Conventional wisdom recommends real assets (i.e., gold/real estate) as protection against inflation. Why aren’t equities protected against inflation? Here’s my train of thought:
Year 0: Company sells $100 worth of goods but spends $90 in expenses for a $10 profit.
Year 1: After 20% inflation, company sells $120 worth of goods but spends $108 in expenses for a $12 profit.
Won’t sales, cost of goods sold, and profit all increase in lockstep with inflation? I understand that there may be long term contracts that aren’t indexed for inflation, but they should exist on both sides of the equation and largely cancel each other out.
While the earnings of equities are somewhat protected against inflation (much like real estate due to higher rents), what you’re ignoring is the negative impact that inflation has on the valuation placed on equities (and real estate) because the discount rate applied to the cashflows increases. So, your earnings may increase but your valuation will probably still decline.
To use your example, in the first instance the discount rate applied to the $10 in profit might be, say, the professorial 10%, comprised of 3% inflation and a 7% risk premium, for a value of $100.
In the second instance the discount rate applied to the $12 in profit might be 27% (20% inflation plus a 7% risk premium), for a value of $44.44.
So your earnings go up, but your valuation declines. So, your cashflow increases but your principal declines… so you’re not really protected are you?
I have had the same thinking recently. It is difficult because business may be somewhat insulated from inflation but they are less so from an economic slowdown. I have been trying to sell equities into the rally over the past few months, but it has been difficult in my mind buying bonds because of my fear that the authorities will just inflate their way out of this mess. Another possible benefit of owning stocks (esp. US large cap) is that in the event of a dollar decline they would benefit because demand for their exports would start to pick up and help profits.
Of course how much of the market’s earnings these days is real, especially in the financial sector? Companies are able to book the interest accumulated on option payment/neg am mortgages but not actually receive the money, how much of this will they collect? So I’m not sure I trust the current P/E of the market anyways.
What I have decided is that in the short term it is safer being more in fixed income/bonds, I would prefer cash but it is not always an option especially in 401(k)’s. In the intermediate term as the stock market corrects and the full gravity of the situation becomes known maybe start moving some money back into equities.
For a good case study, see the ’70s. Corporate profits were actually pretty good. The reason stocks traded at 5x-8x earnings was inflation. Why take equity risk when you could buy a risk-free long-term treasury yielding 12%? Why indeed…
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