Buffett on Inflation and Stocks (Part 1)

[Parsad]

Ersatz Munger may not realize that his box of corn flakes has been shrinking while the price has stayed the same.

 

Yeah that's exactly right Roger!  This has been happening with so many different products.  In Canada, a jar of mayonnaise that used to come in a litre jar, is now coming in an 800mL jar for the same price.  I've seen alot of companies do this with their products over the last year.  And I think it is going to get worse.  Newsprint prices have rocketed up, Starbucks is jacking up prices, everywhere I'm looking prices are rising.  

 

But we are also seeing a ton of companies offering zero interest rate loans for two, three and even five years on all sorts of things.  Almost every car dealer out there is offering zero interest rate financing right now on at least some vehicles, if not their entire fleet.  So the low interest rate environment is actually hiding the fact we've been experiencing relatively strong inflation.  Cheers!

[Munger]

"You had a 33% correction over the next two years and then the market doubled over the next four years.  Even if you had invested in the general market at the top of 1939, you would have been ahead versus holding cash six years later.  If you averaged down as the market went down, you would have done even better!  In the meantime, you were also reaping dividends that would have increased your average investment return."

 

No doubt the right approach if you're not confident in your ability to identify margin of safety.  Buffett has long recommended this approach to the masses.

 

Personally, I have no doubt in my ability to identify margin of safety and I'll wait for the fat pitch.  And the current margin of safety is low at best.

[Munger]

Just to be entirely clear -- from the peak in September 1939 to the trough in April 1942, the market was down 40%.  Wonder what many individual stocks did during that period?  Of course we know the answer -- they got slaughtered far worse than 40%.

[zippy1]

Just to be entirely clear -- from the peak in September 1939 to the trough in April 1942, the market was down 40%.  Wonder what many individual stocks did during that period?  Of course we know the answer -- they got slaughtered far worse than 40%.

From the above, you must also mean that many other stocks did lose less than 40% and did better? 

[Munger]

From the above, you must also mean that many other stocks did lose less than 40% and did better?

 

No I do not also mean that...  But thanks for clarifying my point -- most stocks are not in the index that was down 40%. 

[goldfinger]

Yeah that's exactly right Roger!  This has been happening with so many different products.  In Canada, a jar of mayonnaise that used to come in a litre jar, is now coming in an 800mL jar for the same price.  I've seen alot of companies do this with their products over the last year.  And I think it is going to get worse.  Newsprint prices have rocketed up, Starbucks is jacking up prices, everywhere I'm looking prices are rising.

 

I leave in California and while I noticed some of that a while ago, I haven't seen that recently. Most of the things I buy have actually stayed the same in price and quantity. Maybe it will change again... There is a lot of deals for cars (used and new) and there are sales everywhere I go as shops are going down one after the other.

As for the (total) money supply, it actually shrunk in the last year by at least a trillion in spite of the more than doubling of the monetary base.

[alpha231616967560]

 And the current margin of safety is low at best.

 

You're focused on the macro picture to the exclusion of individual companies. It's no wonder that you're talking about being mostly in cash. The margin of safety applies to companies and individual situations, not to the economy as a whole. This is why Buffett can often be heard echoing Benjamin Graham in saying that he spends no time thinking about the macro environment when evaluating an investment. If you think that you can time the macro economy, you're fooling yourself.

[Munger]

You're focused on the macro picture to the exclusion of individual companies. It's no wonder that you're talking about being mostly in cash. The margin of safety applies to companies and individual situations, not to the economy as a whole. This is why Buffett can often be heard echoing Benjamin Graham in saying that he spends no time thinking about the macro environment when evaluating an investment. If you think that you can time the macro economy, you're fooling yourself.

 

No. 

 

The macro certainly affects individual companies and stocks.  With that said, I am not trying to time the macro.  If great companies were valued at 5-7x earnings, I would buy hand over fist today, regardless of the macro.  And don't be so naive, Buffett understands the macro risks probably better than anyone on the planet.  Buffett looks for a margin of safety that allows him to ignore any macro risks -- important distinction.

