How Did Everything Get Expensive When Reported Inflation Is Low?

by: Wayne Strout

Many have been bewildered by the stock and bond markets over the past year. This includes Nobel Prize winning economist and Yale Professor Robert Shiller who has recently been quoted as stating that the stock market, the bond market and the real estate market all seem “overpriced and expensive”. He says he is puzzled by the phenomenon and uses the analogy of “lifeboats on the Titanic” where people are willing to pay almost any price for protection from a bad future.

Most investors have been taught that a “balanced” portfolio includes a significant portion (30-50%) invested in “fixed income” because they are told that “bonds make money or maintain their value when stocks lose money” and “bonds protect you from market fluctuations”. This is called negative “correlation”. This teaching is not entirely correct.

Many times, bond rise in value when stocks are rising and fall in value at the same time stocks drop. This is called positive “correlation”. Keep in mind that bonds rise in value as interest rates fall, and vice versa: bonds fall in value as interest rates rise. (Interest rates are at historic lows meaning bond prices have risen to high levels.)

In fact, since 1927, we have had 27 periods where stock and bond correlations have shifted from negative to positive or positive to negative correlation. Most recently, interest rates have fallen with rising bond prices right along with rising stock prices. So both the stock market and the bond market seem to many to be overpriced and “expensive”. In the investment world, the term “expensive” means that if you bought at present prices, your return from interest or stock appreciation would be lower than normal… OR….that prices are likely to fall from present levels.

Despite the claims by many that “markets have a lot of room to run” I think that Professor has a point. Asset prices in general have risen quite a bit. (Home prices in the “hot” markets have risen despite the lag in other markets.) Yet, economic conditions, while admittedly improving slowly, are far from “boom times” that would justify a rising stock market. And, there appears to be a general sense of pessimism regarding the future by the majority of people in the developed world.

I would say that in the aggregate, people have bought the argument that wage inflation and inflation in general is subdued. Investors are seeking income. And, when income is hard to find, they are willing to pay a premium price to get it…..high prices for bonds and high prices for stocks. The only restraint on this behavior is fear of loss, but central banks around the world have committed publicly to “do what it takes” to protect investors from losses. So, if many people buy in to the myth that inflation will be low for a long time and therefore interest rates will be low for a long time, they will pay ever increasing prices and inflate the value of every form of investment: stocks, bonds, real estate, art, and collectibles. (With low interest rates the present time value of money received in the future is higher than when interest rates are assumed to be higher.) With the exception of single family homes outside of the hot coastal markets, Professor Shiller is right, everything has gotten “expensive” except the price of an hour of human labor and an outdated plasma TV.

A balanced portfolio should have a significant portion invested in low risk investments to balance the higher risks associated with stocks. Right now, as evidenced by the behavior of some of the world’s best money managers, that low risk investment is very short term fixed income that pays almost no interest, but does not fluctuate in value. Right now, bonds seem almost as risky as stocks. Warren Buffet’s Berkshire Hathaway currently holds almost 20% of their assets in cash!

Has this situation existed before? Can History teach us anything regarding what is about to happen? The answer is Yes and No. People believe in myths until the myths are proven false. Remember in the 1990’s when tech stocks did not need to be profitable, they just needed to be growing? Remember up until 2008, residential home prices could never fall? Remember Y2K when all our computers were sure to crash at the same instant? Right now, the myth is that central banks can provide protection from loss by flooding markets with liquidity and that they can do so forever without creating inflation.

Professor Shiller is correct, we have had significant inflation in price levels of stocks, bonds and some real estate. So, can somehow the central banks keep interest rates low forever? And, if not, then when do markets abandon this myth, leading to higher wages, rising inflation, and rising interest rates---all of which will lead to lower stock and bond prices.

(My belief is that governments and central banks have a very limited ability in the long run to affect the economy in a positive way. They cannot control interest rates anymore than they can control currency values. Central banks have proven throughout history that they do have one ability—to create inflation.)

By now, you should understand why market watchers sit on the edge of their seats to listen and react to every word from Janet Yellen of the U.S. Fed and every other worldwide central banker. The present situation is dependent on continued low interest rates and continued belief that there is little chance of loss. It will change when one of four things happen: 1) It appears the central banks are going to “allow” interest rate to rise; 2) Market participants begin demanding higher interest because of higher costs; 3) Some geopolitical “shock” occurs that causes investors to fear loss; and/or 4) Corporate earnings begin to fall or stagnate and investors decide to take profits, en masse to avoid losses from falling stock values.

My take is that “official” inflation is reported to be low because wages are depressed. I think central banks are focusing too much on the costs of labor and commodities—indicators of past cost-push inflation. They are underemphasizing other costs of doing business. I think corporations are reaching the limits of their ability to borrow and buyback shares in order to report increased earnings per share simply by reducing shares rather than actually increasing profits. I think that rising prices will occur due to the desire and need of public companies to increase profits and these rising prices will lead to a reduction in demand. I think we are already seeing this to some degree as evidenced by struggling retailers.

You see, the average consumer is smart enough to avoid paying too high a price for goods. (Even though they may occasionally be willing to pay too high a price for an investment!) Sooner or later, I think the market corrects with falling stock and bond prices, providing opportunity to buy attractive businesses at more attractive prices.

When exactly? NOBODY knows. Markets could rise significantly higher from here. Be patient, careful and prudent.

Don’t assume that the above analysis means I am pessimistic. I am not. I believe that a well managed investment portfolio will produce returns over the long run consistent with historical norms. Markets fluctuate from one extreme to another. Being “well managed” does not mean that we jump in and out—it means we simply adapt to the environment in the same way we adapt and adjust to the changing seasons.

Disclosure: None

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