Almost all investors use a benchmark to set expectations for a portfolio's performance. For equity securities, those benchmarks may include the major market indices (Dow Jones Industrial Average, S&P 500, Nasdaq, etc.). Treasury yields provide a benchmark for bond securities based on duration. Additionally, these measures may be blended to create portfolio benchmarks based on asset allocation (i.e., 60% stocks, 40% bonds).
However, the benchmarks above do not provide clarity as to whether the value of the portfolio is maintaining the purchasing power of its assets. Today, with gas approaching $4 a gallon nationally and the pending rise in the price of corn, are investments keeping up with the changes in the prices of goods and services we purchase?
Investors can use the Consumer Price Index [CPI] as one measure of an investment's purchasing power of goods and services. CPI is a monthly dataset of price changes in goods and services purchased by urban consumers. The United States Department of Labor's Bureau of Labor Statistics [BLS] updates and publishes this dataset monthly: http://www.bls.gov/cpi/. The approximate weighting of the CPI per expense category is as follows: 16% Food and Beverages, 41% Housing (including Rent), 4% Apparel, 17% Transportation, 6% Medical Care, 6% Education and Communication, 6% Recreation, and 4% Other.
CPI Represents the "Break-Even" Benchmark
It has been nearly five years after the US financial markets reached all-time highs, and subsequently, multi-year lows in the 24 months following this peak. Did investors who bought and held securities during these volatile times ever make it back to break-even?
As an example, this article will first compare the performance of two widely held ETFs, iShares S&P 500 Index ETF (IVV) and iShares Barclays Aggregate Bond Fund (AGG) versus the Consumer Price Index from August 1, 2007 to July 31, 2012. The selection of these two ETFs is to provide a simplified measure of total stock market and bond market performances, respectively.
The graph below simulates a hypothetical investor deciding to buy $10,000 worth of IVV, AGG, and a security mirroring the performance of CPI on August 1, 2007.
Click to enlarge images
Sources: Bureau of Labor Statistics (bls.gov) and iShares
From a nominal standpoint, it took almost 4 years for the investment made in IVV on August 1, 2007, which plunged over 40% in market value, to recover to its cost basis value. However, the investment in IVV is still approximately 4.1% below its purchasing power break-even benchmark as measured by CPI as of July 31, 2012. Conversely, the investment in AGG as of July 31, 2012 is approximately 26.0% above the same benchmark.
Applications: Stock Evaluation and Portfolio Allocation
CPI is applicable as a benchmark to either individual securities or multi-asset portfolios. In the case of the former, CPI provides a tool to evaluate whether a stock's dividend yield and price performance maintains the purchasing power of the value of the original investment. For instance, this distinction can determine whether buying a defensive stock (low price volatility vs. S&P 500, 3% or higher dividend yield) is actually providing some protection against a negative trending market and inflation.
The following graph illustrates the five-year performances of two familiar dividend-paying consumer staple companies, Campbell Soup Company (CPB) and General Mills, Inc. (GIS), versus CPI using the same hypothetical investment of $10,000 on August 1, 2007.
Sources: Bureau of Labor Statistics and Yahoo Finance
In this example, investors who purchased both CPB and GIS recovered their nominal investment. However, CPB underperformed against CPI by approximately 4.5%, whereas GIS outperformed CPI by approximately 46.8% as measured by the value of their performances as of July 31, 2012. Even though both firms distribute approximately the same dividend yield today, these returns indicate that GIS should rank higher as a potential consumer staple investment over CPB.
CPI can also determine whether asset allocations deliver protection from market downturns and increases in the prices of goods and services. As illustrated in the first graph in this article, an asset allocation of 100% stocks in a portfolio modeled similarly to the S&P 500 index would have underperformed CPI and other asset allocations, respectively. However, most investors tend to have a balanced portfolio of stocks, bonds, and alternative assets, such as gold, commodities, currencies, etc.
The following graph diagrams the five-year performance of three simplified multi-asset portfolios versus CPI using the same hypothetical investment of $10,000 on August 1, 2007.
- 40% AGG, 60% IVV
- 20% AGG, 80% IVV
- 35% AGG, 55% IVV, 10% IAU (iShares Gold Trust ETF)
Sources: Bureau of Labor Statistics and iShares
All three of these portfolios outperformed the benchmark as measured by their asset value as of July 31, 2012. Overall, portfolios with diversified bond and gold holdings mostly outperformed the S&P 500 over the last five years due to the flight from risk caused by the US recession and the sovereign debt crisis in Europe. As an example of a vehicle to protect against the still unfolding issues in Europe, investment grade US corporate bond-holdings should continue to protect portfolios from market downfalls and inflationary risks.
Analysis and Conclusions
Using CPI as a benchmark allows any investor to determine whether their investments are at a minimum, maintaining their purchasing power. The performance of CPB indicates that even a consumer staple company's stock that maintains a 3% dividend yield can underperform relative to CPI, which may be due to factors including macroeconomic conditions and product innovation strategies. In the case of GIS, its stock performance can be attributed to its market share in multiple product channels (cereal, yogurt, frozen meals, etc.) that allow it to address and capitalize on changing consumer tastes. On the other hand, CPB is limited in its product offerings. To summarize, failure of stock returns to exceed CPI indicates that the firm may face substantial headwinds and investments in such firms should be avoided.
Equally, this benchmark emphasizes investment diversification of its assets. The multi-asset portfolio with 10% of its initial funding allocated towards gold outperformed the portfolios with funding allocated only to equities and bonds over the same period by a minimum of approximately 10.0%, and CPI by approximately 18.8% as shown in Graph 3. Diversification contributes toward inflationary risk protection, but that strategy can also backfire if not monitored. For instance, if these hypothetical portfolios had substantial holdings in real estate or investment banks at the end of 2008, they would have substantially underperformed against CPI.
The Consumer Price Index is a publicly available and straightforward tool for investors, but it can be improved. As the demographics in the United States shift toward an older average age, the BLS should consider changing the weighting of the expense categories of CPI, especially as it relates to healthcare costs. Additionally, investors can create their own version of CPI from the data available at BLS. Experimentation with the expense allocation over time can be beneficial, especially if consumer-spending habits change.
As with other benchmark strategies, past performance may not be indicative of future returns. CPI should be used in tandem with other fundamental and technical analyses to determine optimal investment choices.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.