Recently, a friend described his experience trying to buy a new car. “I had two choices,” he said. “One dealer wanted full sticker price. The other wanted even more. It wasn’t much of a choice.”
The inflation situation in the car market is well understood. A shortage of components is limiting car makers’ output, driving up prices. But inflationary pressures aren’t limited to cars. The most recent consumer price index reading was higher than it’s been in thirty years. In a recent article, The Wall Street Journal described how manufacturers of everything from handbags to fertilizer have been raising prices due to labor shortages and a snarled supply chain. It’s not a good situation.
But the Journal also noted a less well understood element of this story: Many companies, it turns out, are taking advantage of the situation to push through price increases that are over and above what would be warranted by their own higher costs. The result: Two-thirds of big companies are now enjoying higher profit margins than before the pandemic. For them, it’s been a banner year.
This story illustrates a number of important lessons for investors. Among them:
Investment markets are like a billiards table. I often quote investor-author Nassim Taleb, who likens investment markets to a billiards table: When you hit the first ball, you can be pretty sure where it’s going to go. Skilled players can control what will happen when the first ball hits the second. But beyond that, it’s anyone’s guess. Things are just too random. In the investment markets, we’ve seen that dynamic in living color this year.
Last year, when the economy ground to a halt at the beginning of the pandemic, inflation nearly went negative. At the depth of the recession, no one—that I know of—predicted anything like the recovery we’ve experienced. Notably, for example, even Warren Buffett miscalculated. When it looked like we might be in a work-from-home world forever, Buffett said that he sold out of all of his airline stocks, taking multi-billion dollar losses. With the benefit of hindsight, that was exactly the wrong move. But no one could have known that at the time.
No one knew that multiple rounds of government stimulus would leave people flush with cash, and that months of isolation would make them more eager to spend. No one could have foreseen that a shortage would develop in the semiconductor industry and that it would create a bottleneck for thousands of downstream products. No one could have foreseen that the backlog of container ships waiting off the coast of L.A. would now stretch all the way to San Diego, more than 100 miles south. No one could have foreseen how the resulting shortages would allow companies to boost their profitability. And perhaps most of all, no one could have foreseen “the great resignation” that’s resulted in millions of unfilled jobs.
Taleb’s billiards analogy couldn’t be more apt. I take this as a reminder, once again, that the prediction game is perilous. Why am I repeating this observation, one I’ve made many times before? Because I fully acknowledge how hard it is to avoid making predictions. Whether it’s an economic, political or geopolitical event, sometimes a risk just seems so clear. And that makes it awfully hard to avoid taking action. I recognize that. But that’s why I think it’s so important to follow stories like the one we’ve witnessed over the past year. If the world were simpler and more linear, predictions might be worthwhile. But the economy is not linear. It’s a billiards table.
There are limits to even the Fed’s power. A while back, Fed chair Jerome Powell described the current bout of inflation as “transitory.” While he didn’t precisely define that term, many are questioning whether he still believes that or if inflation has now started to take on a life of its own. I don’t claim to have an answer to this question. There’s too much conflicting data. But the Journal’s observation—that companies are now hiking prices not because they need to but because they can—reveals how tricky inflation can be.
It may be that Powell was right when he made his initial “transitory” comment. The numbers supported his view. What he wasn’t counting on, though, was the human element. The word “inflation” is now in the news so frequently that businesses are taking matters into their own hands, preemptively raising prices. To some degree, this is a defensive mechanism, to offset their own rising costs. But to an increasing degree, it’s now also offensive. Companies are using the current situation as cover to do what they otherwise couldn’t have gotten away with. But taken together, this year’s inflation story reveals that there are limits to even the Fed’s power. To be sure, the Federal Reserve did famously break the back of inflation in the early 1980s, but it wasn’t easy.
Stocks can be a good inflation hedge. In recent months, there’s been a lot of discussion about inflation-linked Treasury bonds. If you’ve held either TIPS or Series I Savings Bonds over the past year, you’ve probably done quite well. But investors often overlook a more obvious and potentially much more profitable way to protect against inflation: stocks. As I’ve noted before, all things being equal, a company’s share price should rise right in line with the prices of its products. That, I think, explains some part of the stock market’s rise this year.
Yes, there are situations in which inflation does hurt the stock market. Historically, in fact, the market has delivered lower returns during periods when inflation has been high. But still, even accounting for those lower-return periods, stocks have delivered far better returns than bonds over time. Stocks have also delivered demonstrably better returns than gold, which has a reputation—undeserved, in my opinion—of providing inflation protection. That’s why, even if you do think inflation will keep going, I still wouldn’t recommend any drastic change to your portfolio. The stocks you already own may do the job quite well.
“Rules” in economics are rarely rules. The financial world relies heavily on rules of thumb for guidance. But these rules often rest on shaky footing. One example, as I noted, is the notion that gold is an effective hedge against inflation. That notion stems from the fact that there have been periods when inflation was high and at the same time gold prices were rising. But the relationship between gold prices and inflation reminds me of the broken clock that’s right twice a day. Multiple studies, including one titled “The Golden Dilemma,” have looked at this question. The data is clear: Despite its reputation, gold is not the inflation hedge it’s perceived to be.
Another rule of thumb that’s been turned on its head this year is the idea that higher inflation punishes growth stocks. This notion is actually grounded in logic. A company’s share price should, in theory, reflect the present value of all future profits. Because of that, higher inflation is more corrosive to the value of faster growing companies because future profits represent a greater portion of their total value. And yet, this year, with inflation as high as it’s been in a generation, growth stocks like Microsoft, Tesla and Alphabet (aka Google) have far outpaced the overall market. That’s why I view rules of thumb as interesting, but hardly reliable.