Saturday, December 16th, 2017

You Absolutely Need To Know This


Inflation

When is a dollar not actually a dollar? When the government controls the money supply.  The chart below shows the history of investment asset classes in the U.S. from 1802 to 2014. All values have been adjusted to remove the effect of inflation, thus the chart reflects what we call the “real return” of the various asset classes. Inflation is  the name we assign to the change in the purchasing power of a unit of currency like a dollar.  The damage due to inflation has been so severe that one dollar from the 1930’s is equivalent to 5.1 cents today. The currency has lost 94.9% of its value and would have to multiply almost 20 times to regain it.

In order to make progress in wealth building our dollar value must climb (after tax) by a rate higher than inflation to make any progress at all. If inflation is assumed to be 2%, which is not unrealistic since the Bank of Canada uses 1%-3% as its target range, then the value of money is cut in half every 36 years.

Gold

Gold is often referred to as a hedge against inflation, implying that owning it as an investment protects you from the destruction of the purchasing power of currency.  In recent times, with governments spending gigantic sums of money that they do not have to prop up businesses that consumers do not support, it is natural to fear governments will simply create more money and distribute it to their preferred groups, usually those with the most political pull or the businesses among the weakest or even insolvent.  If you think it sounds silly to print money to support badly-run businesses, you are not alone.  Gold is a precious metal, meaning it has valuable properties and is relatively difficult to locate and extract from the Earth’s crust.  It is not that gold is actually in short supply, but due to its scarcity compared to other metals it has often been used as a currency and a unit of measuring value. It has the advantages of being non-corrosive, easily melted into different shapes and sizes, being appealing to the human eye and also having value in various industrial products.

 The inflation-adjusted value of $1 of gold in 1802 was worth exactly $1, with modest fluctuations, until the 1930’s and when inflation was initiated by governments the price of gold rose. The price fell again however, drifting downward through the 40’s, 50’s and 60’s, bottoming around 1970. From then until the early 1980’s there was tremendous speculation in gold and its price multiplied several times over. Many people will remember hearing of lineups at banks to buy gold wafers at the end of this bubble. After the early 1980’s gold fell back down to $1 in value (not the price of gold, but a return to its original purchasing power) by the end of the century. After 2001 the price of gold increased significantly, reaching 4.02 by the end of 2010 but declining to $3.11 by the end of 2014. Where will it end up? I expect that in the long run a dollar of gold will be worth a dollar once inflation is included.

Debt
While most people consider personal debt to be a bad thing, when it comes to investing their long-term assets many people still think debt is a good way to go. They perceive that instruments such as guaranteed investment certificates, treasury bills and bonds are safest because they have some guarantees attached and pay a fixed interest rate. How have fixed-income investments actually done in the fullness of time? Are they really the safe haven many perceive them to be?

Take a look at the value of one dollar invested in treasury bills (short term debt) and bonds (long term debt) over the last two centuries, which is really all the history we care about since it covers the industrial revolution onwards. The value of a treasury bill investment has multiplied almost 300 times and a bond investment about 1,600 times! Take a closer look. Notice the actual pattern of the gains was quite steady – as would be expected from a fixed income investment – until the 1930’s. Since then, treasury bills have made no progress and bonds have managed a only a small gain. Why is this and what changed in the 1930’s that so severely changed the returns of these instruments?

The answer is inflation. The 1930’s saw massive intervention in the economy by governments. The end result was nothing less than the gradual destruction of everything measured purely in dollars.  A bond is a promise to pay dollars, not to pay real value. Since 1981 government bonds have paid very well (average of about 8%) compared to their historical average of about 5%, yet this is not sustainable and the story is now over with yields in the 2-3% range. Unless they understand the logic and historical context of investments, investors usually make poor asset allocation decisions and cannot achieve what is almost always their most important goal: the protection and growth of long-term purchasing power.

We know fixed income investing has worked poorly since the advent of inflation in the 1930’s. It is reasonable to state that something which has not and may even promise not to achieve its required task carries a high risk. Have fixed income investments protected and increased wealth over the long term? No, for much of the last 80 years they have not, and they do not appear capable of doing so in the years ahead. The logic of fixed income has changed but most investors’ understanding of this remains incomplete.

Stocks

What about those “risky” investments known as stocks? I prefer to call them “the most successful companies of North America and the world” because they refer to those companies that have grown enough to be listed on a stock exchange and become widely owned by the public. When you hear a reference to “the stock market”, it means the hundreds or even thousands of companies that have reached that level. The chart below shows the returns of major asset classes from 1802-2013, adjusted to remove the illusory gains of inflation and so it is called a “real return” chart. If you follow the line for stocks you can see that they fluctuate constantly and sometimes quite wildly. However, the author of the chart, Professor Jeremy Siegel, has found that you can calculate a line of best fit, known to statisticians as a regression line, through the data for stocks. Stocks, therefore, exhibit the property of regression to the mean – indicating that when their value drifts above or below the line they are pulled back towards it like a magnet.

What is the cause of this tendency that has been completely reliable since 1802, the dawn of the industrial revolution, and can we depend on it continuing?  The slope of the regression line for stocks is  6.7% per year after inflation. Using the rule of 72 that tells us how long money takes to double, we find that stocks have doubled in real value about every 10 years for more than two centuries. This rate has not changed and shows no signs of changing. This 6.7% rate has been labeled by another researcher as “Siegel’s constant” in recognition of its identification and importance in economics. The 6.7% corresponds to the rate of productivity gains over time. It seems that there is a natural rate of progress that is possible under a relatively free economy, and so it is logical to expect the share prices of the largest and most successful companies to eventually reflect this. 

You see, stocks represent more than just a promise to pay dollars. They represent a share ownership of the assets of a company and a claim on the earnings of the company. The company earns income by selling goods and services and over the years the price of these is adapted to the rate of inflation. As such, stocks represent claims on REAL assets and REAL income that protects wealth from the ravages of inflation over the long term. In fact, one dollar in stocks has multiplied 1,033,487 times more than inflation in the time shown on the chart, building more than 62,900% more wealth than bonds, even after the large drop in stock prices in 2007-2008.  The price of stocks is always rising or falling. Sometimes they stay above the trend line for a long period and sometimes they stay below, but they always return to it. The further they are below the line the higher the returns in the years ahead, so the old adage of “buy on the dips” truly does work. With the advantage of the data from Siegel’s chart, we can now understand where stock prices are in relation to their trend line, and see if their market prices are fairly valued or over or under-valued. This may help us set more reasonable expectations for the years ahead.