 

 

[alpha231616967560]

Buffett looks for a margin of safety that allows him to ignore any macro risks

 

Bingo. That MOS doesn't *ever* come from the macro economy. That's the point.

[Myth465]

This is a broken record. I would prefer if you responded within threads of individual ideas. Your thesis seems to be the market is expensive wait till its cheaper. We arent market buyers.

 

What dont you like about the individuals ideas discussed?

[rranjan]

This is a broken record. I would prefer if you responded within threads of individual ideas. Your thesis seems to be the market is expensive wait till its cheaper. We arent market buyers.

 

What dont you like about the individuals ideas discussed?

 

+1

[Parsad]

This is a broken record. I would prefer if you responded within threads of individual ideas. Your thesis seems to be the market is expensive wait till its cheaper. We arent market buyers.

 

What dont you like about the individuals ideas discussed?

 

+2

[premfan]

+3

[Cardboard]

I don't know about Munger's portfolio, but I do own individual issues since they are very cheap and let me tell you, their recent stock performance sucks. If your companies are not part of the ETF's or being very large then they are not participating in this rally. There are exceptions of course, but I see little to no interest in micro caps.

 

So value is there in some places, but there are no buyers to make it surface. Some will go private I suppose as many have over the past 18 months. Also, when I say value, I mean stock that can double and triple. Big caps at 12 to 15 P/E with little to no growth may interest some, but not me. With the correlation present out there in big caps, might as well buy the SPY and forget about the stock market all together. You stock pick for what reason? To make 10% instead of 9%?

 

Regarding the overall market, it is a bubble in the making IMO. Thanks to the Fed and guys like Tepper. Unless earnings suddenly explode with a surging economy, you are paying a fairly high P/E for little apparent growth.

 

The other thing that I find funny is that we never hear the other side of the story. If there is inflation down the road and I mean any small sign of it, then do you believe that treasuries will stick at 2.38% on the 10 year? If rates go rapidly to 5 or 6%, will the paltry 1.9% yield on the S&P look so attractive?

 

And what is that going to do to the economy? Even the earnings on my ignored stocks will get hit hard under a surging treasury yield. That is the macro risk here IMO: a loss of control of yields or currency or both.

 

Don't you guys remember late 08 and early 09 and how useless were any of the moves attempted by the Fed? The sellers kept on selling until they were done. It did not matter what the Fed or the Treasury were trying to do. They had no control whatsoever. This QE2 and yield chasing is dangerous. There is a belief out there that the Fed can control everything right now. This is retarded. It seems to me that it would take very little to unwind it all. Just a small change in confidence due to some event, which will be used as the excuse, to then interpret reality very differently. By the way, it is very hard to notice that you are part of a mania when you are in it. What I see since early September are the pavlov dogs coming in every trading day for their 0.5% fill.

 

Cardboard

 

 

 

 

 

 

 

[Myth465]

Grant is much more eloquent then you are I and he echos my assumptions.

 

http://www.gurufocus.com/news.php?id=109037

 

I think you guys dont give the fed enough credit, and perhaps at times give them too much credit.

 

There concern isnt only the market, we also have a race to the bottom with regard to currencies and a faltering economy with a useless Congress. If they stand still and the dollar rises then most feel the US economy will fail to recover. Asia is intent on keeping a weak currency and inmo we have the beginnings of a currency war. I think the fed believes they can weaken the dollar and others will follow - if they do then assets rise bailing out everyone, if they dont then we have a weak dollar with rising exports. The risk is everyone losing confidence at once and bailing on the system. One has to ask oneself where will they go? If every country around the world increases the price of everything by an equal factor then what happens. Personally I think its the plan.

 

Brazil, Russia, India, China, the UK, EU, and most of South Asia all want a weak currency. Who will not inflate, and loose all exporting ability? Its a huge game of chicken. I dont know how it all will turn out. Its far too complex for me. I just know my stocks are cheap and the only thing stupider then holding stocks which are backed by a variety of different assets - is holding FI and Cash.

