Negative compounding effect of inflation not well understood by investors.
To kick things off on the Stockhouse moderated macroeconomics group (see background article here), SH writer/editor and group moderator Robert Arber (known on Stockhouse as SH_Arber) put out a call to the participants to define inflation – what it is, what it means, and how it is manifested in the economy.
The first participants to contribute were littleguy123 and arnoldj, whose thoughts make up part I of the Inflation and money supply series, published Tuesday, June 10. In part II, published the following Wednesday, frontline_jason and StilesBC carried the torch.
Today we present part III, to which self-proclaimed “indeflationist” gabrielgray weighs in. Part IV, coming Monday next week, sees members moving to a discussion of money supply and inflation measurement tools.
Please add your comments at the bottom of the page, and enjoy!
[Editor’s note: Posts have been edited for punctuation, spelling, grammar and length. Ticker symbols have been modified for Stockhouse style.]
Early in the discussion, StilesBC thought it appropriate (power to him) to disclose some of his investments. Here is what he said:
StilesBC: Thought leaving a little disclosure would be a good idea...
Bearish - deflationary bias
Supporter of Ron Paul
Libertarian, student of Austrian Economics
Long -
Cameco Corp. (NYSE: CCJ, Stock Forum) via calls
Silver
Keegan Resources (TSX: V.KGN, Stock Forum), Adriana Resources (TSX: V.ADI, Stock Forum)
Short -
Euros - via puts
Bank of America (NYSE: BAC, Stock Forum) - via puts
General Growth Properties (NYSE: GGP, Stock Forum) - via puts
Coach Inc. (NYSE: COH, Stock Forum) - via puts
gabrielgray: Really bearish. Indeflationary bias. Supporter of Ron Paul. Somewhat Libertarian, extremely Austrian. I can talk like Schwarzenegger.
I like U3O8 and silver. I'm shorting BAC through a low interest home equity line. =)
arnoldj: "Indeflationary bias"- that's pretty bearish alright…
gabrielgray: Calling the ‘flation is going to be tricky, in my view. Even though the U.S. money supply was debased continuously from 1980 through 2000, there was little inflation awareness during that period. That was mainly because consumer prices generally didn't reflect the monetary expansion. The disinflationary effects of offshore outsourcing of jobs and various productivity increases relating to high-tech manufacturing processes and IT tended to mask monetary inflation by keeping consumer prices tethered.
In the same way, whether or not you see the present environment as inflationary or not depends a lot on whether you're concerned with buying consumer basics, or trafficking in assets, especially paper assets. Gasoline is going up, but bonds, stocks and real estate are not. As arnoldj said, a bunch of fictitious capital in the markets gave rise to a bubble in stocks, real estate, credit derivatives and now commodities, and a lot of bad investments must be liquidated and bad debt destroyed before the markets can normalize. That process is by definition deflationary, but by accepting stacks of unmarketable paper in exchange for Treasury debt, the Fed is interfering with the process.
I think there are several reasons why the stock markets have yet to respond to the bad news. First of all, mainstream financial writers and investment house analysts seldom refer honestly to the depredations of currency debasement on financial asset gains. How likely is your average bond salesman to tell you, "Now the nominal interest rate yield is 3.3%, which after projected CPI inflation of 5.3% leaves you with a real yield of minus 2%, which is probably the best you can hope for in these inflationary days." It's not going to happen.
Second, very few people really understand the nature of monetary inflation or the negative compounding effect of year upon year of inflation. Over time, the chart of purchasing power looks just like an interest-compounding curve, only turned upside down. After a few decades, it goes parabolic towards Hades.
But maybe (and here I'm just taking a guess) the biggest reason is that the stock markets are actually looking forward with their eyes wide open and seeing.... inflation. Stock prices actually tend to hold up pretty well in nominal terms in periods of high inflation. That's because even a paper stock certificate with "General Electric" printed on it looks like a better vehicle for preserving wealth than a $100 bill when the credit presses are in overdrive.
The bad news is that, after adjusting for loss of purchasing power, stocks don't do very well at all in inflationary times. Everyone's heard about the Dow Jones Industrial Average being essentially flat from 1966 until 1982. What's less well known is that, after you back out the effects of dollar inflation, the poor sap who bought the Dow in 1966 didn't break even in real constant dollar terms until about 1990.
I'll finish out my thought with a few paragraphs borrowed from a post I made on the Minera Andes (TSX: T.MAI, Stock forum) board today. The big question is about how the inflationary effect of present Fed actions can only be answered when we know where the money is going to end up. The Fed loosened credit in 2002 hoping to reflate the stock market, but much of the new money flowed into real estate markets instead.
One of the next targets for reflation must be the bond markets, which are teetering on a tightrope way above their proper valuation levels in this environment. I think we'll be getting some visibility soon, because the California Public Employee Retirement System (CalPERS) fund is due to release its annual performance report this month.
CalPERS manages about $240 billion in investments, and they not only hold stocks and conventional bonds, but they have a very broad and deep portfolio of credit derivatives, including auction-rate securities and credit-default and interest rate swaps as well. Bad news is coming.
You may have seen an article by Adrian Ash last spring or early summer called "Investment Landfill," describing an interview with a derivatives trader who told him that Wall Street banks had offloaded much of their structured credit risk onto others by selling them credit-default swaps and synthetic CDOs as safe income streams with "remote" risk of failure. Ash asked the trader (who would not allow his name to be used) who they sold the risk to, and the trader said he couldn't say with certainty, but he had good reason to believe that a lot of it went to pension funds like CalPERS. The funds were desperate to achieve their 8% annual targets because the stock slump of 2000-2002 had put them behind on actuarial terms, and so they went chasing yield, almost always a big mistake. They forgot that rule, "Higher yield means higher risk."
It's hard to say how honest CalPERS will be about their fixed-income stuff. My guess is they'll try to hide behind Level 3 mark-to-model numbers as much as they can, because the losses must be horrendous. The asset-backed market is dead, the auction-rate securities market is crippled, and lots of this paper is simply worthless now.
But they can't hide the equities losses. Some highlights:
- 641,000 shares of Bear Stearns held on the books at $140 per share, now trading at $9.50
- 22,000,000 shares of Bank of America marked at $48 and above, now trading near $33
- 565,000 shares of Ambac (NYSE: ABK, Stock Forum) listed at $87+, now trading near $3
- 948000 shares of MBIA Inc. (NYSE: MBI, Stock Forum) at $62+, now trading below $7
- 23,000,000 shares of Citigroup Inc. (NYSE: C, Stock Forum) held at $51+, now trading at $21 (and headed for five bucks!)
…and lots more.
They have huge additional holdings in the financials which have mostly been clobbered since last June. We're not talking about haircuts, we're talking about decapitations. When these numbers hit the street in a few days, there will be pandemonium. Don't stand in front of the exits.
This group discussion was conducted with members of the Stockhouse community.
Next: Part IV brings the group together in a discussion of how to measure money supply growth, a crucial consideration when trying to gauge the rate of inflation. See Paul van Eeden take it on the chin from Stockhouse’s own next week in “Inflation and money supply, part 4: Measuring money.”
Archive
Investor groups launch with macroeconomics discussion
Inflation and money supply, part I: Treasuries crowd bonds
Inflation and money supply, part II: Buyer’s remorse
Spin-offs
Inflation debate stirs investors
