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  • Inflation: The Lowest Common Denominator 0 comments
    Aug 16, 2010 3:01 PM

    By


    Nathan Kawaguchi

    IgnoreTheMarket.com

     

      

    At the Merriam-Webster OnLine dictionary, the first three definitions of value are:

     

    1:  a fair return or equivalent in goods, services, or money for something exchanged

    2:  the monetary worth of something

    3:  relative worth, utility, or importance

     

    From an investment point of view, these could be combined to broadly define value as, “A fair or equivalent return relative to that for which something can be exchanged.”  It is important to understand this fundamental concept of value in order to protect investment portfolios during this period of unusually wide ranges of probable outcomes.

     

    The most basic decision about money is whether to spend it or save it.  While people as a whole are irrational in the short-term, we tend to be more rational over longer periods of time.  It is fair to assume that in the long run, a rational person’s primary concern should be real present value, which is heavily impacted by the expected rate of inflation.  We know this is true by observing hyperinflationary economies. 

     

    Even in less-educated developing nations, consumers perform present value calculations, often unconsciously.  During hyperinflation, paychecks are cashed and spent immediately upon receipt because people know the money only buys a fraction of the goods later in the day.  Unfortunately, many people fail to make the same basic present value calculations when we move from consumer goods to investments.

     

    Because value does not exist in a vacuum, investors must identify a basis for comparison—a common denominator by which to measure relative value.  Most long-term investors compare expected returns of various investments to “risk-free” U.S. Treasury securities.  Some use rates on 2-year notes, while others use 5-year or 10-year rates.

     

    Treasuries and their “risk-free” rates, however, are not the most fundamental unit of monetary or investment value.  Cash is more fundamental than treasury securities because it is 100% liquid and has zero principal risk (treasuries have principal risk if liquidated prior to maturity).  As we observed in hyperinflation economies, cash derives its value from the rate of inflation.  This makes inflation the most fundamental common denominator.  So why is this distinction from treasury securities so important for investors? 

     

    This distinction from “risk-free” treasuries is important because the potential for rapid inflation exists due to the expansion of the Federal Reserve’s balance sheet.  Yes, inflation is currently being offset by the slowing velocity of money and deleveraging of the private sector.  But without increasing bank reserve requirements or other limiting measures, the probability of high inflation will remain elevated.

     

    This particularly makes sense for investors who believe in mean reversion.  It makes no less sense to believe that inflation is mean reverting than it does to believe that risk premiums (multiples) are. 

     

    Some argue that the current spread of earnings yields over “risk-free” treasury rates suggests a heavy allocation to stocks.  However, the historic spread of “risk-free” rates over inflation is historically low.  If higher, or even average, rates of inflation resurface, financial markets are likely to fall because inflation has a huge impact on the real present value of long-duration investments such as stocks and bonds.

     

    Currently, it appears that the conservative approach for long-term investors is to hold an appropriate mix of high-quality stocks, short- to intermediate-term bonds, and a significant amount of cash.  While it may be frustrating earning essentially zero on the cash portion, the opportunity cost of staying safe in cash is currently very low compared to treasuries. 

    If inflation remains under control, or if we experience slight deflation, the non-cash portion should perform as implied by market prices.  However, if inflation is reignited, it is likely to be accompanied by higher interest rates, which could disrupt markets and present opportunities for those investors patiently waiting with cash in hand.

     

    For more insight, visit IgnoreTheMarket.com.




    Disclosure: No Positions
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