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Inflation, Interest Rates And QE3

QE1, then QE2 and now QE3. Here's a brief video that discusses this topic.

I would like to just add a few things. First, I agree in that equities is where it is at. With bond prices driven to what they are now, the yields are so small and when, not if, they do raise interest rates, whether it be 1,2, or 5 years down the road, they will take a big hit. Pretty basic econ 101, interest rates down, bonds up, interest rates up, bonds down. With interest rates near 0, the only way is up and it is only a matter of time.

In addition, with the fear of inflation, whether it is a legitimate worry or not, may exacerbate the situation. Granted I do not believe inflation will be a major concern. We have had it, it is integrated into our economics, it is happening and will continue to happen. But never say never.

As for predicting what will happen. These people may be right or wrong, but more often than not, they are wrong. So the smartest thing to do is what was said around minute 23 of the video. If you buy undervalued companies with a large margin of safety, you can have decent returns in a sub standard environment.

As a bonus, equities also have a built in inflation protection. Some more than others. Below is a rough example.

Let us have another imaginary cola X company. Say it cost 3 dollars for a 6 pack. They earn a net profit of 1.50 per six pack sold. And there is exactly one six pack sold per share of stock. Meaning each share earns 1.5 dollars per six pack.

Then we introduce inflation of 100%. Cola X is now 6 dollars a pack. Assuming all their margins stay the same, their profit will be 3 dollars per six pack. Or 3 dollars per share.

Assuming Cola X originally traded at a P/E of 15 as does all of its competitors . The stock price would be 22.50 (15 x 1.5). Now that the earnings has doubled, to maintain the same P/E, the stock price would need to be 45 (15 x 3).

The number will rarely ever work out like this, as this shows Cola X as a perfect inflation hedge or 1 to 1. Historically, it has been seen that it is closer to .5 or .6. Still pretty good with the additional potential for undervaluation and growth.

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