Stocks are Generally Good Inflation Hedges
A lot of newbie investors don't realize how good of an inflation hedge stocks are. In the super long run, they have beat bonds, real estate, and even gold. As long as one doesn't buy at a major peak (such as 1929 or 2000) their stock investment should more than handily beat all other asset classes. Mark Hulbert wrote an article for the New York Times commenting on the misnomer regarding inflation and stocks. In it, he refers to studies that show that corporate profits have generally grown faster than inflation:
Not all companies are created equal but most manage to keep their inflation-adjusted earnings growing even in inflationary periods. You would be hard-pressed to find too many other assets that can do as well as stocks can during inflationary periods. Even the much vaunted commodities will correct hard--50% drop is not unusual--and leave you questioning your returns. The only thing that can beat stocks is gold but, contrary to what goldbugs say, it requires precise timing (look at the almost 20% drop in gold or 40% drop in silver within the last two months--such a move would be a major crash for broad market stocks but is nothing unusual for precious metals.)
The risk for investors, though, is that the market will start discounting stocks using lower inflation-adjusted returns during inflationary periods. Even if stocks will outperform most other assets during inflationary periods, stocks with rosy built-in projections will get re-priced.
Contracting Profit Margins A Greater Threat
The biggest threat to stocks right now is not inflation but the unsustainably high corporate profit margins. Many stock-market investors don't realize that most of the profits over the last 5 years has been accumulating to businesses and this will likely reverse. Warren Buffett also alluded to this a few years ago when he referenced a chart showing corporate profits as a percent of GDP (refer to this post from Rational Angle for some past views from Buffett.) It is a certainty in my eyes that corporate profits as a percent of GDP will decline in the future. So be prepared for it! On top of bogus profits--such as "profits" from subprime loans to people who clearly were never going to pay them back--dissapearing, the most likely way corporate profits will decline is with higher taxes.
A future Democratic Presidential administration under Barack Obama will likely reverse the so-called tax-cuts for the wealthy (some of these cuts never should have been enacted in the first place.) A John McCain administration likely won't immediately reverse the massive Bush tax cuts but will still increase taxes in my view. The US government deficit is getting totally out of control and hence I think taxes will be raised regardless of who is drawing up policy (cutting some inefficient branches of the government or war spending is the ideal route but that ain't happening.)
Anyway, the market will likely discount stocks (downward) when profit margins contract. If you are a contrarian or a value investor buying with a big margin of safety, this won't have a big impact; but if you are buying close to market valuations, it will likely be a bigger issue than inflation.
(NOTE: Everything I say here applies to developed stock markets and USA/Canada in particular. Developing markets are totally different, with inflation being a huge problem almost at all times. Far more businesses in developing countries will have problems earning above inflation than in developed countries. It is much harder to pass down prices due to price controls, price ceilings, etc.)
Over the last eight decades, corporate profits have tended to grow faster when inflation is higher. In such periods, companies have been able to pass along higher costs to their customers. As a result, even though higher inflation leads to a greater discounting of future years’ earnings, those earnings tend to be bigger than they would have been otherwise. The net result is that the current value of a company’s future earnings remains relatively stable in the face of rising inflation.
Not all companies are created equal but most manage to keep their inflation-adjusted earnings growing even in inflationary periods. You would be hard-pressed to find too many other assets that can do as well as stocks can during inflationary periods. Even the much vaunted commodities will correct hard--50% drop is not unusual--and leave you questioning your returns. The only thing that can beat stocks is gold but, contrary to what goldbugs say, it requires precise timing (look at the almost 20% drop in gold or 40% drop in silver within the last two months--such a move would be a major crash for broad market stocks but is nothing unusual for precious metals.)
The risk for investors, though, is that the market will start discounting stocks using lower inflation-adjusted returns during inflationary periods. Even if stocks will outperform most other assets during inflationary periods, stocks with rosy built-in projections will get re-priced.
