Some have mistakenly contended that stocks have done well as an inflation hedge, but history shows that has not necessarily been the case. Meb Faber had a good post about the impact inflation has historically had on various kind of investment instruments. He uses a graphic from the 2012 Credit Suisse Global Investment Returns Yearbook to illustrate the sensitivity of various real returns for various popular investments to inflation. While stocks have historically offered a healthy real (that is, after inflation) return, they, like other assets that lay claim on future cash flows, have had a negative relationship with inflation:
This is a conundrum for investors as inflation has tended to be on the rise throughout history. As Ben Carlson pointed out last year, stocks can do well when inflation is positive but subdued. However, when inflation exceeds these moderate levels, the real returns of cash, stocks, and bonds have all suffered:
Source: A Wealth of Common Sense
The best explanation for this, I think, is Warren Buffett’s. Writing in Fortune in the midst of the inflationary 1970s, Buffett explained the poor performance of equities during this period of elevated inflation by comparing the market to a bond:
There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner. You hardly need a Ph.D. in economics to figure that out.
It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms, let the politicians print money as they might.
Any why didn’t it turn out this way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds.
I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact not varied much at all.
Mr. Buffett goes on to explain that in the postwar period right up to the period of his article’s publication (1977), the return on equity (ROE) for American stocks has been right around 12%. It is fascinating to observe that in the almost 40 years since Mr. Buffett made this observation, the market’s ROE hasn’t varied much from the 12% Mr. Buffett used as his market “coupon.” One can observe the mean-reverting trend about which Patrick O’Shaughnessy wrote in 2014:
Source: The Investor’s Field Guide
This observation of Mr. Buffett’s has made me begin to think that perhaps we, as investors, require a better way to think of our cash, bonds, and stocks. Typically, we define our investments in terms of risk. Cash, because of its more or less static nature, is viewed as risk-less. Bonds, because they are legal obligations of the debtor, are seen as riskier than cash, but safer than stocks, because they have a defined rate of return (interest) that the debtor is contractually obligated to pay under pain of default. Stocks, of course, are considered the riskiest because they are merely units of participation in the fortunes of a given company, and that participation, as Mr. Buffett writes in his article, comes only after the various government entities have laid claim to their share of the profits.
These are useful distinctions, but they typically lead investors to consider their portfolios’ risk profiles by considering primarily the exposure to volatility in equity markets. Because it has been so long since our economy and our market have been subject to severe inflationary pressures, I suggest that it is more useful for investors to observe what these instruments have in common instead of pointing out differences. Basically, whether you own cash, bonds, or stocks, you own assets that are essentially claims on future cash flows. Cash, for example, basically has a duration of zero, with a claim on the future cash flows of the debtor if it is held in bills, or the bank, if its deposited. Beyond cash on the maturity spectrum are bonds, defined in terms of their various extended maturities, usually a few years to a few decades, and so the bondholder is entitled to the cash flows of the government or corporation to whom he has loaned his money for that specified period.
Similarly, equities are a claim on the cash flows of the corporation of which the investor is an owner. However, unlike bill-holders and bondholders who have somewhat short-term claims on future cash flows, stockholders must accept that stocks are perpetuities. As Mr. Buffett writes, “[Stocks] have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn…Bond coupons eventually will be renegotiated; equity ‘coupons’ won’t.”
Because they are essentially present-value claims on future cash flows, thinking of investment assets in terms of their time horizon to “maturity” helps us better understand the roles they play in our portfolio. Furthermore, it helps us appreciate their sensitivities to various headwinds such as rising inflation. Lastly, it might help investors make better decisions. For example, by thinking of investments in terms of maturity, an investor who sells stocks to buy cash should think of it in terms of selling a claim on the future and buying more of the present, with all the implications that entails. Conversely, when one makes the decision to re-balance a portfolio that is overweight in terms of bills and bonds and buying stocks, he should think of it as moving further out on the maturity spectrum and placing a bigger bet on the future cash stream (in real terms) of corporate profitability.
Hopefully, considering the differing temporal natures of our investments will aid us in making wiser investment decisions, and help us to be better prepared when the inflationary cycle, long benign, turns.
