Stocks As An Inflation Hedge

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Stocks As An Inflation Hedge… The Naysayers Respond

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Friday, June 27, 2008: Issue # 813

Monday’s column about the value of stocks as an inflation hedge generated a flurry of responses.

Some readers pointed out that just because stocks have generated better real returns (i.e. after inflation) than bonds, real estate, or precious metals over the past couple hundred years, it doesn’t guarantee that they will in the future.

I wholeheartedly agree. Not much in life comes with an ironclad guarantee – and certainly not the stock market. Of course, there are no guarantees with other assets, either.

Debt securities that come with a guarantee of interest payments and a return of principal, for instance, offer low annual returns. And, remember, those guarantees are only as good as the guarantor, whether corporate or sovereign.

And even with the most conservative investments, you still don’t know what your return will be after inflation. (The sole exception is Inflation-Protected Treasuries, which currently yield 1%.) For example, you can buy and hold a 10-year Treasury bond guaranteeing 4% interest. But if inflation averages 4.5% over the next 10 years, all you’re really guaranteed is a negative real return.

Predicting Stock Market Returns Over 200 Years

While stocks have averaged 10.8% a year for more than 200 years, it’s true that no one can predict stock market returns from year to year. As Patrick Henry famously said, “I know no way of judging the future but by the past.”

Another reader wrote to complain that he disagreed with my analysis of historical returns, adding that the stock market is nothing more than “a great big casino.” In some ways, I agree. From one day to the next, changes in share prices are almost totally random. That’s why day-trading is really nothing more than glorified coin flipping.

But over the medium to long term, the stock market is anything but a trip to the Las Vegas Sands. Over periods measured in years, you can bank on share prices following earnings.

I challenge readers to:

Identify a single company that increased its profits quarter after quarter, year after year, and the stock didn’t tag along.
Conversely, try to find a single company whose earnings declined year after year and the share price continued to rise. It doesn’t happen.

As the father of value investing, Benjamin Graham, famously observed, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.” And what it weighs is corporate profits.

Unintentional Stock Market Investing

Finally, one of the most comical responses – probably unintentional – came from a gentleman who told me he is getting out of the stock market to invest in a business instead. I don’t know what he believes a stock certificate represents, but most of you are surely aware that it signifies fractional ownership in a business.

Sure, running your own business is different from a passive investment in a publicly traded company. But a private company faces the same challenges as any public company: a weak dollar and weak economy, high energy-prices, rock-bottom consumer confidence, etc. It is also a well-known statistic that 4 out of 5 new businesses fail in the first five years.

Look, it’s no news flash that the stock market has had a difficult year so far. But let’s maintain some perspective.

Owning shares in a public company offers many advantages. You can start with a small investment. You aren’t required to raise capital. You don’t have to fill out government forms, manage people or deal with lawyers and accountants. Heck, you don’t even have to show up for work. What’s not to like?

As Warren Buffett once remarked, “Real estate? Why should I bother when the stock market is so easy.”

Good investing,

Alex

By combining a trailing stop discipline with quality stock selection, Alex Green’s recommendations have beaten the Wilshire 5000 Total Market Index by more than 3-to-1 over the past five years. To join The Oxford Club, and to get access to all of Alex’s growth-stock recommendations.

Today’s Investment U Crib Sheet

“Everyone is a disciplined, long-term investor… until the market goes down!”
It takes nerves of steel to be unfazed when the market drops 3% or more, like it did yesterday. It can be harder to watch when your portfolio takes significant hits. However, that doesn’t mean you should put your head in the sand and pray for a miracle…
On Wednesday, Louis Basenese gave us a refresher course on The 4 Pillars of Investing that bears reviewing. Let’s take a look at perhaps the most relevant Pillar for this week’s market.
Pillar 2: Adhere to a Sell Discipline

Everyone knows you should cut your losses early, and let your profits run. But the practice can be a bit harder than it sounds. In down markets, the only way to consistently protect against a catastrophic loss is to use a trailing stop – a 25% trailing stop requires you to sell if any stock pulls back more than 25% from its high.

It defines an exit strategy for all our positions right from the start… and makes sure we have the gumption to stick to it. Earlier this month, Floyd Brown devoted an entire article to understanding and using this strategy. Learn how to cut your losses and protect your profits with trailing stops.
Guarantee your portfolio will be worth more in the future. Read all 4 Pillars of Investing.