Contracting Profit Margins A Greater Threat
The biggest threat to stocks right now is not inflation but the unsustainably high corporate profit margins. Many stock-market investors don't realize that most of the profits over the last 5 years has been accumulating to businesses and this will likely reverse. Warren Buffett also alluded to this a few years ago when he referenced a chart showing corporate profits as a percent of GDP (refer to this post from Rational Angle for some past views from Buffett.) It is a certainty in my eyes that corporate profits as a percent of GDP will decline in the future. So be prepared for it! On top of bogus profits--such as "profits" from subprime loans to people who clearly were never going to pay them back--dissapearing, the most likely way corporate profits will decline is with higher taxes.
A future Democratic Presidential administration under Barack Obama will likely reverse the so-called tax-cuts for the wealthy (some of these cuts never should have been enacted in the first place.) A John McCain administration likely won't immediately reverse the massive Bush tax cuts but will still increase taxes in my view. The US government deficit is getting totally out of control and hence I think taxes will be raised regardless of who is drawing up policy (cutting some inefficient branches of the government or war spending is the ideal route but that ain't happening.)
Anyway, the market will likely discount stocks (downward) when profit margins contract. If you are a contrarian or a value investor buying with a big margin of safety, this won't have a big impact; but if you are buying close to market valuations, it will likely be a bigger issue than inflation.
(NOTE: Everything I say here applies to developed stock markets and USA/Canada in particular. Developing markets are totally different, with inflation being a huge problem almost at all times. Far more businesses in developing countries will have problems earning above inflation than in developed countries. It is much harder to pass down prices due to price controls, price ceilings, etc.)
Two remarks on the notion that corporate profits may decline as a share of GDP in the near future:
ReplyDelete1. The opening of the vast labor potential of India, China and the former Warsaw pact countries is putting massive pressure on wages. The balance of power between labor and capital has for the moment shifted decisively to capital. Given the huge reserve if underutilized labor remaining in those countries I don't see this changing soon.
Over here you can read regularly that workers at a given factory or other facility are given the choice between taking a big effective paycut (often largely in the form of longer hours and reduces benefits rather then a straight cut) or getting fired with the facility moved to Eastern Europe. The workers always cave. If I am not mistaken similar moves are afoot in the US (no clue about Canada).
2. At least in Europe the burden of taxation is shifting away from corporations and rich individuals, who are generally adept at tax evasion, and coming to rest on the (lower) middle class. Corporate tax is coming down and will continue to go down as long as places like the Baltic states offer rates of 15% with big allowances for reinvestment and the like. The US seems to be able to avoid this tax competition for now, but I doubt it will last.
In many ways the current period is comparable to the 1870-1914 period with large parts of the world opening to business and rapid technical innovation. In that time also labor was continuously on the defensive and wages declined as a share of GDP.
Much as a president Obama might want to jack up taxes "for the rich" he may find this impossible in practice without causing heavy flight of capital. (tellingly, our own socialist government over here is raising taxes on the poor and lower middle class while simultaneously mulling cuts in the corporate tax rate)
I think a decline in corporate profits as a share of GDP is not a given. It might happen, but some important developments are pushing the other way.
I concur with your first point. Namely, labour arbitrage will keep a lid on worker compensation.
ReplyDeleteHowever, there are two scenarios that will likely unfold.
The first scenario, as I mentioned in the post, is increased taxes. Your seem skeptical that tax increases will occur but I'm not so sure about that. The burden has been increasing on the working and middle class and it wouldn't surprise me if there was some backlash. Given the huge fiscal deficits in some countries, I just don't see government continuing to shift the tax burden to the middle class.
Also, do keep in mind that so-called Globalization seems to have hit some bumps of late. On top of some increased conflicts and disagreements, the increase in oil prices has made transporation less efficient.
The other scenario is inability of corporations to increase prices. If consumer demand is weak then businesses will have to absorb margin compression. Given that the consumer balance sheet in America (and most of the developed world) is stretched, I suspect corporations will see declining margins. In the past they have been able to pass on cost increases since the consumer was doing well. But with the consumer potential deleveraging in the future, I see companies absorbing increased costs.
To be clear, compression in corporate profit margin is not the same as declining profits. If the GDP is growing, corporate profits will still grow--but at a slower rate (and hence the market will price down the assets.)