The Brooklyn Investor

Inflation, Valuations etc.

Posted on by kk

By the way, thanks for all the comments. One of the fun things about writing this blog is all the great comments I get, whether agreeing with me or not. Most comments are pretty well thought out, intelligent and very interesting. And I don’t mind at all when people disagree with me on anything. As I often say, Buffett and Munger, arguably the two smartest people on the planet often do not agree on things and they get along fine. Who am I to get upset with anyone that disagrees with me?

Also, you may have noticed I started a Substack email list so I can send out a link every time I make a new post. Even before my recent blog migration, I have been getting emails requesting that I add them to the email list. I used to have a list on Blogger, but that broke years ago. And I know many people aren’t on Twitter X, and many people I know who used to be on X left after Musk took over. You can register to get email updates at the bottom of this blog (in the footer).

Anyway, someone did ask about inflation and stocks, so I just thought I’d remind people that inflation is bad for stocks over the short term, but good over the long term. OK, saying it’s good for stocks may be overstating it. There are a lot of problems with high inflation. But let’s say, stocks may be better than cash and bonds.

Remember, Buffett’s estimate of future stock market returns is simply nominal GDP growth plus dividend yield. Which is, real GDP growth + inflation + dividend yield. You see that inflation is additive to expected stock market returns.

I won’t do all the math, but also, keep in mind what’s happened over the last 100+ years. How much did a serving of Coke cost back then, and how much is it now? Gold? And what happened to the S&P 500 (or Dow) over that time?

People keep talking about the dollar being devalued, and I keep reminding people we have already devalued the dollar by more than 98% (since, say, the 1930s), but the country did fine, and you would have done great in the stock market since then.

Now, over the short term, rising inflation makes the Fed raise rates, and bond yields can go up too. Rising bond yields increase the discount rate on assets, so will put downward pressure on all asset prices. But over time, higher inflation will usually lead to greater pricing power for businesses and they will be able to make back higher costs. This is why, by the way, we like high quality businesses. You have to own businesses that have pricing power.

I tend to think that a lot of the bull market in the 80’s was driven by large corporations’ ability to hike prices to increase profit margins. People were trained to accept inflation during the 70’s, so mid-single digit price hikes became acceptable compared to the inflation they saw in the recent past (again, anchoring at work!). The opposite seemed to happen in the 2000’s where a long period of low inflation took away pricing power from the big companies (well, increasing buying power of the large discount / big box retailers (WMT etc.) and competition from private labels / internet were probably big factors, but low inflation certainly didn’t help).

This is also why you want to avoid leverage. If you have a lot of debt and interest rates go up, this can be a problem. If you have a solid balance sheet and plenty of liquidity, then rising interest rates can help you as those more unfortunate might have to dump assets on the cheap.

Fortress Businesses

So this is the whole point, of course, of investing in strong businesses. If you invest in a well-run business, then you shouldn’t have to worry about the economy, interest rates, inflation etc. The business will evolve and take care of those problems.

When you drive a car, you don’t put a knife facing you on the steering wheel, seat belt unfastened and drive 120 mph on the highway, and then say, “oh, this is where many accidents happen”, and then slow down, remove the knife from the steering wheel, fasten your seat belt and then carry on at 70 mph. And then you see a straight and then you remove your seat belt again, put the knife back on and then speed back up to 120 mph. Do you see what is wrong with this strategy?

As dumb as this sounds, this is exactly what people are doing with their portfolios when they lighten up and reduce exposure because pundits tell them that a recession is coming, or that the Fed will raise rates one (or two or three) more time. You see how silly the driver above looks, but that’s how silly portfolio managers sound when they tell us that they are tilting their portfolio this way or that way because the economy is going to do this, or do that. Or that inflation is going higher, or will go lower.

You should probably just keep a steady pace (let’s say, no knife, seat belt always fastened, and then maintain a steady pace, and do it in a safe car).