 

---

 

Cardboard, I dont think its a huge Mania, I believe its a good old fashion rally. We went down and now people want a reason to go up, and they are latching on to QE. All of my stocks have been in on this rally and many are small. Even FBK is up a bit. One piece of bad news and we stop and a series of bad news starts taking us back down. I think it will continue for a while, even years between 8500 and 12500. I say get on when its cheap and off when its dear. Bonds are a bubble but who here owns bonds, who here owns treasury? I think that talk should be saved for another audience. People feel like they are missing out. They should have got in at 9900 when Parsad said things were cheap, now they are late to the party but still want to dance. Those are the same guys who will leave late when the cops knock on the door and get busted. Its a cycle. Rinse repeat.

 

I think Tepper is doing the right thing. The man manages billions, he has to do something with it. Should he tell his people he is going to hold cash while the Fed is promising it will be worth much less tomorrow. Its a world full of risks and bad decisions. One has to pick one and move on.

 

----

 

Munger I would still like an answer to my question, and would also like to know what you are doing with your money. If you are holding cash then I think we should wait and see how that works out.

[Munger]

Myth -- happy to move on but note most of my most recent posts have been in response to absurd comments like the one I will now address.

 

Bingo. That MOS doesn't *ever* come from the macro economy. That's the point.

 

This comment is absurd as it doesn't relate to anything previously discussed -- the person is living in their own world.

 

As evidenced by the origination of this thread, Buffet does pay attention to macro risk -- he wrote a lengthy and incredibly insightful essay on the impact of inflation (a macro factor) on equity returns.  Macro risks are among the many that must be considered when determining the required margin of safety.

 

Moving on to Myth's comments -- I just plain disagree, in the most respectful way possible.

 

Grant is an intelligent man but has not proven much of an investor.  I've been a long time subscriber and he is insightful and I have learned a lot about the history of finance and markets but I have rarely walked away with a great investment idea.  Note Grant long argued for a booming and robust recovery from the current recession -- not such a great call.

 

Cardboard, I dont think its a huge Mania

 

Could not disagree more -- we are in the middle of a mania surrounding QE2, fueled by guys like Tepper talking his trading book.  Not a mania of tulip bulb proportions but the hysterics around QE2 are everywhere, everyday.

 

People feel like they are missing out.

 

Sounds like the making of a mania.

 

They should have got in at 9900 when Parsad said things were cheap

 

Let's be clear -- the stock market did not spike in Sept because people woke up and thought stocks were cheap.  The market has gone up because of the hype around QE2, which has not doubt caused some short covering.

 

I think Tepper is doing the right thing. The man manages billions, he has to do something with it. Should he tell his people he is going to hold cash while the Fed is promising it will be worth much less tomorrow.

 

Tepper sounded like an idiot on CNBC.  The guy is not an investor in the mold of Buffet, Munger, or BG.  He is a trader and hearing him talk the other day reminded me Jesse Livermore.  Using Tepper's name on a board dedicated to Buffett is a borderline criminal offense:)

 

Should he tell his people he is going to hold cash while the Fed is promising it will be worth much less tomorrow.

 

This is part of the mania -- there is absolutely no guarantee that the Fed policy will work -- see Japan.

 

Its a world full of risks and bad decisions. One has to pick one and move on.

 

Again -- borderline criminal statement on a board dedicated to Buffett.  How many times has Buffet asserted that the great investors realize they don't have to swing -- they can sit on their ass and wait as long as it takes for a fat pitch.

 

 

If you are holding cash then I think we should wait and see how that works out.

 

You are intoxicated with QE2, the "certainty" of dollar debasement, and cash is trash.  "Playing" a trade on QE2 is just not my style.   And I agree only the passage of time will show the correct approach -- so let's move on...  

 

 

 

 

 

 

 

 

 

 

   

 

 

 

 

 

 

 

 

 

[tradevestor]

Hi Munger,

 

You make great points, and am hoping to get your thoughts on these.

 

1. Currently, there are two main, opposing macro events. A rapidly de-leveraging credit bubble (deflationary), and QE2 (inflationary).  Eventually, whether we will have deflation or inflation will depend on the difference in magnitude of these two.  I believe that deflationary spiral has not played out yet, and there's still more time before housing market stabilizes. That said,  I am seeing the effects of inflation in the commodities and consumer market.  So, maybe, these forces are affecting different segments differently.

