Chapter 2 The Investor and Inflation
The annual inflation rate of about 2.5% for the entire period 1915-1970.
The rise of the DJIA from an average of 77 in 1915 to an average of 753 in 1970 works out at an annual compounded rate just about 4%, to which we may add another 4% for average dividend return.
There is no close time connection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices.
Inflation and Corporate Earnings
Another and highly important approach to the subject is by a study of earnings rate on capital shown by American business.
It has shown no general tendency to advance with wholesale prices or the cost of living. Actually this rate has fallen rather markedly in the past 20 years in spite of the inflation of the period. (To some degree the decline was due to the charging of more liberal depreciation rates. See Table 2-2.)
The cold figures demonstrate that all the large gain in the earnings of the DJIA unit in the past 20 years was due to proportionately large growth of invested capital coming from reinvested profits. If inflation had operated as a separate favorable factor, its effect would have been to increase the "value" of previously existing capital; this in turn should increase the rate of earnings on such old capital and therefore on old and new capital combined. But nothing of the kind actually happened in the past 20 years, during which the wholesale price level has advanced nearly 40%.
The only way that inflation can add to common stock values is by raising the rate of earnings on capital investment. On the basis of the past record this has not been the case.
In the economic cycles of the past, good business was accompanied by a rising price level and poor business by falling prices. It was generally felt that "a little inflation" was helpful to business profits. The effect of all this on the earning power of common-stock capital ("equity capital") has been quite limited; in fact, it has not even served to maintain the rate of earnings on the investment.
Clearly there have been important offsetting influences which have prevented any increase in the real profitability of American corporations as a whole. Perhaps the most important of these have been (1) a rise in wage rates exceeding the gains in productivity, and (2) the need for high amounts of new capital, thus holding down the ratio of sales to capital employed.
*Table 2-2 Corporate Debt, Profits, and Earnings on Capital, 1950-1969
Our figures in Table 2-2 indicate that so far from inflation having benefited our corporations and their shareholders, its effect has been quite the opposite. The debt of corporations has expanded nearly fivefold while their profits before taxes a little more than doubled. With the great rise in interest rates during this period, it is evident that the aggregate corporate debt is now an adverse economic factor of some magnitude and a real problem for many individual enterprises.
Alternatives to Common Stocks as Inflation Hedges
The standard policy of people all over the world who mistrust their currency has been to buy and hold gold. This has been against the law for American citizens since 1935-luckily for them. In the past 35 years the price of gold in the open market has advanced from $35 per ounce to $48 in early 1972-a rise of only 35%.
All we should say to the investor is, "Be sure it's yours before you go into it."
Commentary on Chapter 2
"Americans are getting stronger. Twenty years ago, it took 2 people to carry 10 dollars' worth of groceries. Today a five-years-old can do it."
Inflation? Who cares about that? After all, the annual rise in the cost of goods and services averaged less than 2.2% between 1997 and 2002-and economist believe that even that rock-bottom rate may be overstated. In recent years, the true rate of inflation in United States has probably run around 1% annually-an increase so infinitesimal that many pundits have proclaimed that "inflation is dead."
Inflation is not dead.
In years when the prices of consumer goods and services fell, as on the left side of the graph, stock returns were terrible-with the market losing up to 43% of its value. When inflation shot above 6%, as in the years on the right end of the graph, stocks also stank. The stock market lost money in eight of the 14 years in which inflation exceeded 6%; the average return for those 14 years was a measly 2.6%.
While mild inflation allows companies to pass the increased costs of their own raw materials on to customers, high inflation wreaks havoc-forcing customers to slash their purchases and depressing activity throughout the economy.
Stocks failed to keep up with inflation about one-fifth of the time.
2 Inflation Fighters: REITs (Real Estate Investment Trusts), TIPs (Treasury Inflation-Protected Securities)