An inflation questionnaire for investors
This U.S. advisory supplies answers for investors on the prospects of inflation — and updates its report on Canada’s biggest tech stock.
Inflation appears to be the least of our worries right now.
Citizens across North America are dealing with gnawing financial issues such as debt, rising taxes and an uneven economy.
But we’re surely not going to face a situation like that of Germany in 1923, as described by the famous novelist Erich Maria Remarque:
"Workmen are given their pay twice a day now — in the morning and in the afternoon, with a recess of a half-hour each time so that they can rush out and buy things — for if they waited a few hours the value of their money would drop so far that their children would not get half enough food to feel satisfied."
Nor are we in immediate danger of facing the 14 per cent inflation jolt that struck during the oil crisis of 1973.
Still, we ignore inflation at our peril. As investors, we should be especially wary of the effects of inflation, even when it is relatively low, says Dow Theory Forecasts.
So this U.S. advisory has crafted a question and answer approach to the dangers of inflation. The figures are revealing.
Before we get to that, we will turn briefly to the advisory’s update on Canada’s largest tech stock.
Explosive growth
Research in Motion (TSX-RIM; NASDQ-RIMM) was featured as this advisory’s “Analsyts’ Choice” stock just a short time ago, as we duly reported (see Daily Buy-Sell Adviser, March 29).
Shortly thereafter, RIM released its fourth-quarter results, which did not quite meet the expectations of analysts. Profits rose 41 per cent, but missed the consensus by one penny. Revenues had a similar fate.
This did not worry the advisory unduly. Nor did the fact that even before the report, “RIM’s stock dipped on chatter that its BlackBerry could face a new challenge from Apple’s (NASDQ-APPL) iPhone.” Not a problem, says the advisory.
“The explosive growth of smart phones leaves plenty of opportunities for both companies. Research in Motion’s quarterly results were disappointing, but the company’s revenue and profit guidance seems solid, and the earnings miss doesn’t invalidate the growth story.”
In short, while some other analysts have reservations about the competition that RIM faces, this advisory does not. It pointedly makes the stock a Buy now and a Long-Term Buy for the next 24 months.
The market is still wary. Trading at $77.99 ten days ago, the stock now stands at $69.83. There is no dividend.
Lower than average inflation
Should I be worried that inflation will rise? That’s the first question this advisory puts in the mouths of investors.
“Probably not in the near term,” is the short answer. The most common gauge of inflation is the Consumer Price Index (CPI). The bible of economic measurements, Blue Chip Economic Indicators, projects the CPI to rise by 2.2 per cent this year and 1.9 per cent next year.
These are both well below average inflation growth, which is 2.8 per cent since 1990 and 3.8 per cent since 1948. The consensus for the next 10 years calls for an average of 2.4 per cent.
The advisory is cautious, but hopeful.
“Economic forecasts are just educated guesses,” it says, “and we do not put too much stock in any long-range forecast.” But it appears reasonable to expect lower-than-average inflation for five to 10 years.
A drag on returns
So why worry about inflation at all? “Because over long periods of time, inflation drags on investment returns,” says the advisory.
From 1926 to 2009, $1 invested in large-cap companies in 1926 turned into $2,754 by 2009. But after inflation, the real return is $215.
For small caps, the initial return of the dollar was bigger, at $12,639, while the inflation-adjusted return shrinks to $1,055. For bonds and treasury bills the numbers are much more discouraging.
One dollar in long-term corporate bonds returned $123 in all those years — but just $10 after inflation. Treasuries returned $21 before inflation, but after 83 years, inflation turned $1 into just $2.
In short, even modest inflation will start chipping away at your returns. And as inflation grows, the chipping gets worse.
So what should I do to protect my portfolio? is the final question.
54,000 per cent
In the short term, says the advisory, you can invest in commodities and other assets usually considered hedges. But this is not an entirely effective strategy. “They do provide a hedge, but they don’t necessarily enable market-beating returns.”
Commodities and real estate tend to rise in periods of inflation, it adds. So do Treasury Inflation Protected Securities (TIPs) — real return bonds are the Canadian equivalent.
Thus holding 5 to 10 per cent of your portfolio in these investments can make sense as a hedge. But over the long haul, says the advisory, they are unlikely to match the returns of stocks.
Here is a final set of figures. Since 1950, gold has risen at an annualized rate of 5.6 per cent, while oil prices rose a bit more, at 5.8 per cent. Real estate delivered an annualized return of 8.3 per cent.
Over the same period, large company stocks returned 11.1 per cent annually. Taking just the two best returns, the growth rate for real estate works out to 12,000 per cent. For stocks, it’s 54,000 per cent.
In the end, says this advisory, the only way to beat inflation is to make sure your returns stay ahead of it. You can’t protect yourself simply by hiding behind hedges. Over the long run, you have to stock up on stocks.
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