A good business will have pricing power. Even if earnings take a hit in the short term, they will make it back, and usually, they will more than make it back. Recession? A good business is not going to go kaput just because the economy weakens a little, or a lot. In fact, they will take advantage of the situation and maybe buy out competitors at very low prices (JPM, BRK during the financial crisis; even though many BRKers complained that Buffett didn’t do enough back then!). Munger often reminds us, this is how Carnegie, Rockefeller and all those guys got rich; they just operated their business well, when the economy got bad, they just bought up their weakened competitors. Rinse, repeat over decades.

Valuations

Also, I do keep repeating that 4% is my long term expected bond yield, therefore a 25x P/E is totally reasonable for the stock market. But I actually don’t depend on this being correct at all. In fact, this just all started because since the early 90’s, I have been reading that the market is overvalued, that every time the P/E gets over 20x, the market will crash (since it did so in 1929 and 1987) etc. And my analysis was just due to my wanting to dig into that, to see if it’s true or even meaningful. And that’s when I started to realize, maybe a P/E over 20x is not really all that overvalued (due to lower interest rates).

Again, I am too lazy to do the work to show you, but back when I first started in the late 80’s, someone dropped a chart on my desk and it was an X-Y plot of 10-year bond yields and the S&P 500 earnings yield with a regression line on it and standard deviation bands around it. He just pointed to a dot way out of the normal zone and said to me, “This is why the market crashed”.

The gist of it was that the earnings yield and bond yield tracked each other closely, but what happened in 1987 was that the bond market crashed (due to the plunging dollar, Baker comments etc…) with yields spiking up to 10% in August / September while the stock market kept rallying with a P/E over 20x (actually peaked in August). Think about this for a second. This means that the bond yield – earnings yield gap expanded to over 5%! When you looked at that chart, it looked like a rubber band really stretched out ready to snap, and snap it did.

It sounded great when I first heard it years ago, but I get tired of hearing it now, but it is still true: It’s not what you don’t know that’s going to kill you, but what you think you know that isn’t true.

I know ‘this time is different’ and ‘new era’ talk is very dangerous. I was a big fan of reading about bubbles and crashes during my hedge fund years, but I remember seeing a long term chart of dividend yields and bond yields, and how until the 50’s, dividend yields were above bond yields. And then it flipped. If you believed that dividend yields should always be higher than bond yields, you would have gotten out of the market in the 50’s, and wouldn’t have gotten back in until the late 2000s/2010s! Back then, it must have felt like a ‘new era’, and who would have expected that dividend yields will be below bond yields for so long? Of course, now, in 2023, it is obvious why dividend yields should be below bond yields (because dividends grow, bond coupons don’t).

Likewise, pre-1990’s, it does seem like the market rarely traded over 20x P/E, but after the early 90s, the market seems to have been valued at over 20x more often than not. In technical analysis terms, it seems like the old resistance became the new support (ugh… I hate those terms, lol…). So instead of selling P/Es over 20x, it seemed more profitable buying P/Es below 20x!

I remember mentioning a mutual fund, a long time ago, where the strategy was to go net long when the dividend yield is over 6% and net short when dividend yield is below 3%. Sounds logical, even rational, but how did that turn out?

Anyway, these are just some random, residual thoughts related to my other recent posts. Actually, this draft has been kind of sitting here for weeks as I got bogged down in some other things and didn’t have time to get back to it.

I was going to add more, but I will make other posts in the future. I decided to just blast this out for now, and I will complete my thoughts or talk about other stuff in other posts.

56 thoughts on “Inflation, Valuations etc.”

  1. I’ve been looking at pharma lately. But you have now reminded me the importance of pricing power, the ability to raise price (in inflationary environment). Drug pricing is non-trivial with constraints for good reasons. What’s hard to discern is how big this is a factor in affecting the quality of the business. Any thoughts?

