by David Fessler, Advisory Panelist, Investment U
Friday, August 22, 2008: Issue #843
Ask any economist what inflation means and he or she will likely tell you that it’s directly related to the growth of the money supply, also referred to as the “debasement” or devaluation of a given currency.
In its earliest forms, kings would order the collection of all of the gold coins in circulation, have them melted down, mixed with another metal (lead was often used), and reissued with the same face value. The coin was the same, but it was worth less in terms of its gold content.
The rate of inflation relates to how fast additional money is created: The faster the growth of the supply, the higher the level of inflation. Some economists would argue the point that it’s the demand for more money versus the actual supply.
A more generalized definition from Wikipedia states: “Inflation means a rise in the general level of goods and services over time.” But inflation has another dark side as well: It’s the killer of earnings. Let me explain…
The Meaning of the Price-to-Earnings Ratio
When researching a company, one of the measures investors often look at is its price-to-earnings ratio (P/E), also referred to as its “earnings multiple.” It affords us the ability to compare any number of companies with regards to their earnings, regardless of the size, industry or other variables.
It’s worth noting, however, that sometimes comparisons between different companies in different industries and time periods may be misleading in their results. In addition, companies who have yet to turn a profit – and therefore have no earnings – have P/Es of zero.
Companies experiencing faster rates of growth generally have higher earnings, making them more desirable to own as an investment. When demand kicks in, the share price goes up and its P/E ratio is higher.
Most companies have P/Es in the 15 to 25 range, although a company with an outstanding earnings growth pattern can sport a P/E that’s much higher. If a company has a P/E that’s twice that of another stock – everything else being equal – its attractiveness from an investment standpoint begins to diminish.
How Inflation Affects Company Earnings
But getting back to our original question, how does inflation affect the earnings of a company? Well it turns out that there’s an inverse relationship between the inflation and the P/E ratio, and thus earnings.
Let’s take a closer look…
- In periods of low inflation, companies make more profit (their costs are rising slowly or not at all), and as a result, their P/E ratios tend to rise.
- However in periods of higher inflation – similar to the one that we’re experiencing now – costs rise, companies earn less, and P/E ratios begin to erode.
The latest figures released just last Thursday suggest a worsening scenario. Inflation for July was up 0.8%, primarily due to rising energy, food, clothing and airline fares. This was 5.6% higher than a year ago, and represents the biggest jump in the last 17 years.
Of course, we’ve seen the precipitous drop in earnings in the financials for the last two quarters. And with the global slowdown gathering a head of steam, it’s increasingly likely we’ll see more drops in earnings over the next 6 to 12 months.
Inflation Fuels Our Economy’s “Death Spiral”
At first blush, one could easily come to the conclusion that we’re in a negative “death spiral,” fueled by high inflation and lower earnings, with the undesirable result of share prices continuing to drop.
But before you decide to sell everything, it might be time to pause. As bad as inflation may appear to be (and if history is any guide), it tends to peak well in advance of bottoming earnings cycles. In all likelihood it will begin to subside over the next 6 to 12 months.
Remembering our inverse relationship, this should have a positive effect on P/E ratios, with the net effect that the overall markets remain parked about where they right now.
Of course, the question begging to be answered is, “When will it be time to buy?” Not yet, is the quick answer. History tells us that the current U.S. market P/E – around 14 to 15 times 2008 earnings – still has a way to go to the downside before doing a U-turn.
If you “lightened your load” when the market was at its zenith, pat yourself on the back. But it might not quite be time to be jumping back in with both feet.
Today’s Investment U Crib Sheet
- Some consumers shrug and say, “What difference does it really make if inflation bumps up another point or two? What’s the big deal?” Don’t make that mistake.
- Even a slight increase can have a significant impact, and relatively modest inflation rates can rob investors of their purchasing power. With a 4% inflation rate, an income of $100,000 is worth only $70,000 after nine years. After 17 years, its real worth is cut in half. After 30 years, it only has the purchasing power of $30,000.
- Many of the investments that offer the greatest safety of principle, also see their purchasing power drop fastest in periods of high inflation. Investors planning for retirement might be unpleasantly surprised to see the $100,000 investment income they counted on generating only $30,000 worth of purchasing power. And that’s before taxes.
- With inflation currently at 5.6%, many “safe” investments are losing their appeal. But recently Alex Green shared with us the ultimate inflation hedge, and how investors can actually benefit in periods of high inflation.