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
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.
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.
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.