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Price Protection

Adam M. Grossman

INFLATION THIS YEAR has been running at more than four times the Federal Reserve’s target of 2%, forcing the central bank to raise interest rates multiple times. As a result, both the stock market and the bond market have been struggling. This has investors searching for alternatives.

At the top of the list for many people is gold, which gained a reputation as a bulwark against inflation in the 1970s. During that decade, when inflation was running hot, gold rose eightfold. More recently, gold climbed nearly 25% when COVID-19 first emerged in 2020.

Gold, however, also has a habit of being erratic. After its strong 2020 performance, gold dropped 4% in 2021. So far this year, it’s dropped a further 8%. What’s going on? As I’ve discussed before, gold lacks intrinsic value. Unlike stocks, bonds or real estate—which do have intrinsic value—gold doesn’t produce dividends, interest or any other kind of income. Gold is worth only what the next person is willing to pay for it, and that can vary wildly. This calls into question its inflation-fighting ability. That’s why I don’t recommend owning gold—except as jewelry.

If gold isn’t the solution, how can investors protect their portfolios in today’s inflationary environment? The most obvious answer: Treasury Inflation-Protected Securities, or TIPS. These are U.S. Treasury bonds that offer built-in inflation protection. Today, the five-year “breakeven rate” on TIPS is about 2.4%, meaning that TIPS prices assume inflation will drop substantially from today’s 8% or 9% level. If inflation over the next five years turns out to be higher than 2.4% a year, TIPS investors will do well. Since the jury on inflation is still out, I think TIPS are a good idea for most investors.

A close cousin of TIPS are Series I savings bonds. These must be purchased directly from the Treasury, there’s typically a $10,000 cap on annual purchases and you can’t sell them in the first 12 months after buying. Aside from those limitations, Series I bonds are another good way to shore up a portfolio against inflation. The rate on new bonds today is an annualized 9.6%, which is guaranteed for six months and then varies with inflation thereafter.

TIPS and I bonds make sense as part of an investor’s bond portfolio. But I don’t see either as a cure-all. After all, they’re still just bonds. Beyond their inflation adjustments, they offer very little upside. For inflation protection that carries the potential for more robust growth, there’s another asset class to consider: stocks.

This might seem surprising. After all, stocks have taken it on the chin this year. That’s true, but I don’t see this as a permanent condition. To understand why, it’s worth reviewing the fundamental driver of share prices: the profits of the underlying companies.

If you were to look at a chart of the S&P 500 index over time and lay it side-by-side with a chart of the S&P companies’ combined profits, you would see that they mirror each other quite closely. The relationship isn’t perfect. But if you take a longer-term perspective, market prices—on average—tend to follow corporate profits.

What are we seeing in corporate profits today? This is where it gets interesting. Read the headlines, and you might think companies are in trouble, struggling with higher costs for energy, raw materials and payroll. Those factors don’t seem like they’d bode well for stocks.

But that would overlook a critical factor: companies’ ability to raise prices. Consider Hershey. The cost to make its candy products has increased this year. But at the same time, it’s been able to pass a good bit of these increases along to customers in the form of higher prices, thus preserving much of the company’s profit margin.

Some companies have more of an ability to raise prices than others. But so far, it’s clear that corporate America has, on average, been managing the inflation squeeze fairly well. You can see this in companies’ gross margins—the difference between the price at which a company sells its products and what it costs to make them.

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What do we see in public companies’ gross margins? Among the companies in the S&P 500, gross margins have improved, on average, by 0.6% this year. For comparison, gross margins increased by 0.2% between 2018 and 2019—the most recent normal, pre-pandemic years. In other words, companies have so far done a fine job passing along price increases to customers and thus maintaining their profits.

Gross margins are one measure of corporate profits. Another measure—and the one that matters most to investors—is earnings per share. The results on that score have been similarly positive. In total, S&P 500 companies’ earnings are projected to grow by 8% this year. In 2023, earnings are projected to notch another 8% or 9% increase.

Because share prices ultimately track corporate earnings, these numbers are clear evidence, in my view, that stocks offer solid protection against inflation. You might, however, dismiss this as an academic exercise. After all, stocks are down this year even though profits are up. There’s no denying that, but there’s an explanation—​one that, in my opinion, should help investors maintain their faith in stocks.

As noted earlier, stock prices generally follow corporate profits, but they don’t move in lockstep. Here’s how I’d think about it: Imagine two people driving to the same destination but taking different routes. They’ll diverge along the way. But in the end, they should converge upon the same place. That’s how I look at the stock market. Divergence is what we’ve seen this year. Corporate profits are positive, but the market is negative. Convergence will happen down the road.

There’s a ratio to measure the relationship between stock prices and corporate profits. You’re probably familiar with it: It’s the price-earnings, or P/E, ratio. This is a useful measure because it helps explain what we’re seeing in the market this year.