 

2. In an inflationary environment, the prices of everything goes up as currency is devalued.  Wouldn't this raise the (relative) price of the book values (comprised of real assets) of companies ? Wouldn't the stock price reflect that ?

 

Thanks

[Myth465]

Myth -- happy to move on but not most of my most recent posts have been in response to absurd comments like the one I will now address.

 

Bingo. That MOS doesn't *ever* come from the macro economy. That's the point.

 

This comment is absurd as it doesn't relate to anything previously discussed -- the person is living in their own world.

 

Macro is an important and unknowable thing. Which is why one shouldn't overdue it. Thats one of those Buffett quotes you so selectively choose to ignore. I would prefer to listen to him vs. a person who thinks he knows what he means. Buffett speaks in simple words, I dont think he needs an interpreter.

 

 

As evidenced by the origination of this thread, Buffet does pay attention to macro risk -- he wrote a lengthy and incredibly insightful essay on the impact of inflation (a macro factor) on equity returns.  Macro risks are among the many that must be considered when determining the required margin of safety.

 

Moving on to Myth's comments -- I just plain disagree, in the most respectful way possible.

 

Grant is an intelligent man but has not proven much of an investor.  I've been a long time subscriber and he is insightful and I have learned a lot about the history of finance and markets but I have rarely walked away with a great investment idea.  Note Grant long argued for a booming and robust recovery from the current recession -- not such a great call.

 

Lol Grant is on your side, he feels the Fed has gone mad. But he is useful in terms of his explanation for whats going on and more importantly why, which mirrors mine.

 

 

Cardboard, I dont think its a huge Mania

 

Could not disagree more -- we are in the middle of a mania surrounding QE2, fueled by guys like Tepper talking his trading book.  Not a mania of tulip bulb proportions but the hysterics around QE2 are everywhere, everyday.

 

Fair enough. I think its a market. Fear and Greed, 2 extremes. The market going up 10% after going down 20% hardly seems like a mania. Maybe it will turn into one, but my guess is it turns on the first piece of bad news. We have had a good week or two after 5 - 6 bad ones. With a 24 hour news cycle everything feels like a mania. Europe issues were made to feel like the world was coming to an end. Funny how its only a mania when things go against your theory. I think they call that confirmation bias.

 

I can honestly say I dont know what the hell will happen. I think / hope its going to be range bound while things sort themselves out. Either way I buy cheap and sell ...

 

 

People feel like they are missing out.

 

Sounds like the making of a mania.

 

They should have got in at 9900 when Parsad said things were cheap

 

Let's be clear -- the stock market did not spike in Sept because people woke up and thought stocks were cheap.  The market has gone up because of the hype around QE2, which has not doubt caused some short covering.

 

Sounds like a market to me. People got in because they thought they missed the boat. I got in because my stocks were cheap. I will get out when it gets less cheap and they will probably take the hit and ride it down. Then I will get back in. Buy cheap, sell dear. Jim Rogers has the best rationale. The market rallies when it needs to and sales off when it needs to. It will find a reason to do what it needs to do. Why they get in doesnt matter to me. I buy cheap, sell less cheap in this market, dear in a normal one.

 

 

I think Tepper is doing the right thing. The man manages billions, he has to do something with it. Should he tell his people he is going to hold cash while the Fed is promising it will be worth much less tomorrow.

 

Tepper sounded like an idiot on CNBC.  The guy is not an investor in the mold of Buffet, Munger, or BG.  He is a trader and hearing him talk the other day reminded me Jesse Livermore.  Using Tepper's name on a board dedicated to Buffett is a borderline criminal offense:)

 

The man has made more money then this board aggregated. Stop being such a purist. He obviously knows something and it all spends the same, and you dont get extra points for doing it the Munger way. His thesis was 100% correct during the financial crisis. Calling him an idiot is like calling Soros an idiot because he doesnt invest how you do. Lets save that word for the real idiots - Jim Cramer.

 

 

Should he tell his people he is going to hold cash while the Fed is promising it will be worth much less tomorrow.

 

This is part of the mania -- there is absolutely no guarantee that the Fed policy will work -- see Japan.

