Stocks
and Inflation
Adam Hamilton
Archives
Aug 26, 2005
Inflation, a pernicious stealth
tax on purchasing power surreptitiously levied by immoral governments,
is one of the greatest persistent obstacles to serious wealth
generation.
By creating fiat money out
of thin air and spending it today, governments increase the amount
of money in circulation. The larger the money supply grows,
the more dollars bid on and compete for goods and services driving
up general prices. These rising prices reduce the purchasing
power of investors' scarce capital, effectively expropriating
it through a dishonorable "tax" that not 1 in 50 people
truly understand.
Inflationary policies increasing
monetary growth are tax increases, no different in ultimate
effect than directly raising marginal income tax rates. But
since so few people, including sophisticated investors, really
grasp this, governments often prefer inflation
to politically unpalatable direct tax increases.
Somewhat ironically, this relentless
monetary inflation hits the poor the hardest, as rising general
prices have the largest proportionate effect on those with the
lowest incomes. This strikes me as irony-laden because governments
across the world actively subsidize the poor in order to bribe
them for votes at election time. If these poor folks really
understood just how regressive inflationary taxation truly is,
they would probably revolt.
Thankfully we investors are
not burdened with poverty. The ultimate source of investment
capital is savings, consuming less than one earns. And
since we investors have lived under our means long enough to
save capital to invest, we are obviously not living hand-to-mouth
where any rise in general prices would crush us.
Nevertheless, inflation is
still a dire threat to our hard-earned investment capital. Over
long-term secular time horizons, the inflationary erosion of
purchasing power can radically alter our ultimate returns. It
does an investor no good to earn 10% when general prices also
rise 10%, as his net gain in purchasing power is zero.
We invest in order to earn greater purchasing power to
increase our standard of living, not to merely see nominal numbers
grow.
Interestingly, the groups of
investors that seem the most savvy in considering real (inflation-adjusted)
returns instead of the usual nominal ones are the contrarians
investing in commodities. As I discussed last week, commodities
investors often know exactly where key commodities like gold
or oil traded in real terms over the past half century.
Studies of real commodities price histories are fairly common
in contrarian circles.
But sadly mainstream stock
investors are seldom if ever exposed to inflation-adjusted studies
on the stock markets. Whenever Wall Street talks about secular
gains, like in the Great Bull Market from 1982 to 2000, nominal
stock-index numbers are used. This serves Wall Street's interests
well by seriously overstating the actual purchasing-power gains
won by past investors, but it does a great disservice to today's
investors.
If an investor earns 100% over
years but general price levels rise 50% over this same time,
half of the investor's perceived gain is nothing but an illusion.
Nominal numbers over long timespans are meaningless as investors
seek to multiply capital in order to ultimately spend it on actual
goods and services some day. True gains are only relevant in
terms of their impact on raw purchasing power. Stock investors
really need to take this to heart.
In order to analyze the impact
of inflation on stock investors, we did some research work on
the mighty S&P 500 this week. The S&P 500, of course,
is the flagship US stock index that represents the preeminent
publicly traded corporations in America. It is the best proxy
for the US stock markets as a whole and it yields the benchmark
returns by which all other investments and even portfolio managers
are measured.
Using monthly data since 1950,
we overlaid the usual nominal S&P 500 with a real
S&P 500 adjusted for inflation. The US Consumer Price Index
was used for computing the monthly inflation adjustments, which
is extremely conservative.
The CPI is intentionally lowballed
to understate inflation for political reasons since inflationary
expectations are so dangerous for the financial markets. Indeed
even Alan Greenspan has said many times that the Fed fears the
rise of inflationary expectations even more than inflation itself
since the mere expectation of inflation radically alters
global capital flows and buying patterns in stocks and bonds.
In addition, non-discretionary
government expenses like pensions are directly tied to CPI inflation,
so the lower the numbers conjured up the more cash Washington
has for discretionary programs it would rather pursue. Higher
reported inflation would lead to higher interest rates too, forcing
the US Treasury to pay much more to finance its gargantuan debt.
True inflation is raw money supply growth, not the heavily manipulated
CPI.
So as you drink in this chart
and its sobering implications, please realize that these numbers
are the most conservative possible estimate of inflation that
your ever-benevolent government wants you to believe. If broad
M3 money
growth was used to measure inflation as it ought to be rather
than the controlled CPI, the results below would be far, far
worse. CPI inflation truly is the best-case scenario for investors.
The blue line below is the
usual nominal S&P 500 and the red line represents the CPI-adjusted
real S&P 500, in constant 2005 dollars. At various major
long-term highs and lows the actual index levels are noted, and
the nominal (blue) and real (red) returns between these interim
extremes are computed. Yellow numbers under these returns show
the ratio between real and nominal gains. Ratios under 1.00
indicate that actual real returns were smaller than nominal S&P
500 gains.
