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Stock Ideas Investors Daily Edge Is It Performance Or Is It Inflation Behind Stock Returns?
Stock Ideas Investors Daily Edge Is It Performance Or Is It Inflation Behind Stock Returns? 
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Fording Canadian Coal Trust (FDG:NYSE) Over the last few weeks, the major market averages have been stuck in a severe sell-off. But coal stocks, on the other hand, continue to appreciate in value. That’s why I feel that every Taipan reader (like you) needs to own some upside exposure to the coal sector. |
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| Is It Performance Or Is It Inflation Behind Stock Returns? |
| Wednesday, 27 August 2008 | ||||||||
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Strong currency—weak stock market; weak currency—strong stock market. That’s what the London Business School/ABN Amro study I mentioned a while ago came down to. Readers have some additional insights on that subject. First, there’s a good question: Dear Lynn, I wonder if there is anything more to this phenomenon than the simple fact that when currencies fall, it always takes more of the currency to buy other assets – including stocks. Everything goes “up” when a currency falls but it isn’t necessarily the kind of “up” we might have been hoping for. Your thoughts? Richard. Good thinking, Richard, that’s surely part of the puzzle. I remember being so young once that I thought, “$40 for a share of stock, wow!” It sounded expensive back when you could take $40 into Lord and Taylor and actually expect to buy a blouse and something else like a belt. It doesn’t sound like much now. Maybe you can throw a couple of non-dry-aged steaks on the grill and eat in your back yard for that price. Inflation does make all varieties of assets go up, except for those that are under a shadow of some sort—as single-family homes are at present. This is part of the thinking when companies do stock splits. The sweet spot is $20 to $40. That’s high enough per share to attract mutual funds, but low enough not to be scary. Half the stocks that trade with reasonable liquidity (250,000 shares or more a day) are priced from $15 to $50. So, yes, the attractiveness of a $40 asset when all things begin to cost $40—that is, when a currency is weak—is part of it.
But the main push comes from the fact that money flows to assets that pay off. We tend to forget that cash itself is an asset. And when cash is losing vigor, it is natural for people to convert it quickly to some other asset form to protect their wealth. Stocks are the most convenient one because CDs and treasuries are nearly cash themselves, and most bonds are just barely a step removed. Buying houses and whole businesses is a lot of trouble and takes large commitments. Buying art and collectibles calls for specialized knowledge and a lot of personal time spent in the buying and selling. Maintaining and insuring collectibles is expensive, too. That leaves stocks… clearly the easiest alternative when cash is weak. So, inflation is a factor, but prospects of better returns is trump, I’d say. Another IDE regular asks an astute variation on the inflation question: Lynn, That was an interesting article you wrote regarding the relationship between strong currencies and stock market performance. Just one problem I see with your analysis: You are judging the strength of stocks in dollars, but this is a misleading indicator of market strength. When a currency such as the U.S. dollar is weak, this results in inflation. Wouldn't inflation account, in large measure, for the overall increase in stock prices? Best regards, Alan Alan is right, too. The LBS/ABN study merely tallied the outcomes of stock markets in weak- or strong-currency countries. It did not address the problem that both Richard and Alan can see here: But does the greater return actually put you ahead? Sometimes, the answer is no. From year to year, your stock market return may not beat inflation. It means very little to make 9% on stocks if inflation is roaring through the land at 10%. You have more money on your books, but you are still going backwards. The best you can say in those circumstances is usually that you are going backwards much more slowly than you would be with a 7.5% CD or a 6% AAA-rated bond. However, in the longer run, the story changes. In the longer run, stocks have beat inflation and done it far, far better than real estate, savings accounts, or bonds. This brings us to what we really want from our investments—beyond providing basic security for that rainy day. We want wealth. I mean “wealth” in its simplest, most literal sense. “Wealth” is technically more money than required to survive and pay bills. That extra can be used for living better, traveling more, endowing children, giving them superior educations or a start in business, giving to charities of our choice, financing a comfortable post-working retirement… All the joys of a rich life that money can buy, including the basic pleasure of looking at a nice brokerage statement and knowing you’ve done a good job at building your assets. We don’t put our money in stocks, bonds or any other asset to be like squirrels, expecting 10 nuts in to yield 10 nuts out minus some spoilage. So we want to cover inflation and then some. And stocks tend to be the best way to do it for those of us who have the wealth (read that as simply a little extra) to invest. The Kansas City Federal Reserve Bank has found that stocks do beat inflation in the long run. And guess what? Surprisingly, they beat inflation 68% of the time on a 1-year basis. Over 10-year periods, stocks beat inflation 89% of the time. And over 24-year periods, they beat inflation and multiplied wealth 100% of the time. In contrast, bonds don’t hold up nearly as well against inflation. Their returns beat inflation 53% of the time on the short 1-year term. They beat inflation 88% of the time over 10 years, though not by as much as stocks. In addition to being better and getting ahead of inflation, stocks beat bond returns 98% of the time on a 20-year basis. By now, you may have forgotten the original topic! It was about the stock markets of weak currency countries’ returning more than the markets of strong currency countries. Bottom line, Richard and Alan are surely right that inflation plays a role in the apparent gains. But it turns out that stocks give a bit more than that, even if a currency is weak, as the U.S. dollar has been for a long time, stocks have added to your real wealth. Lynn P.S. To let me know what you thought of today's article, send an e-mail to: This e-mail address is being protected from spam bots, you need JavaScript enabled to view it
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