I’m writing this from Sussex for a change, as I’m staying with family down here. It’s been a breath of fresh air in more ways than one. Somehow concerns about the virus seem lessened, the wind is refreshing not annoying, the blazing sun offers opportunity now, rather than just more Google searches for “best value fan”.
The waters of the channel are as invigoratingly cold as ever, and running along the coast certainly beats my 50th lap of the local common – along with a few hundred other people (no matter what time of day I go – runners).
You wouldn’t expect that in such idyllic conditions and while reconnecting with cousins, aunts and uncles, I still spent the weekend thinking about inflation.
And not just because last Friday I read Nickolai Hubble and Boaz Shoshan’s excellent monthly issue on it, for their newsletter The Fleet Street Letter Monthly Alert.
The reason is that an opportunity to turn a membership into a one-off payment has recently come my way.
For example (using fake numbers), would you rather pay £1,000 per year for the rest of your life to access X or Y, or would you rather buy lifetime membership for £20,000? That is the question.
It’s even split by age – so that it costs more if you’re young like me, because you’re going to get better value out of a lifetime membership.
And it reminded me of those times when a friend says – oh you’ll never believe it, but by chance my friend’s girlfriend’s dog’s former owner told me about his pal who bought a house (/car/painting/boat/whatever big purchase you can think of) for just a few hundred quid. Now – they tell you – it’s worth millions!
The point is that while £10,000 seems like a hell of a lot of money today, and it sure is, in 30 years people will be saying I just can’t believe so-and-so managed to pick up a house on the coast for only a cool £500K. It’s worth over a trillion euros now (we’ve rejoined the euro by then – thanks millenials).
Oh damn, I just wish I’d bought that house in Shoreditch back in 2000 when I had the chance! It’s worth five times that now.
Anyway, I mention this because today I want to talk about inflation. Warren Buffett, in a 1977 article, described how inflation “swindles” the equity investor, and this article is doing the rounds once more. It’s well worth a read, you can see it here.
The wide sharing of this article is just one indicator of inflationary fears returning. The gold price is another (it’s breaking out, don’t you know), as is the fact that pretty much everyone is talking about it!
The point is this. Your paper returns are not your real returns. Those trees are not real trees.
Here are two charts – the first of the S&P 500’s return on a log scale (ie, in percentage increase terms), and the second, again on a log scale, but using inflation adjusted prices. You can see that the latter is much more volatile.
For me, the most important thing is how much inflation impacts your real returns.
For example, we are only seven times higher in real terms than where we were in 1929 – but every linear, non-adjusted chart you look at makes it seems like extraordinary share price growth since then.
Also, the 2008 peak is actually noticeably below the 2001 peak, and the low after the global financial crisis was lower than in 2002, though on traditional index charts it doesn’t appear so. The run-up to 2007 looks like a mere bear market rally once inflation is accounted for.
But the key period to look at is the 1970s.
That’s one of those bear markets which Russell Napier speaks of – where for 12 years prices ranged and ended up exactly where they were, but during that period, inflation stole away the purchasing power of that share price, and profit growth also eroded valuations at the same time.
So valuations fell, let’s say from a price/earnings ratio of 20x to 10x (same share price, double the earnings), while inflation was so rampant that your real return was a loss of 63% – with inflation-adjusted prices for the index falling from 750 to 280.
That is why inflation is important. And I think we need to start factoring inflation into our charts, models, and thinking from now on.
The thing is, many clever people will tell you equities are an effective hedge against inflation because they can raise prices in line with inflation and thus sales and profits can keep up.
But Buffett’s long article slowly dissects why that isn’t the case.
He builds a beautiful case to show this.
Firstly, he imagines the equity as something more akin to a perpetual bond, arguing that through history, equities have rarely delivered much more or less than the 12% return on capital.
So in that sense you can expect a company to earn 12% each year forever, or until it goes bust.
Assuming that it pays roughly half its earnings in dividends, an investor is essentially holding a 6% perpetual bond.
But once inflation starts to come into the mix, this gets big chunks eaten out of it each year. A 3% inflation in prices cuts the purchasing power of your 6% return in half.
Throw in trading and other costs incurred by the all-too-regular turnover in retail portfolios (he calls this “thrashing about, obviously fruitless in aggregate”, which made me feel rather bad about my own busy activity of late) and your normal return is looking seriously diminished.
Of course, the real bonus of stocks over bonds is that the half the company keeps – the retained earnings – are reinvested at a growth rate of 12%, which will be reflecting by a growing share price as the company grows.
But nonetheless, Buffett was right, as he was in the midst of a terrible bear market in real terms, even though prices were flat on paper. Valuations in nominal terms peaked in 1968 and didn’t bottom until 1982, and inflation during that period robbed investors blind.
But what can be done about this? In usual fashion, we are back to gold.
Gold (blue line) which has, priced in pounds, outperformed the FTSE 100 (red line) by an extraordinary amount over the last few decades even when inflation was ebbing to very low levels.
I showed what happened to stocks in the 1970s once inflation has been priced in.
It won’t come as a surprise that the price of gold went another way, in a big way.
The below chart is inflation adjusted, on a log scale, and must also be placed in the context of the breaking in the gold standard in 1971, allowing the dollar to float free from the metal and letting it shoot upward.
In inflation-adjusted terms then, the gold price in US dollars soared, growing almost tenfold from $237 to $2,234.
In real dollar terms, the rise was from $35 to $677, and unsurprisingly it peaked once Paul Volcker came in as Federal Reserve chairman and brought inflation under control.
You can even go as far as measuring the S&P 500 relative to the gold price, to give an indication of the extent to which gold outperforms during periods of rising inflation. In the below chart, you can see the index falling in value relative to gold, most abruptly in the periods after 1929, 1971 and 2000.
I’m sure you’re all aware, but just a visual reminder of what inflation did during this same time period, rising to the mid-teens and peaking in 1980, the same year that the S&P-to-gold price chart bottomed:
And bear in mind, the UK just recorded its lowest monthly inflation figure (0.5%) since 2016.
The market thinks I shouldn’t be concerned about this at all – inflation-protected bonds reflect expectations that inflation will be only slightly above 1% for the next decade in the US (it’s around 3% here in the UK).
It’s worth remembering though, that a long period of inflation that low has never happened before in the US, especially not in the wake of the largest ever expansion of fiat currency and fiscal stimulus we’ve seen in centuries. At the very least I think we’re right to consider it, worry about it and plan for investing during it.
And the point is – it doesn’t take falling prices to create a bear market.
And even if stocks go up, inflation will turn real returns negative or at least reduce them hugely.
And finally, even if stocks go up and inflation doesn’t totally erode positive returns, gold, precious metals, miners and other hard assets will outperform traditional equities, especially (in my opinion), overpriced US “tequities” like Amazon, Tesla, and the rest.
Buffett has shown that most equities cannot keep pricing in line with inflation, and cannot deliver returns which are truly inflation protected.
History shows that gold doesn’t just hold its value during inflationary periods, it soars.
And finally, I hope that today I’ve shown that all investors need to start factoring in inflation when thinking about prices and returns.
All the best,
Editor, Southbank Investment Research
PS To find out about our specialist gold and precious metals investing advisory that we offer, click here.