At the start of 2022, the P/E on the S&P 500 stood at 23. But as share prices have tumbled even as earnings have climbed, it’s fallen to just 17 today. That’s a roughly 25% decline. In industry terms, this is called multiple compression. It’s what typically occurs in periods of increased investor anxiety. But there’s no reason to believe this will be permanent. When today’s dark clouds give way to clearer skies, it’s reasonable to expect the market’s P/E to expand again. When that happens, we’ll see the opposite of what we’ve seen this year: Stock prices will rise disproportionately faster than earnings.

When will that happen? I can’t put a date on it, but it’s easy to see what might make that a reality: anything that helps allay investors’ present concerns—a resolution to the war in Ukraine, for example. When positive developments like this arrive, stock market investors will likely be rewarded. In the meantime, I wouldn’t worry about this year’s difficult environment.

I also wouldn’t worry if things get worse before they get better. In recent public statements, the Federal Reserve indicated its intention to continue raising rates, even at the risk of pushing the economy into recession. That very well could happen. Indeed, some observers believe the economy is already technically in recession. Still, I wouldn’t let that hurt your confidence in the stock market as a reliable tool for building wealth and protecting against inflation over time. Remember: The stock market never moves in a straight line. But historically, over the long term, it’s always taken patient investors where they’ve wanted to go.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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Jack McHugh
Jack McHugh
2 months ago

Conclusion first: Stocks may indeed be the best inflation hedge in the long-run, but for me and some others here, that may be “Keynesian” long-run:

