Some of you who have known me for a very long time know that I began my investment career working in the fixed income departments of two different mutual fund firms. I eventually spent ten years doing that, a period in my career which I now regret - not for lack of engaging, intelligent colleagues with whom to work, but for the fact that I was stuck in bonds. We spent our days analyzing a steady stream of economic data, and the cryptic comments of prime ministers, treasury secretaries, and central bankers from around the world, trying to guess if the data and the comments implied higher or lower inflation and, if one or the other, what we should do about it. We adjusted the average maturity of our portfolios minutely, by selling one bond and buying another one, and engaged in this activity so frequently that we needed several full time employees to do the buying and the selling (one of whom, to begin, was me).
It's hard to find a more futile endeavor. Forecasting the future is always dangerous. Trying to do so on a daily basis in 10 different countries borders on madness. I don't think that we added much value, and I am still surprised that our supposedly efficient, market-driven economy finds room for such activity, sometimes rewarding it handsomely.
As soon as I had the opportunity, I left fixed income and transitioned to stocks, which I have never regretted. I eventually formed a view that bonds - all bonds - were lousy investments, suitable only as a hedge against the danger of a stock market crash, and then almost exclusively for retirees. To the extent that anyone can stay out of the bond market, I advise them to do so.
Investing in stocks requires guessing about the future also, but with one big difference. The stock market goes up. Since 1932 - 90 years - US stocks have only experienced a few brief moments when, measured over rolling five year periods, and including the benefit of dividends, they went down.
They're going to go up again this time. But since we currently have a stock market going down, maybe we should briefly revisit why stock markets only go up over the long term. I've written about this before, and if you have heard it before, feel free to skip ahead. But I think that now might be a good moment to review.
Trends come and go, but three really big forces push the stock market continuously higher:
1) Global population growth
2) Technological advances, and
3) Inflation
When the headlines of the day bring you down, think of these three trends working constantly in the background, always working in your favor, and you will feel better.
I think that the reasons why the first two of these forces push the market up are fairly intuitive. 1) Population growth means that ever more people need to buy groceries, build homes, raise children, retire and travel, and do all of the other things in life which contribute to our economy. Each new person in the world enlarges the opportunity for companies to sell something, and the effect is cumulative.
2) Advances in technology make us all more productive. Today, we have the computer and the internet, cell phones and Zoom calls. In earlier eras, think of the invention of fire and the wheel, of agriculture, the printing press, the car, the telephone and the airplane. How about the genius who invented double entry bookkeeping and accrual accounting, or the actuary who thought up the first mortality table, to help insurance companies price life insurance? Facebook and Twitter fit in here somewhere, although I sure don't know where. Technological advances proceed unevenly, but they never stop, and they make huge contributions to our well-being.
3) What about inflation? I don't know anyone who likes inflation. And right now, just as inflation makes the headlines for the first time in decades, the stock market wobbles and starts down on the news. Why would I suggest that inflation works to our advantage?
To understand why inflation helps the stock market, consider a company which makes widgets. Each widget costs $1 to make, and the company sells it for $2, earning a profit of $1 per widget. Then imagine that a bout of inflation sweeps through the economy, and everything doubles in price. Now the widgets cost $2 to make. But the company can sell them for $4, and it earns a profit of $2 per widget. See how that works? Earnings have kept up with inflation. All other things being equal, the stock price of the company will double also. You may not be richer than you were before, but you have at least kept up. No one at the widget firm has been laid off.
That's it - the entire explanation. Corporate earnings respond to inflation. We have a built-in mechanism to ensure that they do.
In any given year, when inflation crawls along at 2 or 3%, we don't notice the effect on stock prices. Companies rarely mention it in their annual reports. Management would much prefer that you attribute the good results to their business genius. But cumulatively, inflation gives a gigantic push to stock prices on a continuous basis, and should be seen, if not as a positive force for your retirement, at least as a neutral, as long as you invest in stocks.
Still don't believe me? Look at the problem from the other side. Think of your widget company again, only this time imagine that it experiences a big bout of deflation. When the dust settles, widgets only cost 50¢ to make and your company sells them for $1. Profit falls from $1 to 50¢ per widget. Now the company must sell twice as many just to tread water, at exactly the moment when demand dries up. Layoffs ensue. Everyone in the country cancels their holiday plans to Hawaii and tightens their belts. If you would like to see the stock market go down in style, do it this way. In 2009, when inflation teetered close to zero, but did not turn negative, the stock market fell by 45% just on the fear that it might. Between 1929 and 1932, prices in the US declined by 25%, but the stock market crashed by 90%.
My father, who was a professional economist, and usually knew what he was talking about, first mentioned this to me in about 1989, after I had begun investing professionally in bonds. "What's wrong with a little inflation?", he asked. "Bond investors don't like it, but it helps everyone else. It's good for the country, and great for the stock market."
I had held my job for a year or so, and did not know much, but had already adopted the rigid, hard-money opposition to inflation and a pessimistic outlook towards stocks, seemingly shared by everyone in that business. (Working in bonds also clouds your perception of reality.) I thought and thought about it. HIs question challenged everything which I thought I knew. It took me years, far longer than it should have done, to finally conclude that he was right.
The problem with inflation, of course, is that it can spiral out of control. In anything more than small doses, inflation destabilizes. Pensioners living on fixed monthly incomes suffer badly. High inflation demands that we all make a new calculus of how much things will cost next year and the year after that. It throws our retirement plans into disarray and screws up our college savings plans. Nobody likes that. We need to control it.
Ideally, Congress and the President take responsibility for inflation, and respond to it with the same zest with which they respond to other economic troubles. But those two branches of government demonstrate, repeatedly, that they cannot do so. No elected official is ready to tighten fiscal policy or intentionally slow down the economy, ever, and perhaps with reason. It falls to the Federal Reserve, an unelected body, to manage the process and prescribe the tough medicine.
Which brings me back to the question, if inflation is so good for the stock market, why has the market gone down these last few months just as inflation hit the headlines. My answer is, it didn't. Inflation has built gradually in this country over the last few years, and the stock market went up on that news. If you look at a chart of inflation, you can clearly see the break towards higher inflation which coincides with the onset of the pandemic. Inflation surely had an effect on the strong run of the stock market during that time. Only in the last few months, has the Fed begun to publicly discuss doing something about it. It's the threat, and now the reality of higher interest rates which pushes the market down.
I think that we still have scope for substantially higher interest rates, and that the pain of the market downturn has not finished. At some point, the stock market will stop going down on this news. Each Fed hike will elicit a muted response or maybe even a rally. That's when we will know that the worst part of the pain for your stock portfolio is over, and that you can look forward to better returns in the days ahead.