A Fundamental Economic Fact Fiduciaries Use to Fight the Fear of Falling Markets
Charles C. Scott comments about fundamental economic facts of inflation were featured in Christopher Carosa’s recent article for Fiduciary News.
A Fundamental Economic Fact Fiduciaries Use to Fight the Fear of Falling Markets
The twin hobgoblins of fear and greed consistently vex and harass the best interests of retirement savers. Behavior economists know these gremlins all too well and the way they skew the decision-making abilities of unsuspecting victims. An experienced fiduciary learns the tools necessary to fight these evil treasure trolls. Behavioral economics does offer concise – albeit complex – explanations for atrocious choices, but few can readily grasp them. Traditional economic concepts, however, provide easier-to-understand common sense interpretations that can quickly illustrate how to avoid harmful knee-jerk responses.
Headline-grabbing market declines often present opportunities to efficiently shield retirement savers from exercising poor judgment. Whether it’s saving for retirement or making every day purchasing decisions, it’s important people know, grasp, and understand the impact these five fundamental economic facts can have on their lives. Over the next several months we’ll be featuring articles that highlight each of these five facts. For fiduciaries, it’s important to know how to communicate these concepts in ways that the average retirement saver can best appreciate. These articles will provide examples of how to do precisely that.
Fundamental Economic Fact #1: Inflation
This represents the focal point of current events. With an economy beginning to rev up to traditional post-recession level, we expect to see a return of inflation. “Inflation is a percentage rate at which the prices of goods and services rise, which reduces the purchasing power of the same amount of money you have today,” says Milena Thomas, a professional educator with Master of Science in Finance and Specialization Equivalent in Economics who resides in Franklin, Michigan.
Because of its long-term impact and the potential for counter-intuitive side effects, it’s important we understand not only what causes inflation, but how it might hurt us and what strategies we might employ to reduce that possibility of getting hurt. “Inflation is the erosion of purchasing power and increasing prices over time and can have the adverse effect of increasing the cost of living,” says Gary Rudow, Managing Director/Investments at Stifel, New York City. “It usually occurs during periods of excessively high public debt levels and overexpansion of the money supply. It is generally considered to be a negative consequence, except when it has the effect of reducing the burden of debt (servicing with dollars that are worth less in real terms). The impact is usually reduced through implementation of tighter monetary policy and/or stimulation of supply.
We can see the effects of inflation in our daily lives over extended periods of time. “According to the United States Department of Labor, Bureau of Statistics,” says Dave Barr, a CPA in Pittsburgh, Pennsylvania, “a loaf of bread only cost 59¢ in 1988. In 2013, the same loaf of bread cost $1.42. This is an increase of 83¢ or 140%. Nothing about the make-up of the bread has changed, just the cost to produce and sell it.”
“The best example I have ever seen is the first-class postage stamp,” says Charles C. Scott, founder of Pelleton Capital Management in Scottsdale, Arizona. “It doesn’t do anything different today than it ever has – it simply delivers a letter to someone. But it costs 50 cents today, compared to 42 cents in 2008, 32 cents in 1998, and 22 cents in 1978. Exactly the same service that now costs more than double what it did 40 years ago. That’s inflation.”
Inflation can give you a false sense of security as it eats away at your standard of living. “For example,” says Thomas, “if inflation is 3% and you got a 2% raise last year, you actually got a pay cut. Another very sneaky way inflation makes its way into our lives is by the reduced quality or quantity of goods we usually buy. For example, the box of cereal or jar of peanut butter you buy may be the same price, but the packaging has reduced in size in order to save costs for the manufacturer.”
“Simply put, when it cost more to buy groceries or put gas in your car, you’re experiencing inflation.” says Bill Rice, President of MyPerfectMortgage.com in Flat Rock, Michigan. “Inflation isn’t necessarily a bad thing and if you want to beat it you have to understand it.”
So, what do you do to beat it? In part echoing Thomas’ concern, Stephen Nelson, a Wealth Associate at Aldrich Wealth LP in Carlsbad, California, says, “Negotiate salary to increase with inflation or hold investments that typically meet or exceed inflation; such as stocks or rental real estate.”
Barr says, “It is important to find a career path that has the opportunity to increase your salary year over year. Jobs, where wages have been stagnant for long periods of time, could pose problems in the future. Inflation is also the reason that it is not wise to stash all of your cash under your mattress. Finding a solid savings account with a higher interest rate will help protect their money from losing value over time.”
This is where those counter-intuitive measures can strike. During inflection parts – when inflation changes direction (like we’re experiencing today) – markets often react in knee-jerk fashion. For example, a robust economy generally sows the seeds for higher levels of inflation. Left unattended, this might lead to runaway inflation. Most policymakers consider runaway inflation a bad thing and try their best to thwart it. For the fed, this means raising interest rates. As interest rates rise, so does the cost of capital. This places financial pressure on equities, often leading to a short-term drop in equity prices. Once we’re past the inflection point, equity prices stabilize, and we can return to standard equity valuation measures.
“When the economy gets stronger, goods and services get consumed faster, and things get more expensive,” says Rice. “Therefore, if you want to beat inflation then you need to ride the wave of businesses making more money. This means investing your money wisely in an asset class that is earning more than the rate of inflation. Despite your natural instincts, this probably doesn’t mean hoarding cash or stashing it in a money market or savings account. Quite the contrary, you are generally better off taking a little more risk and investing in stocks and bonds, the profits and debts of successful companies, either directly or via mutual funds or ETFs.”
What an example showing why stocks offer such a tremendous hedge against inflation. On February 5, 2018, the Dow Jones fell 1,175 points, its largest ever daily point loss (surpassing the TARP driven drop of 777 points on September 29, 2008). The 2018 fall represented a single day loss of 4.6%. That might sound like a lot, but it doesn’t even make the top 20. By the way, coming in at #20 is the 777-point drop which accounted for a loss of 6.98%. This shows you the extent to which stocks have “inflated” over the last ten years.
Historically, a shift to rising rates can cause markets to fall. Yet, the cause of those rising rates –inflation – also provides the cure to the falling market. Equity markets have consistently demonstrated they can present a successful method of hedging inflation.
If that sounds like a catch-22, then you’ve mastered an understanding of the meaning of counter-intuitive.
Inflation isn’t the only economic fact that moves prices. Indeed, one can argue it’s not even the primary factor relating to price movements. We’ll address this economic fact in the next article in this series.