“In the long run we are all dead.”

~~~~~~~~~~~

My sense is, you can run but can’t hide from high inflation/negative real interest rates.

I think a lot about the retirees of 2001, who had to wait a long, long time before liquidating equities with a gain not a loss.

For these reasons, I’m treating my entire bond portfolio (100% 2-year treasuries) as THE distribution “bucket” for as long as stocks remain underwater. With yields improving, ongoing hits from inflation (hopefully) won’t be so bad.

Family history suggests my bonds would carry me pretty close to the end, and even if stocks remain in a deep hole then, they’ll still provide “enough.”

With all this in mind, I was lucky/smart in 2021 by taking profits on stocks the whole way up, boosting my asset allocation for the first time (and just in time) to more bonds than stocks (55/45 bonds/stocks).

Last edited 2 months ago by Jack McHugh
Jack McHugh
Jack McHugh
2 months ago
Reply to  Jack McHugh

ETA, I forgot to give the context for those recent moves: I retire at the end of 2022.

steve abramowitz
steve abramowitz
2 months ago

Thanks Adam and thanks to all you guys for a great conversation. I want to mention an important topic left out of the discussion so far—sequence-of-return risk, when a bear market early in retirement ravages all those years of delightful compounding returns. This can decimate a fixed withdrawal strategy and leave a retirement stash too depleted to generate an income stream high enough to support the level of withdrawals required by the plan. It is well to remember that a 20% loss on say $200,000 early in the accumulation stage is nothing like the devastation wrought by a 20% hit on your $2,000,000 amassed just before retirement.

Fortunately, several remedies have been proposed though unfortunately not one is perfect. We can set aside a cash bucket or other diversification strategy or implement a withdrawal strategy that varies in concert with market performance. The latter solution is, as you might expect, controversial and Morningstar has presented some sophisticated analyses comparing the benefits and risks of the fixed and flexible approaches. And for those not deterred by their humungous commissions, there Is always a complementary fixed annuity option. Hope this helps to clarify an often overlooked problem.

Jonathan Clements
Admin
Jonathan Clements
2 months ago

Rick Connor recently had a good piece on the topic:

https://humbledollar.com/2022/09/beginning-badly/

Kevin Thompson
Kevin Thompson
2 months ago

Great article, however I would like some context.

  1. TIPS? They are based not on where inflation is currently but what inflation expectations may be in the future. Therefore, TIPs have been a laggard not only this year but “may” continue to lag in the future, especially with rising rates eating away bond returns in earnest. (Just for everyone’s edification) Furthermore, TIPs investors have lost money because they have been bid up in the secondary market, so I say caveat emptor. The market had already anticipated inflation and priced it into TIPs.
  2. Multiple Compression: it is true many companies were benefiting from lower rates producing much higher multiples. The real issue with rising rates comes in regard to expected earnings and cash flow. I now have to discount future earnings using a higher risk free rate, thus producing lower multiples.
  3. People often say markets trend higher over time, which is correct, however, I often have recency bias thinking about the lost decade for stocks. For most on this thread, which I am assuming are retirees, stock gains are not as relevant as mitigating stock losses and maintaining a sustainable income stream. There are some great opportunities laddering treasuries at this current stage.
  4. Bonds will turnaround eventually and that 60/40 portfolio will come back in vogue. It will take time and patience like you mentioned.
Last edited 2 months ago by Kevin Thompson
Kevin Thompson
Kevin Thompson
2 months ago
Reply to  Kevin Thompson

Also, be cognizant that TIPs are not reacting to inflation, they are reacting to how reactive the Fed will be in attacking inflation, hence the reason they are lower. Short maturity TIPs May be best. Maturities 2022/2023. Best advice is to purchase them direct from treasury versus buying the less than perfect index TIPs. There is a big difference in performance when considering an etf versus buying them direct.

Last edited 2 months ago by Kevin Thompson
wtfwjtd
wtfwjtd
2 months ago

A thoughtful take on an interesting subject, thanks Adam. I’ve recently been pondering many of these same issues, so I decided to do a real-world exercise: I compared the total return of some I-bonds that I purchased in 2001, to the hypothetical return of stocks and a typical 60/40 portfolio. Those I-bonds had a fixed rate of 3% + inflation, and were a great find at the time (especially in hindsight!). The result: after 21 years, the all-stock portfolio, as well as the 60/40 portfolio, still managed to out-perform the I-bonds, which have roughly tripled in value since then. However…(and this is a BIG however), there were many ups and downs in the stock portfolios, while the I-bond collection went smoothly up over time. The stock portfolios actually *under* performed the the plain old I-bonds for over 15 years; it wasn’t until the late teens that it finally overtook the I-bonds and delivered the higher returns.
It was an interesting exercise, and as far as I’m concerned, it’s a real-world example that perfectly correlates what you’ve written here. Stocks will eventually win out, for the reasons you outline, but sometimes it takes time. In the mean time, a few TIPS, I-bonds, and other things are needed to keep us afloat, and timely articles like yours helps keep us sane. Thanks again!

Last edited 2 months ago by wtfwjtd
Jonathan Clements
Admin
Jonathan Clements
2 months ago
Reply to  wtfwjtd

We don’t know how stocks and bonds will fare from here. But Series I bonds bought today offer no gain over and above inflation, unlike your impressive 3% real return, and will fall below inflation once income taxes are figured in. The comparison going forward will be much kinder to the balanced portfolio.

Kevin Thompson
Kevin Thompson
2 months ago

100%. What you have to do is compare those against a basket of cash and cash equivalents. Their return will be far superior than your regular cash accounts. I use them as a cash substitute with short maturity. So I will receive an 8% nominal return on cash and cash equivalents on my Ibonds just having held them 15-months. After tax will come in roughly around 6% nominal. Much better than I can get in any cash account without risk. Just my 2 cents.

Last edited 2 months ago by Kevin Thompson
wtfwjtd
wtfwjtd
2 months ago

“The comparison going forward will be much kinder to the balanced portfolio.”
Absolutely! Those 3%+ inflation I-bonds were worthy of serious consideration all by themselves as a respectable investment vehicle, in my opinion. Unfortunately, they’re long gone, but the 60/40 portfolio is something within reach of most everyone. Now just combine a little patience with that 60/40, and after a while you’ve still got something very respectable. Sometimes it just takes a little longer, that’s all.

Nate Allen
Nate Allen
2 months ago
Reply to  wtfwjtd

You have illustrated why investors and asset managers don’t just rely on returns (CAGR) to compare between different investments. They use other types of risk-adjustment calculations to capture the volatility that you describe. (“Volatility” being the “ups and downs” you talk about.)
Some popular risk-adjusted calculations to compare between investments are Sortino, Sharpe, and Treynor. (Among many others.)

Last edited 2 months ago by Nate Allen
wtfwjtd
wtfwjtd
2 months ago
Reply to  Nate Allen

Your comment reminds me of a couple of illustrations I saw on a You Tube video the other day. One was a cartoon of a guy standing at the base of a gently, upward-sloping line, with a caption “how we imagine retirement”. Next to this was cartoon drawing of “our retirement as it really is” that has the same guy looking at a jagged, crooked, up-and-down, all-over-the-place line. After the market turmoil of the last few years, I can strongly relate to this, for sure. Makes me think that Sharpe fellow really was onto something.

Last edited 2 months ago by wtfwjtd
TomandDeb Leigl
TomandDeb Leigl
2 months ago

Wow!!! you contributors on Humble Dollar continue to knock this stuff outta the park!! Excellent article Adam…..some of the best in class. I never supported investments in Gold…..thanks for adding some perspective to the folly of gold.
The stock market has many folks worried…..great job adding an insightful presentation to what’s really going on and what to expect…..very well done Adam!!

Rick Connor
Rick Connor
2 months ago

Adam, thanks for the insightful and calming article. It’s been tough recently to keep the faith.

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