Intelligent Investor Ch. 2&3 - Inflation & Stock Market History

The Investor and Inflation

Inflation is when prices increase and you hereby lose purchasing power! Something that cost $100 dollar this year might cost $130 dollars next year. On this basis, many financial authorities have concluded that:

1. bonds (or any other fix income security) are an undesirable form of investment
2. common stocks are more desirable than bonds

So the question that this chapter in the books is to shed light on this statement. The book uses past experiences to try to make some intelligent conclusions for the future. The world had a lot of inflation in the past and from the statistics, there have been times where bonds performed better than common stocks and vice versa!

Inflation and Corporate Earnings

How the rate of inflation affects corporate earnings is not clear, but the two important effects of inflation are:

1. A rise in wages rates exceeding the gains in productivity
2. Huge amounts of new capital (especially for companies with high capital need)

The short summary and conclusion here are that it was generally felt that "a little inflation" was helpful to business profits, where good companies could raise prices but poor business had falling prices. 

Alternatives to Common stocks against Inflation

The book mentions gold and real estate as an inflation hedge, but gold was discarded due to no income return on the invested capital, and in real-estate, the wide fluctuations can destroy your investments, as there are based on location, the price paid, etc.

To summarize it here, there is no certainty that common stocks or bonds that will fully protect you against high inflation. The commentary section of this chapter, with latest statistics, put it in another light:

"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"

As soon as the inflation shot above 6%, common stocks also sucked!

A Century of Stock Market History

The stock market swings a lot between highs and lows and everything in between. You have times of many years of prosperity (bull markets) and then you have times where markets are declining (bear markets). 

In general, common stocks in bull markets increases with corresponding increases in earnings and dividends. But it is far from a 1:1 relationship - markets are normally overpricing companies in bull markets and underpricing companies in bear markets. 

The Price/Earnings ratio of stock can give some guidance on how the market is valued or better how the market temperature is. In general, you can assume, that with a P/E ratio below 10 it is considered low, between 10 and 20 moderate, and greater than 20 is expensive. If we follow the rules and look at the S&P 500 P/E right now, it is > 20, which says to us the market temperature is expensive - but that doesn't mean that there are common stocks that trade below 10! 

Regardless of which market condition you are investing in, there is a great section in the book with the title "What Course to Follow" that you really should follow (as it was written  in 1964 condition where the market was "expensive"):

1. No borrowing to buy or hold securities
2. No increase in the proportion of funds held in common stocks
3. A reduction in common-stock holdings down to a maximum of 50 percent of the total portfolio. 

The Commentary section further explains what the stock market's performance depends on:

1. Real growth (Increase of companies earnings and dividends) 
2. Inflationary growth (general rise of prices in the economy)
3. Speculative growth or decline (public's appetite to pay extra on top)

So in the long run, you could on average expect 6% return on common stocks (Real Growth (1.5%-2%) + Inflation (2.4%) + Dividends (1.9%)) - or after inflation roughly 4%!

The greatest lesson of this chapter, except the expected return, is that:

"The only thing you can be confident of while forecasting future stock returns is that you will probably turn out to be wrong"