Business Week - 1979 - The Death of Equities

[Viking]

It is entertaining to read history. This article was written in 1979 (and NOT by Barry Ritholtz). Some lessons:

1.) The article was a great contrarian indicator - it actually called the bottom for stocks

2.) the persistent inflation of the 1970’s was terrible for most equity investors; bear markets can last a decade
==========

BusinessWeek: The Death of Equities: How inflation is destroying the stock market

https://ritholtz.com/1979/08/the-death-of-equities/

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The one rule whose demise did the stock market in could be summed up thus: By buying stocks, investors could beat inflation. Stocks were a reasonable hedge when inflation was low. But they proved helpless against the awesome inflation of the past decade. “People no longer think of stocks as an inflation hedge, and based on experience, that’s a reasonable conclusion for them to have reached,” says Richard Cohn, an associate professor of finance at the University of Illinois. Indeed, since 1968, according to a study by Salomon of Salomon Bros., stocks have appreciated by a disappointing compound annual rate of 3.1%, while the consumer price index has surged by 6.5%. By contrast, gold grew by an incredible 19.4%, diamonds by 11.8%, and single-family housing by 9.6%.

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There are at least four good reasons why inflation is killing equities:

• Stock prices reflect anticipated corporate profits. During periods of rapid inflation, however, profits fall because most businesses cannot raise prices quickly enough to keep up with costs.

• Even gains in profits are largely illusory because inflation makes them look rosier than they actually are. And because plant and equipment are depreciated at historic cost rather than replacement price, money that should go into capital investing and inventory purchasing instead goes to the government in taxes.

• Experience has taught investors that inflation will lead to an economic downturn that will wreck corporate profitability and stock prices. This happened in 1974, when the worst recession since the Depression followed the last burst of double-digit inflation.

• Investors jump from stocks to bonds to nail down high rates. Inflation also promtps corporations to sell debt because it is tax-deductible and can be paid off in cheaper dollars—thereby reducing the flow of new stocks to market.

Further, inflation makes investors very cautious. “We are coming down with the European disease,” says Thomas A. Martin, president of American Asset Management Co., pension managers with $127 million in assets. Indeed, European institutions have been putting up to 40% of their money into hard assets—especially real estate—for years.

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Just about the only group no discouraged by such figures are U.S. corporations. Although generally unable to sell stocks themselves, companies have jumped on low stock prices to set off the biggest takeover binge in history. “The merger boom is essentially an attempt to invest in hard assets,” points out one investment banker, adding. “A buy rather than build decision makes excellent sense, since buying at these prices is cheaper than building.” Indeed, in the past few weeks alone, Mannesmann of West Germany has announced plans to take over Harnischfeger for $245 million, Britain’s Midland Bank to acquire Walter E. Heller International for $531 million, and McGraw-Edison to buy Studebaker-Worthington for a staggering $723.5 million.

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Other corporations are following a slightly different strategy: Buying up their own shares. “The market is understating the real value of assets, and this does not encourage companies to add new assets but instead to use their cash to buy back their own stock,” says Salon Patterson, president of Montag & Caldwell Inc., an Atlanta investment adviser. Indeed, the average stock price is now about 60% of the replacement value of the underlying assets. Thus, a company can acquire $1 worth of assets by paying about 60~ for its shares. And despite soaring interest rates, borrowing to buy back stock makes sense because the debt will be paid off in ever-cheaper dollars that are tax-deductible to boot. Finally, by eliminating outstanding stock and the dividends on that stock, a company raises its earnings per share.

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Housing, in fact, has become the most popular inflation hedge for most Americans. “For the past five years, real estate has been the equity market that stocks used to be,” points out Allen Sinai, a Vice-president of Data Resources Inc., a leading economic consulting firm.

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Today, the old attitude of buying solid stocks as a cornerstone for one’s life savings and retirement has simply disappeared. Says a young U.S. executive: “Have you been to an American stockholders’ meeting lately? They’re all old fogies. The stock market is just not where the action’s at.”

 

Edited May 29, 2022 by Viking

[scorpioncapital]

" the persistent inflation of the 1970’s was terrible for most equity investors;"

 

Honestly I do not understand it.

Hyperinflation is very good for stocks. And where is the line between run of the mill 20% a year inflation and hyperinflation? Does something flip at some point to make the 70s result become its opposite in hyperinflation?
Venezuela had one of the best performing stock market of all time. Vertical. All assets, even financial, should skyrocket under high inflation. Of course the society may fall apart and everything confiscated but it seems even under this threat at least stocks do very well (although the currency is trashed and you have to sell your stocks for local currency).

 

Or was something else happening in that 70s article? Were interest rates rising by any chance? 

 

Also shouldn't we look at the 70s experience as a continous process. Sure there were gains after in the 80s but people who held from the 50s and 60s probably got clobbered on the 25 year downside. The sp500 was flat from 1968 to 1991 i think. That was all due to higher rates compressing multiples I imagine. Am I to understand that inflation accumulates stock gains by front-loading them and when the Fed 'fights inflation' , the front-ended gains (often called a bubble) are reversed, causing the index to revert to the level it was many years before??