 

Its a world full of risks and bad decisions. One has to pick one and move on.

 

Again -- borderline criminal statement on a board dedicated to Buffett.  How many times has Buffet asserted that the great investors realize they don't have to swing -- they can sit on their ass and wait as long as it takes for a fat pitch.

 

If you are holding cash then I think we should wait and see how that works out.

 

You are intoxicated with QE2, the "certainty" of dollar debasement, and cash is trash.  "Playing" a trade on QE2 is just not my style.   And I agree only the passage of time will show the correct approach -- so let's move on...  

 

First of all your hero's business partner is convinced of the certainty of Dollar debasement. History has shown that the dollar has been debased on just about a yearly basis. Second, who here is trading on QE2?

 

Third, Lol you totally missed my point. Your options are as follows - Stocks, Bonds, Gold, Commodities, Housing / Realty, or Cash. All are bad options. Pick one and move on. I pick Stocks. You pick Cash. I hold some cash to hedge my bets, sleep a little better, and reload on the downside. Your rhetoric and refusal to name 1 investment idea implies that you hold significant amounts of cash, waiting on that magical day where the best companies in the world trade for pennies on the dollar.  I am not thrilled about my prospects but yours look pretty bad as well. For a guy like Tepper who manages billions to hold more then 20 or 30 percent cash would be almost criminal. He would simply lose his assets under management.

 

The market is full of uncertainty. Get used to it. Make your bed, lie in it, and sleep tight. I am indifferent to QE2 from an investment perspective. I think its ingenious from a monetary academic perspective (global coordinated inflation). Bernanke's job sucks. Inept fiscal policy, stupid electorate, useless Congress, 20% real unemployment, deflation on the horizon, everyone trying to debase there currency to inflate the dollar stealing our manufacturing and pushing up our unemployment, and 70% of the US Engine / 14% of the WW Engine (the US consumer) loaded with debt.

 

I think sitting on his hands hoping it all works out looks just as bad from where im sitting, and doesnt work well economically or politically. Buffett is man enough to realize that and avoids throwing stones. You seem to be bitching and thats about it. All options look bad. I have consistently said its a high stacks game of chicken. That sort of implies its not guaranteed to work. What do you propose. Probably something regurgitated from Rand, Keynes, Hayek, Friedman, Rothbard, Paul, or some other guy / girl. Guys like you would still have Brazil mared in semi hyperinflation.

 

At least when I tone into Schiff, Rogers, Faber, and company I get some sort of advice vs. sit on your hands.

 

I have assets and they need to be allocated. My stocks which are backed by oil, tankers, planes, buildings, and businesses and are cheap in my opinion look better to me then your cash which is likely to shrink in value. Keep waiting on coke for 5 times current year earnings. I think it will be a long wait. If you are right hopefully I have a bit of cash to be buying as well.

 

I admire your energy but would prefer to read about the ideas you like vs. hearing the market is overvalued. I tend to agree with you giving the crummy outlook, but I dont own the market. What I do own, I think is cheap, but would welcome any and all feedback. I would also like to trade out for cheaper higher quality ideas and look forward to those posts.

[opihiman2]

-1

 

Keep posting.  They make for interesting reading.  And you're right about Grant.  Over the years I've gotten my hands on his Interest Rate Observer and although well written, he goes on tedious, lengthy diatribes written in semi-prose that's absolutely laborious to read.  The worst part is, I never got a good investment idea from them.

[Munger]

Tradevestor -- excellent questions and I'm not sure I have the answers but here are my thoughts.

 

1. Currently, there are two main, opposing macro events. A rapidly de-leveraging credit bubble (deflationary), and QE2 (inflationary).  Eventually, whether we will have deflation or inflation will depend on the difference in magnitude of these two.  I believe that deflationary spiral has not played out yet, and there's still more time before housing market stabilizes. That said,  I am seeing the effects of inflation in the commodities and consumer market.  So, maybe, these forces are affecting different segments differently.

 

Very much agree with everything above.  

 

In short, would just add the money supply is contracting (which is deflationary) but the Fed hopes to offset with QE.  Can the Fed micromanage the inflation rate -- personally, I think highly unlikely if not impossible.  As Grant has noted, there is a very high likelihood that the macro inputs into the Fed's models are not even accurate -- in fact, it is almost certain.  