The net impact of even conservative
CPI inflation on long-term stock investors in the last half century
has been staggering. Inflation matters, in a monumental way,
for stock investors working hard trying to multiply their scarce
and precious capital. Only fools ignore the long-term effects
of inflation on investments.
One of Wall Street's greatest
selling points, which is unfortunately a myth, is that stocks
always do well over any long-term span of time.
In reality the precise endpoints bracketing a particular long-term
timespan are crucial for determining long-term investment success.
And the ravaging effects of inflation act to magnify the paramount
importance of exquisite buy and sell timing.
Note on the blue line above
how the S&P 500 went from 108 in the late 1960s to 107 in
the early 1980s for a small 1% loss. That is bad enough, to
not earn any money over more than a decade, but if you look at
the same slice of time in the red inflation-adjusted data, investors
actually lost nearly two-thirds of their purchasing power
over this same period! Real losses ran 54x the nominal losses
during the last secular bear market a few decades ago.
This illustrates one of the
key points of long-term real returns. When stock prices are
flat or declining, inflating money supplies accelerate
the real losses borne by investors. Somewhat frighteningly,
we have already witnessed this in the first downleg of the latest secular
bear since 2000. Real losses were already running 1.05x
the nominal losses and I suspect this multiplier will only grow
as the years march on.
Speaking of years, careful
observers will note that the durations marked in gray above for
major secular bull and bear markets differ somewhat from those
periods recently discussed in Long Valuation Waves 2. The reason is the monthly data
used here versus the daily data in my long wave studies. Since
CPI data is only available monthly, it makes sense to use monthly
stock-index closes as well for this analysis. Actual monthly
tops and bottoms can differ significantly in time from when the
absolute intra-month daily tops and bottoms are achieved.
And inflation doesn't just
accelerate real losses during secular bears, it retards
real gains investors earn during secular bulls. Both secular
bulls rendered above clearly drive home this key point. In the
1950s and 1960s, nominal gains ran 536%. But in real terms investors
only earned 322% over nearly two decades, or 0.60x the headline
gains. While 322% is not trivial, it is vastly inferior to 536%.
And during the greatest bull
market in US history, in the 1980s and 1990s, nominal gains rocketed
up a staggering 1317% higher. But after inflation was accounted
for, investors only earned about half that, 0.53x or 700%, in
terms of raw purchasing power. This reveals the unpleasant truth
that fully half of the bull-market gains of legend in
the last couple decades were illusory, solely driven by Washington
and the Fed relentlessly expanding money supplies and driving
up general prices.
Now at this point it wouldn't
surprise me if stock investors are thinking, "So what?
A 700% increase in my purchasing power is excellent and beyond
ridicule." But they have to realize that this 18-year period
of 700% real gains is a major anomaly. Not only is it
rare, but investors would have had to buy at exactly the 1982
low and sell at exactly the 2000 high. Perfect timing is not
very likely in reality.
What if, instead of buying
in 1982 at a major low where everyone hated stocks, investors
had bought at a major real high in the late 1960s when everyone
loved stocks? In November 1968 the real S&P 500 closed at
599 on a monthly basis. It would not hit this level again until
December 1992 and not go materially higher until March 1995.
Thus, investors buying at the wrong time during the late 1960s
top would have waited 26.3 years before they earned even
one additional percent of purchasing power! Ouch.
Such a quarter-century drought
devoid of any real gains is absolutely catastrophic. If an average
investor starts investing at 25 and retires to live off investments
at 65, he only has four decades in which to earn his fortune.
Losing 26 years out of these 40 due to buying at the wrong time
in the Long
Valuation Waves and being ravaged by inflation would utterly
scuttle any chance of recovery.
While it is certainly fascinating
that the effects of inflation accelerate losses in secular bears
and retard gains in secular bulls, the longer term that one's
perspective becomes the more the ravages of inflation become
evident. The popular Wall Street assertion that stocks always
do well in the long term, when adjusted for declines in purchasing
power due to monetary inflation, becomes a pale shadow of its
former self.
In the chart above one truly
huge timespan is delineated. It runs from 1950 to 2000. Now
please realize that the US stock markets made a major secular
bottom in 1949 and a major top in 2000, so out of any times to
buy and sell since World War 2 these are the most optimal by
far. There are no other two interim extremes that would yield
higher gains. In this perfect best-case scenario, the S&P
500 rose by a massive 8801% over a half century!
These are awesome gains, but
once again they are nominal, not adjusted for purchasing-power
declines. If we take the inflation-adjusted S&P 500 in constant
2005 dollars, the gain is gutted to merely 1111%. Over the past
half century from the absolute best-case moments in time to buy
and sell for the long term, fully 7/8th of the gains investors
could have reaped are illusory. These are wiped out by rising
inflation decreasing purchasing power.