Edited May 29, 2022 by scorpioncapital

[SharperDingaan]

History is always entertaining, but it also rhymes ....

 

Stocks rise primarily because shares are bought back with debt. Inflation typically reduces margins to sh1t, and the higher prices kill volume .. but if you multiple sh1t by higher leverage (debt to buy back shares), you can maintain the EPS number. However, buy back 10% of your stock and you raise EPS by 11% ((100/90)-1)x100. The multiple also increasing, the more your industry is going the buyback route (agency). Buy popularity, and buy the industries doing buybacks.

 

Under inflation it is better to buy versus build assets; the EPS benefit is immediate (no construction delay), and the transaction can be financed via inflated stock values. The seller uses the opportunity to sell their crap, and remove future liabilities from their BS (o/g ARO liabilities). But when the times change ....  debt on the buyers books, and the write-down on those crap assets, bankrupts the buyer. Sell when asset purchases are the norm, and park in cash.

 

The index on a domestic economy goes from 100 to 200; to the 'local', business is great it's up 100%! But to the foreign buyer .... if the FX rate on purchase was 1:1, and it is now .5:1, the return after FX devaluation is 0%. Exporters in commodity producing countries live very well, and it is summer in the southern hemisphere when it is winter in the northern hemisphere.

 

Nice thing with inflation, is that both coupon rate, and market yield rise as the CB acts to bring inflation under control. Convexity, and agency/media making the 'cash is trash, buy hard assets' case - driving competition and coupon rates higher. Turn today's 'opportunity loss' (agency) into tomorrow's debt/equity swap, park cash in provincial debt (NL), and simply wait for the CB to do its thing. Like the target company, but buy it at 10-15c in the dollar.

 

Lots of 'traders', all doing well, trading the story at various points in the inflation cycle.

But the real money going to the predators trading the 'traders' over the whole inflation cycle.

 

Good luck!

 

SD

 

 

 

[TwoCitiesCapital]

On 5/29/2022 at 3:57 AM, scorpioncapital said:

" the persistent inflation of the 1970’s was terrible for most equity investors;"

 

Honestly I do not understand it.

Hyperinflation is very good for stocks. And where is the line between run of the mill 20% a year inflation and hyperinflation? Does something flip at some point to make the 70s result become its opposite in hyperinflation?
Venezuela had one of the best performing stock market of all time. Vertical. All assets, even financial, should skyrocket under high inflation. Of course the society may fall apart and everything confiscated but it seems even under this threat at least stocks do very well (although the currency is trashed and you have to sell your stocks for local currency).

 

Stocks may have their prices rise, but there has NEVER been a high inflationary episode that was "very good" for stocks. 

 

Even in your example of Venezuela, the real purchasing power of the money invested in stocks was falling rapidly even as share prices climbed vertically. You'd have been better off holding foreign currencies outside of a bank and gold. 

 

Inflation drives people to hoard. In moderate inflations, people don't tend to hoard equities but focus on things like floating rate bonds, TIPS, commodities, oil, etc. Stocks tend to face margin compression which can result in falling earnings even as revenues rise. This is typically a negative environment for equities. 

 

Also, inflation doesn't have to be persistent. Even in the 1970s US, inflation started around 6%-7%, fell to 4%, rose to 12-13%, fell to 5%, and then rose to 15% before cratering back below 4% in the early 80s. These are dramatic swings in prices/expectations and leads to dramatic swings in supply/demand based on inflationary expectations. Equities do NOT do well in periods of uncertainty - not knowing if inflation will be 15%, or 5%, the following year fits that bill. 

 

Now in severe inflations, people will hoard ANYTHING. Physical goods. Real estate. Food. Etc. Anything is better than cash. Stocks get hoarded because because they have a longer shelf life than food and have a small amount of inflation protection from rising revenues. But you still tend to underperform other real assets and still tend to have a negative real return. It's not 'very good', but it is better than some alternatives. I'd still rather own gold, foreign currencies, foreign real estate, crypto, etc over equities in that environment. If you're going to play stocks, you're best bet is to be leveraged with non-recourse debt and pray you catch a pop and not a dump. 

[scorpioncapital]

"Even in your example of Venezuela, the real purchasing power of the money invested in stocks was falling rapidly even as share prices climbed vertically. You'd have been better off holding foreign currencies outside of a bank and gold. "

 

I don't know the situation but do you mean the stock rise was less than the currency devaluation?

 

What you write sounds sinister. Almost makes you want to take even a 50% stock drop to get rid of it. I suppose if you buy the stocks after they get knocked down you get real earning power which has to be more valuable than gold but perhaps less so than immediate needs like housing and food.

How do you know WHEN the inflation is coming to an end to buy though?

 

In a scary inflation would renters feel worried? Can you hypothetically get a case where all landlords evict everyone and retake posession for themselves? Presumably governments will enact laws and the worst case you need more worthless money to rent housing. If you don't have the extra money not sure what happens. Perhaps homelessness and poverty are a consequence of inflations. Then the homeless squat on properties, violence, real end of civilization stuf.. More likely the government via populism will expropriate the real property to give to those who can't keep up. What happens though when the entire middle class can't keep up? Seems inflation really leads to dog eat dog world.