 

The experience with Japan suggests QE won't work -- as the real Munger emphasized in the Univ of Michigan Q&A, Japan tried every fiscal and monetary trick in the book and it didn't work.  But Bernanke increasingly seems an ideological madman and if pushes the envelope too far, he will turn the US into a banana republic, with all asset prices getting destroyed and society as we know it today, completely falling apart.  Buffet said as much with Carol -- "we are on a path that you don't want to continue on much longer," which he likened to Munger's frequent quip "just tell me where I'm going to die and I won't go there."  I'm hoping Bernanke is just aggressive in his rhetoric but not in actual policy because the risk are enormous -- no one knows the actual tipping point for hyperinflation.   So I chose to have a fairly large holding of cash rather than buy stocks as a speculative hedge against massive currency debasement.  If I find great companies trading a valuation that offers a high margin of safety, I will buy regardless of the macro.

 

I am almost certain that if true inflation takes hold, stock valuations will ultimately take a serious tumble from current levels.  And if we experience an extended period of deflation, I am also almost certain stock valuations will ultimately take a serious tumble from current levels.  In the interim, anything can happen as the Fed tries to interfere with and distort the market, which is why I have no short positions.  

 

Further, the Fed's policy will only be successful if consumers borrow more and spend more, which just kicks the can down the road, is ultimately unsustainable, and doesn't address the root of the problem -- too much debt.  Inflation triggered by currency debasement (i.e., a run on the dollar) would appear disastrous for the average family and consequently society, as I address below.

 

 

2. In an inflationary environment, the prices of everything goes up as currency is devalued.  Wouldn't this raise the (relative) price of the book values (comprised of real assets) of companies ? Wouldn't the stock price reflect that ?

 

Possible but here is a question -- with real unemployment around 20%, there is zero evidence that inflation triggered by a currency debasement will lead to a rise in wages.  Let's think this through but note that this is complete speculation on my part -- nevertheless, here goes...if the currency gets meaningfully debased and the price of everything goes up while salaries remain unchanged -- the cost of living will then consume more than the average wage.  In this scenario, consumers and companies would be trying to sell hard assets to cover the cost of living (cost of business), which begs the question of who will buy these assets at inflated prices...there is a reasonable scenario that hard asset prices fall not increase when inflation is triggered by currency debasement.  

 

Separately -- remember that virtually all entitlement obligations (pensions, SS, medicare, medicaid etc) are currently indexed to inflation -- so Fed stoked inflation doesn't remove the vast majority of the debt burden overhanging the US economy.  The one obvious benefit of currency debasement -- the US gov't could theoretically more easily pay off foreign debt, which assumes China doesn't dump the debt when they realize the Fed is trying to debase the currency.

 

 

 

 

 

 

 

Myth, my man -- honestly appreciate the thoughtful response, some of which I agree with but most of which I don't. We both want to do well -- just seem to have different perspectives/thoughts on the issues.  As you noted, we could go round and round...  So, let's respectfully move on and see how all of this plays out.  If I get any great ideas, I'll certainly post on the board.

 

Best.  

   

 

 

[Munger]

Just my humble opinion but should have added that I think Cardboard's most recent post on this thread is outstanding.

[twacowfca]

Obviously Munger you didn't read the article you posted  What is important is not only what Buffet says but what he doesn't say. He says inflation swindles the equity investor but that is only because it swindles the cash holder, bond holder, gold holder, property holder EVEN MORE!

 

Steel1 noted the important qualification to the simplified nonsense posted above -- at least they are if you buy in at appropriate prices

 

Couple of observations:  

The best approach is always and will always be to wait for Mr. Market to sell you great companies at bargain prices -- margin of safety.

When the margin of safety is high, buy hand over fist.

Inflation is not a problem today and will not be any time soon -- so holding cash has not resulted in a loss of value.  

If inflation truly rears its ugly head, the stock market will tumble more than the loss of value for cash, given current multiples -- see the 1970s.

