Inflation's Next Stage Is Inching Closer
Editor's note: The future of inflation could change your life...
Rising prices have slapped consumers in the face, recently hitting the highest point in 40 years. And while inflation will eventually dip below today's record levels, Income Intelligence editor Dr. David "Doc" Eifrig says it isn't going away anytime soon...
Doc believes we're nearing the next phase of today's inflationary environment – long-term intense pressure that could weigh on your portfolio (and your wallet). And to make matters worse, the relationship between inflation and the stock market is anything but simple...
In today's Masters Series, originally from the February issue of Income Intelligence, Doc compares rampant inflation in the 1970s to what we're seeing now... and explains why the conventional market wisdom might not apply today...
Inflation's Next Stage Is Inching Closer
It's like calling Michael Jordan "a retired Chicago athlete" or referring to Paul McCartney as "a songwriter from Liverpool."
But when Warren Buffett took to the pages of Fortune in 1977, the magazine felt obliged to introduce him to its readers...
Buffett, who is now forty-six and still operating out of Omaha, has a diverse portfolio. He and businesses he controls have interests in over thirty public corporations. His major holdings: Berkshire Hathaway (he owns about $35 million worth) and Blue Chip Stamps (about $10 million).
Even then, Buffett was a fairly prominent investor. Today, he's a household name... well-known far outside financial circles. And that $45 million ownership of Berkshire and Blue Chip has grown into $114 billion worth of Berkshire Hathaway. (Blue Chip Stamps merged into Berkshire Hathaway in 1983.)
Through all the changes, though, Buffett's Fortune essay contains lines that could have been written in 2022 – simple yet valuable wisdom and an insightful summation of the challenges we face.
First, Buffett diagnoses the causes of the 20-year bull market of the time – and the story looks eerily similar to today...
Stock investors can think of themselves in the 1946-66 period as having been ladled a truly bountiful triple dip. First, they were the beneficiaries of an underlying corporate return on equity that was far above prevailing interest rates. Second, a significant portion of that return was reinvested for them at rates that were otherwise unattainable. And third, they were afforded an escalating appraisal of underlying equity capital as the first two benefits became widely recognized.
In other words, businesses earned high profits and reinvested them at good growth rates, and the valuations on all stocks rose. But before long...
This heaven-on-earth situation finally was "discovered" in the mid-1960s by many major investing institutions. But just as these financial elephants began trampling on one another in their rush to equities, we entered an era of accelerating inflation and higher interest rates. Quite logically, the marking-up process began to reverse itself. Rising interest rates ruthlessly reduced the value of all existing fixed-coupon investments. And as long-term corporate bond rates began moving up (eventually reaching the 10% area), both the equity return of 12% [Buffett's estimate of the long-term average] and the reinvestment "privilege" began to look different.
Buffett looks at inflation as the driving factor for the future, but...
Which brings us to the crucial question – the inflation rate. No one knows the answer on this one – including the politicians, economics, and Establishment pundits, who felt, a few years back, that with slight nudges here and there unemployment and inflation rates would respond like trained seals.
And, as always, society doesn't change much...
Most of those in political office, quite understandably, are firmly against inflation and firmly in favor of policies producing it.
The essay, titled "How Inflation Swindles the Equity Investor," dealt with the inflation rampant in the 1970s – again, similar to what we're seeing today. And Buffett's conclusion was that stock returns going forward would be lackluster. Sure enough, the S&P 500 Index returned just 5% per year for the next three years – failing to keep up with 9% inflation – before inflation started to decline.
In the essay, Buffett relays what makes inflation so tough on stocks. At the time, it was clear that inflation can make stocks struggle... although the reason for this was anything but obvious.
Today, however, we seem to have forgotten this lesson. But we'd do well to take heed... and, specifically, buy the type of stocks that Buffett's prescription tells us will do well during inflationary periods.
Every inflation report makes headlines, especially when it keeps hitting new highs.
The most recent report for February inflation came in at 7.9% – the highest since January 1982 – right in the shadow of Buffett's essay.
I've written to my subscribers at length about inflation, how it works, and that it was coming... Now that it's here, it's time to shift gears.
We're entering a new stage.
The first stage was the shock of inflation. That's when people don't expect it – and it comes and slaps them in the face.
This quickly changes people's behavior, dislocates asset prices, and leads our politicians to dramatically shift their rhetoric (though not their policies, of course).
That has already happened. It's not quite over, and it's not our place to pinpoint the exact date it will end. But now we're looking to the future.
That's because after the shock comes the grind...
That's where there's still intense inflationary pressure in the economy, but less than the recent 7.9% level. It doesn't mean 1% or 2% inflation – at least, not for a while. We're building our outlook around inflation of about 4% or 5% for a couple years.
That's the grind... Prices keep edging higher across the economy. And that makes a big difference to your daily life because prices compound. If prices rise 5% per year for five years, your weekly grocery bill ends up roughly 30% higher. (Of course, you've likely seen a bigger jump than that already.)
So now we're looking at the longer term. We're not trying to anticipate the market's reaction to the news of inflation – we're focusing on how persistent inflation will drive the prices of different assets and how to position ourselves as investors.
You might think that sounds simple enough. But it's not...
The conventional wisdom for this bout of inflation is that you want to own stocks, since businesses can raise their prices.
But that relationship is far from proven. Stocks have been hammered lately as inflation is raging.
Buffett starts his 1977 essay, "It's no longer a secret that stocks, like bonds, do poorly in an inflationary environment."
At the time, inflation ripped through the economy and hammered the stock market...
Like now, many 1970s investors also expected stocks would do better than bonds because businesses can raise prices. However, the opposite occurred. And that caught a lot of people wrong-footed.
So while the theory points to a nice relationship, the data – at least, so far – have shown otherwise.
But the data don't tell us that stocks will suffer during inflation, either. The truth is, we don't have enough history to study.
Every inflationary period is different. Bull and bear markets happen for different reasons. And if you look at the relationship between stocks and inflation, it's hard to discern a clear relationship...
Perhaps the 1970s were a unique time with inflation, economic stagnation, and therefore falling stocks. And that unique time is skewing our ability to study stocks and inflation.
Again, we just don't have enough data yet.
It's a simple theory that businesses can raise prices to counteract inflation, keeping their stock values safe. That theory may well prove correct. But for whatever reason, it didn't happen in the '70s.
Fortunately, Buffett explained how to find stocks that will thrive... Tomorrow, I'll share his winning formula for choosing "inflation resistant" businesses.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Editor's note: With inflation soaring and stocks crashing, Doc has an urgent new warning that could change the idea of retirement in America forever. In short, he believes today's investors are facing their most important decision in more than a decade...
Doc recently released his latest video presentation detailing how to navigate today's dangerous market – and why your nest egg could disappear when the next crash arrives. But if you follow his advice, it could set you up to make a whole lot of money this year... even if most people you know are sitting on significant losses. Learn more here.