    @portfolio14

    Reply

    1. Yeah, I hate saying this, but that’s sort of a ‘too hard pile’ thing… Pharma is so hard as it’s so subject to regulatory risk and whatnot, and what turns me off is how much money they make from off-patent uses, how they block generics, how they boost prices (like, look at how they ramped up prices on epipens, so much that it didn’t even make economic sense at all, but the CEO at a congressional hearing explained they had to raise prices so they can use that money to develop other drugs or some such, lol… I don’t remember the details, but it was total nonsense). And I tend to believe this country is way over-medicated etc…

      So when I see businesses operate like that, it is hard to support, and if they didn’t have so much influence, who knows what the businesses would be worth in a fair world… I don’t know…

      But maybe there are some ideas somewhere. Good stable portfolio of products etc… not too dependent on any one big seller, no patent cliffs etc… but it is. treacherous territory, I think…

      Reply

  6. With 4% long term bond yield, a 25x P/E is totally UN-reasonable for the AVERAGE stock (market), I believe. These E(arnings) are sometimes far from cash earnings, since the average business must invest more than depreciate (inflation), and bonds are contractual Cashflows whereas your stocks can trade all over the place (does not mean the should) and you might need to cash out at an inopportune time… (Not as a billionaire though)

    Reply

  9. I wonder whether the E/P to Treasury yield relationship would be improved by adding expected growth. That sounds reasonable, but maybe surveyed growth adds noise, and actual expectations are already in the relationship.

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  10. Thanks for this ! I disagree with this: “This is also why you want to avoid leverage. If you have a lot of debt and interest rates go up, this can be a problem. If you have a solid balance sheet and plenty of liquidity, then rising interest rates can help you as those more unfortunate might have to dump assets on the cheap.”

    If a business has pricing power, they can actually “inflate away the debt” (similar to governments), where profits can increase in excess of interest costs increases, and thus the ratio between i.e. Net Debt / EBITDA can reduce rapidly (similar to governments with debt / GDP). This then provides scope for re-leveraging by the corporate, often ideally at the point the economy goes into recession, and thus that allows them to scoop competitors up on the cheap. This partly explains the incredible returns of select “Serial Acquirers”. They benefit from winning in both “Heads & Tails” scenarios.

    Reply

    1. Good point. I should say, “excessive leverage”.
      John Malone is one of our heros, and he is always levered.
      Thanks for dropping by!

      Reply

  22. Great post.
    Many of your readers are young or in late 30s like me.

    What would you advise them on how to construct a portfolio? Lets say if you had 100k cash at current market how would you go about investing it?

    Thanks! Hoping some day you can share your process 🙂

    Reply

    1. Thanks. Hmm… I don’t really get into that sort of thing, how to construct porfolios and things like that.
      If you are young, the important thing is to be invested, and if you have an income, you can afford to be fully invested in most cases, I would think.
      As Greenblatt said in a great essay after the financial crisis, he said the mistake wasn’t that people didn’t get out before the crisis, but that they freaked out and sold out at the bottom of it.
      Buffett’s will states that his wife’s assets should be invested 90% in the S&P 500 index, and the rest in cash to pay bills. This is probably not a bad idea for most people.
      But it depends. If someone is old and barely has enough for retirement and needs the assets to pay bills in the next few years, then of course it’s a bad idea to be too invested in stocks as a badly timed bear market can be a big problem.
      For young, active, working people, this is really not an issue.
      As for the index, if you are worried about ‘timing’, I tell people to just scale in over time. You can spread it out over 3 months, 6 months, a year or whatever you want.
      Also, it’s fine to have, say, 80% in the index, or whatever you want, and then have some on the side to play with to invest in stuff that may interest you. Or if you are going to spend a lot of time on investing, then maybe don’t even buy an index.

      etc…
      So as you can see, it all just depends on who you are etc…

      Reply

      1. Thank you! This is a great piece of idea. Apologies, I did not mean to force you into talking about portfolio construction but nevertheless you answers my question precisely

        Reply

  28. Thank you for all of your thoughtful posts over the years. Please notify me of new posts by email.

    Reply

  32. This is really interesting, however over the past 20-30 years there has been a move towards stock buybacks as a way to return capital in addition to dividends. How do you think about the “apples to apples” comparison? Could it be to compare the LT bond rate to total cap return (dividends + buybacks) for it to be apples to apples?

