s, employers were unable to keep lid on wage costs
- meant their margins took a double hit from rising raw materials and labour costs
- this time: workers in the developed world seem to have less bargaining power
- risks of a 1970s-style inflation (and according slump in profits) are thus much lower
- but: if workers see their real wages fall at the same time as the credit crunch is construing their ability to borrow, consumer demand will suffer
- whichever way the inflation scare plays out, profits are sure to take a hit
- stockmarkets retreating accordingly