Edited May 31, 2022 by scorpioncapital

[Gregmal]

Some inflation is healthy, crazy high inflation is not. All inflation eventually ends up being transitory. You will never get hyper inflation in a first world county.
 

So again you always have the “what if this happens” folks, who take the highest high, go out the longest tenure possible, and point to the lowest lows, and then assume nothing ever recovers. But these things always end up working themselves out. Then life goes on. Its why it becomes silly making the blanket bear predictions. Earnings don’t need to come down 50% or markets don’t need to crash 80% because rates or inflation are high for a few years. At some point you get past those few years and then those same folks go back to talking about how expensive everything is again. If you bought stocks in the 70s I’m pretty sure you had earnings growth and share appreciation for the next several decades….in fact, the 70s was the perfect time TO BE BUYING stocks, which is very different than the narrative being peddled today by folks about the 70s. Unless of course your goal was to not make money or avoid volatility/meaningless drawdowns.

Edited May 31, 2022 by Gregmal

[mattee2264]

Lesson from the 70s is that in the transition to an inflationary era paying high multiples especially for growth stocks doesn't work out too great. Especially if the central bank is serious about doing something about the inflation. 

 

I'm not convinced we are heading towards an inflationary era. Perhaps in relation to commodity prices given resource scarcity and governments making it difficult to bring new supply online. But aggregate demand will cool down as all the stimulus wears off and supply chain issues will ease and the labour market should normalize as well.

 

At the same time the inflation genie is out of the bottle which probably does mean that there will be more cyclicality (as the Fed can no longer prioritize full employment) and interest rates will probably have to average a lot higher than the last decade and both factors are negatives for stock prices and while the FANG stocks should continue to do well they won't be as supportive of stock price appreciation as they have been over the last 10 years and multiple compression could be a headwind. Accompanying multiple compression could be some margin compression. Since the GFC earnings have grown a lot faster than revenues helped by margin compression and buybacks using cheap debt. I think going forward earnings growth will be more closely tied to GDP growth. 

 

 

[thepupil]

15 hours ago, Gregmal said:

Some inflation is healthy, crazy high inflation is not. All inflation eventually ends up being transitory. You will never get hyper inflation in a first world county.
 

So again you always have the “what if this happens” folks, who take the highest high, go out the longest tenure possible, and point to the lowest lows, and then assume nothing ever recovers. But these things always end up working themselves out. Then life goes on. Its why it becomes silly making the blanket bear predictions. Earnings don’t need to come down 50% or markets don’t need to crash 80% because rates or inflation are high for a few years. At some point you get past those few years and then those same folks go back to talking about how expensive everything is again. If you bought stocks in the 70s I’m pretty sure you had earnings growth and share appreciation for the next several decades….in fact, the 70s was the perfect time TO BE BUYING stocks, which is very different than the narrative being peddled today by folks about the 70s. Unless of course your goal was to not make money or avoid volatility/meaningless drawdowns.

stocks returned less than t-bills in the 70's (5.4% vs 7% 1968-1981), and abouyt the same as high quality bonds.... but of course that massive decade long de-rating set things up for a hell of a next 40 years. 

 

the equivalent of t-bills in the 70's is i-bonds since normal t-bills don't yield 7%. 

 

Edited June 1, 2022 by thepupil

[thepupil]

[manuelbean]

On 5/29/2022 at 8:57 AM, scorpioncapital said:

" the persistent inflation of the 1970’s was terrible for most equity investors;"

 

Honestly I do not understand it.

Hyperinflation is very good for stocks. And where is the line between run of the mill 20% a year inflation and hyperinflation? Does something flip at some point to make the 70s result become its opposite in hyperinflation?
Venezuela had one of the best performing stock market of all time. Vertical. All assets, even financial, should skyrocket under high inflation. Of course the society may fall apart and everything confiscated but it seems even under this threat at least stocks do very well (although the currency is trashed and you have to sell your stocks for local currency).

 

Or was something else happening in that 70s article? Were interest rates rising by any chance? 

 

Also shouldn't we look at the 70s experience as a continous process. Sure there were gains after in the 80s but people who held from the 50s and 60s probably got clobbered on the 25 year downside. The sp500 was flat from 1968 to 1991 i think. That was all due to higher rates compressing multiples I imagine. Am I to understand that inflation accumulates stock gains by front-loading them and when the Fed 'fights inflation' , the front-ended gains (often called a bubble) are reversed, causing the index to revert to the level it was many years before??

 

I think you might enjoy reading this one from Buffett back in 1977.

 

http://csinvesting.org/wp-content/uploads/2017/04/Inflation-Swindles-the-Equity-Investor.pdf

Edited June 2, 2022 by manuelbean

[scorpioncapital]

22 hours ago, thepupil said:

 

So bills did yield 7% in the 70s? I am not sure if holding cash in a money market won't eventually get to be a return (almost) the same as a i-bond or any shorter term bond. But the escalating phase takes some time so maybe that is why people buy a TIP or 2-5 year bond, trying to time the rate of acceleration of rates.