    Reply

    1. Good point. It is probably not a bad adjustment to make. Frankly, I don’t spend much time on this sort of thing, but I have seen analysis with this adjustment.

      Reply

  41. Hello Brooklyn Investor, I’ve been following your blog for years. I find it really interesting. I am thinking of staring a blog myself to cover global value investing ideas. Just out of curiosity, how does one make money doing this? Do you make ad revenue? Thanks!

    Reply

    1. Hi,
      I have no idea how to make money doing this. I just started it a while back for a few reasons. One is that writing helped me to organize my own thoughts. Two is that it created a record of my own thoughts that I can go back and look. So it is sort of my own little ‘notebook’, or diary of thoughts, if you will. Another thing that got me to write in a blog was that back in 2011, I kept reading things all over the place that I thought was so wrong and misleading, I felt the urge to really speak out and say, hey, that is nonsense. So that was another part of it. And then one more thing was that a lot of people would ask me about this or that, and I found myself writing the same email over and over again, sometimes even cutting and pasting one email I sent to someone to someone else, as it was the exact same question / content, lol… So I figured, hey, if I had all these things written out on a blog somewhere, I can just tell them to read that…

      So put all that together, I had a lot of reasons to write a blog. So I did. And then something else started to happen… People started to participate and leave great comments. Always positive. Even when people disagree with me, it’s always been polite, respectful and great conversation. Nothing like you see in public forms. So that was an unexpected kicker. When I started, I barely mentioned it to anyone. I just started writing. And before I knew it, people were talking about it. But that was not my intent at all… If 10 or 20 people read it, I would have been totally happy.

      As for money? I don’t know. I have thought about starting a newsletter more than once, but oddly, long before I started the blog, but I thought it would just be a chore and I would have to come up with something to say every week or every month, even if I had nothing to say. And then I might just end up ranting about this or that, endlessly, lol… which seems to happen to many letters… So I said, nah… not for me…

      It seems like people make more money these days doing podcasts, youtube videos and whatnot. A friend of mine is a star now with millions of followers and is making a ton of money… just a couple of years ago, he was just a young kid not knowing what to do with his life, lol… (but, alas, the content is not financial!)

      So the world has changed dramatically from the old days of newsletters… way more things to do now.

      I don’t follow too many blogs so I don’t really know if blogs make any money, especially financial ones (unless you are some ‘get rich overnight’ scheme, which probably do make a lot of money, lol…)
      I know the serious ones that do are probably sort of more the aggregators, not some guy writing one blog by himself… But I may be wrong. Again, I have no idea as I don’t follow too many myself and am not in their ‘network’…

      Reply

  44. What do you think will happen to the housing market now that housing prices has gone up like 50% in the past few years and interest rates being much higher?

    I remember when I 1st started following your blog interest rates were suppose to only remain low until 2015-2016 until QE ended lol. Now interest rates has rised but housing prices hasn’t fallen like people expected.

    Reply

    1. Sorry for the late response. That’s an interesting question. I actually haven’t done much work on housing so I don’t know. But I would just say one thing. Remember that in the short term, interest rates will cause housing prices to drop as it will be more expensive to buy a house with a higher mortgage rate. This is obvious. But the other issue is that rates are rising due to inflation, and if inflation is increasing building costs, housing prices can’t come down as much as you would think. This is what would cause sales to go down etc… and prices will fall over time, but won’t fall all the way back (or I should say, may not fall all the way back down) as much as you would think due to inflation.

      So it’s a good question, but I don’t have a good answer…

      Reply

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