If hyperinflation truly took hold, the allocation between cash and stocks won't matter -- society will collapse.  Always has and always will in hyperinflationary periods.

If deflation takes hold, which is still entirely possible (see Japan), equity prices will tumble and cash will be king.

 

Holding cash at the current time does take some strong internal fortitude when the rest of the world is shouting cash is trash, but be patient and wait for the fat pitch -- it will come...and most of all don't panic and follow the crowd.

 

 

 

 

 

 

 

Ugly things may happen, but society doesn't usually collapse when there is hyperinflation.  Typically, better businesses survive, except when a successor government expropriates business. Businesses that don't have to continually reinvest or extend a lot of credit to their customers or debtors and those that can pay off their obligations with depreciating currency, tend to be the ones that can survive without bailouts.

[twacowfca]

but hardly massively overvalued either, especially relative to alternatives.

 

Be clear -- this may work for a trade but completely irrelevant from an investment perspective.  In terms of valuation, the only consideration that matters for the economic return an investor will realize on his/her capital outlay is absolute value not relative value.

 

I'd argue that asset inflation will precede physical inflation such that holding cash can result in substantial loss of value in asset terms.

This would be called an asset bubble fueled by artificial low interest rates manipulated by the Fed -- these bubbles always have and always will pop.  So there will be no real loss of purchasing power in this scenario.  If you held cash during the housing bubble and bought after the burst, you did fantastically well.  Note holding cash when everyone else appears to be making easy money, riding the bubble is not easy to do.

 

current ratio of stock market capitalization to GNP is around 94%

On your comparison of market capitalization to GDP, note that GDP is clearly artificially inflated by artificially low interest rates and 10% budget deficits.  At normalized interest rates and 3% budget deficit, GDP is a helluva lot lower.

 

 

That's a good insight that GDP is lower at normal interest rates and a small deficit.  Situations like the current one do not have good endings.

[twacowfca]

Anyone seen coffee prices lately?  Sugar?  Gold?  Steel?  You name it!  Other than pretty much orange juice, we've already encountered some inflation at the raw materials and commodities level, and that will probably continue for the next year.  In the short-term (1-2 years out), I don't see deflation as a possible scenario.  

 

We had this discussion a month or so ago, and I mentioned that when the market turns it turns hard.  September was the largest September gain since 1939!  Investors are reaching for yield and they will continue to do so for the next six months to year.  Is it to their detriment long-term?  Probably.  But the fact remains that investors are slowly piling into other assets because fixed income instrument yields are so low.  Why do you think there is such a huge revival in the junk bond market?  That will probably also continue for at least another year or so.  Cheers!

 

 

 

Great post, Sanjeev.  But why do you think it will have to take another year or more for interest rates to rise?  You mentioned something that Keynes said: that when the market turns, it may turn with sudden and unexpected force.  I'm reminded of something that Klarman described in his book, Margin of Safety.  In early 1993, everyone expected interest rates to remain low because they had been increasingly low for an extended time.  But within six months, by October of that year, rates doubled unexpectedly.

 

Recall that the period leading up to late 1992 and early 1993 was not unlike today. There had been the S&L crisis, exacerbated by overreaching for yield with bad junk bonds.  S&L managers skimmed off big salaries, despite having inflated balance sheets that didn't recognize mark to market losses.

 

Most S&L's had then been taken over by the government and closed. Many thought some big banks might fail. Bush the first had been voted out.  The economy was slow to recover with the big overhang of defaulted real estate  clouding the view.  

 

Then, the Fed tightened up a little bit, and WHAMO!  Longer term interest rates doubled!  

[savant]

"There is no such law, of course. On the other hand, corporate America cannot increase earnings by desire or decree. To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes, (5) wider operating margins on sales."

 

Cheaper leverage is definitely available to American corporations today. Most of the blue-chips can issue long-term debt below dividend yield to buyback equity. Also, from what I can see by comparing balance sheets from today to 3 / 4 years ago - there is definitely more cash on balance sheets and less debt. I'm incapable of predicting where interest rates are going to go in the future and when exactly we can expect taxes to go up. At this point, there are certain companies out there with a reasonable margin of safety. It's not March 2009, which is why I am 30% in cash.