Now in order to earn 8801%
over a little under 51 years, an investor would have to earn
9.25% a year on average in nominal terms. But this same 8801%
corresponds with only 1111% in real terms, which works out to
an average of 4.87% a year over a half century. Thus inflation
wiped out half of the best possible annual gains in the last
half century or nearly 7/8th of the final compounded return.
Inflation has a huge impact.
All long-term investors, regardless
of what they choose to invest in, must consider the relentless
impact of inflation. In this stock market case 4.87% real compounded
annually is certainly not bad at all, but it is over the most
optimal period possible and is a far cry from 9.25% a year nominal.
And this inflation obviously doesn't just affect bonds and commodities
as many folks believe, but stocks and even real estate.
The bubblicious real-estate
industry today makes a big deal out of quoting nominal gains
in houses over long-term periods often running several years
to several decades. While inflation has a minor effect over
several years, when you get into decades its effect is huge.
Just as in stocks, the majority of any gains in a house from
1950 to 2000 are likely eaten up by inflation with true real
gains only comprising a modest fraction.
In order to increase their
real wealth, investors must seek gains that handily outpace inflation
in order to multiply their purchasing power over time. Stocks,
bonds, real estate, and commodities can all do this easily if
they are purchased near the bottoms of their long cycles. But
if they are purchased near the tops of their long cycles, they
could face decades with no nominal returns and massive
real losses.
As I outlined recently,
unfortunately stocks are still near the 2000 top of their long
cycles. It usually takes 17 years or so for stock markets to
run from their secular peaks to their secular troughs, so unfortunately
we are probably only a third or so into this current secular
bear. Investors who buy stocks today and want to hold for a
decade or more likely face flat markets at best.
Flat markets may not seem like
the end of the world, but when the Fed's relentless fiat inflation
is factored in it can lead to massive real losses over timespans
exceeding a decade. From the late 1960s to the early 1980s the
S&P 500 was unchanged nominally. But after inflation is
considered these same investors lost nearly 2/3rd of their purchasing
power just for being invested in stocks at the wrong time.
Investors face similar peril today due to our similar waning
phase in the long cycles.
No investment, including stocks,
is immune from the scourge of inflation. Rising money supplies
raise general prices across the board simultaneously making each
dollar an investor earns worth less in terms of the actual goods
and services it can buy. All long-term returns, regardless of
the market of origin, must be considered in real terms
to be honest and relevant.
The only way to beat inflation
is to ride the perpetual bull. There is always a bull market
somewhere. When stock cycles are in their rising phase as from
1982 to 2000, investors should be heavily long stocks where they
can reap excellent real returns. That particular period yielded
awesome real returns running 11.4% a year on average.
But from 1966 to 1982, a bear phase, investors would have lost
7.2% real annually in the exact same stock markets.
Thankfully when stocks are
in the bearish phase of their long cycles commodities are in
their own bullish phase, and vice versa. The commodities markets
tend to move exactly out of phase with stocks. Commodities were
topping in the early 1980s when stocks were bottoming and they
were bottoming in 2000 when stocks were topping. Now today as
stocks grind lower commodities are already marching higher in
their greatest bull market in decades.
If you are a long-term stock
investor who hasn't yet been exposed to these ideas, I understand
that they can seem pretty radical. If you do want to understand,
I have written several essays just for you. Check out "Long Valuation
Waves 2" and "Curse
of the Trading Range 2" to see why stocks likely face
very tough sailing ahead for the next decade or more. The offsetting
bull in commodities is outlined in "CRB
300 Breakout!"
At Zeal we are trying to ride
these secular trends and are heavily deploying capital in this
young commodities bull. Commodities are vastly more likely to
yield returns far exceeding inflation than the receding stock
markets at this point in history. As we find promising new commodities-related
companies to buy, we profile and recommend them in our acclaimed
Zeal Intelligence
monthly newsletter. Please
subscribe today!
The bottom line is inflation
does matter for all long-term investors, regardless of
which particular market they choose to invest in. When individual
markets are in secular bear phases inflation accelerates real
losses, and when they are in secular bull phases inflation retards
real gains.
In order to stay ahead of inflation
and actually multiply their purchasing power, investors can't
stay in one market forever but must periodically switch from
a receding market to an ascending one. Rather than wait out
a bear in stocks that inflation will make much worse for investors,
why not instead invest in a commodities bull where gains will
probably far outstrip inflation in the years ahead?
When central banks and governments
conspire to expropriate wealth from investors via their inflationary
stealth taxes, the only way to come out ahead in this game is
to always be invested in whichever market happens to be in a
secular bull.
Adam Hamilton, CPA
August 26, 2005
Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!
Copyright©2000-2025 Zeal Research All Rights Reserved.
321gold Inc

|