When the prices of goods and services increase over time, consumers can buy fewer of them with every dollar they have saved. This erosion of the real purchasing power of wealth is called inflation. Inflation is an important element of investing. In many cases, the reason for saving today is to support future spending. Therefore, keeping pace with inflation is a crucial goal for many investors. To help understand inflation’s impact on purchasing power, consider the following illustration of the effects of inflation over time. In 1916, nine cents would buy a quart of milk. Fifty years later, nine cents would only buy a small glass of milk. And more than 100 years later, nine cents would only buy about seven tablespoons of milk. How can investors potentially prevent this loss of purchasing power from inflation over time?
Exhibit 1. Your Money Today Will Likely Buy Less Tomorrow
In US dollars. Source for 1916 and 1966: Historical Statistics of the United States, Colonial Times to 1970/US Department of Commerce. Source for 2017: US Department of Labor, Bureau of Labor Statistics, Economic Statistics, Consumer Price Index—US City Average Price Data.
INVESTING FOR THE LONG TERM AND OTHER “TIPS”
As the value of a dollar declines over time, investing can help grow wealth and preserve purchasing power. Investors should know that over the long haul stocks have historically outpaced inflation, but there have also been short-term stretches where this has not been the case. For example, during the 17-year period from 1966–1982, the return of the S&P 500 Index was 6.8% before inflation, but after adjusting for inflation it was 0%. Additionally, if we look at the period from 2000–2009, the so-called “lost decade,” the return of the S&P 500 Index dropped from –0.9% before inflation to –3.4% after inflation.
Despite some periods where stocks have failed to outpace inflation, one dollar invested in the S&P 500 Index in 1926, after accounting for inflation, would have grown to more than $500 of purchasing power at the end of 2017 and would have significantly outpaced inflation over the long run. The story for US Treasury bills (T-bills), however, is quite different. In many periods, T-bills were unable to keep pace with inflation, and an investor would have experienced an erosion of purchasing power. After adjusting for inflation, one dollar invested in T-bills in 1926 would have grown to only $1.51 at the end of 2017.
Exhibit 2. Growth of $1, 1926–2017
S&P and Dow Jones data © 2018 Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Past performance is no guarantee of future results. Actual returns may be lower. Inflation is measured as changes in the US Consumer Price Index.
While stocks are more volatile than T-bills, they have also been more likely to outpace inflation over long periods. The lesson here is that volatility is not the only type of risk that should concern investors. Ultimately, many investors may need to have some of their allocation in growth investments that outpace inflation to maintain their standard of living and grow their wealth.
One additional tool available to investors who are concerned about both stock market volatility and inflation are Treasury Inflation-Protected Securities (TIPS). TIPS are guaranteed by the US Treasury and as such are considered by the marketplace to have low risk of default. The Treasury issues TIPS with a variety of maturities, and these securities are easily bought and sold. Unlike traditional Treasury securities such as T-bills, TIPS are indexed to inflation to protect investors from an erosion in purchasing power. As inflation (measured by the consumer price index) rises, so does the par value of TIPS, while the interest rate remains fixed. This means that if inflation unexpectedly rises, the purchasing power of any principal invested in TIPS should also increase. Although they may not offer the long-term growth opportunities that stocks do, their structure makes TIPS an effective risk management tool for investors who are concerned with managing uncertainty around future purchasing power.
Inflation is an important consideration for many long-term investors. By combining the right mix of growth and risk management assets, investors may be able to blunt the effects of inflation and grow their wealth over time. Remember, however, that inflation is only one consideration among many that investors must contend with when building a portfolio for the future. The right mix of assets for any investor will depend upon that investor’s unique goals and needs. A financial advisor can help investors weigh the impact of inflation and other important considerations when preparing and investing for the future.
Six months have gone by since I passed the reins of Rathbone Warwick to the very capable hands of Ryan, Ben and Brooke.
Staying busy has not been a problem. A highlight was spring skiing with my son, 26, and nephew, 21, at Crested Butte, Colorado. We all had so much fun that we decided to make it an annual trip. For me to ski with 20 something rippers requires training six days a week. Busy.
I have found a new joy listening to podcasts while on the road or bicycle. Podcasts are college level classes for free while only taking the classes which interest you the most.
One of my favorites is Econ Talk hosted by Russell Roberts. Roberts is a Research Fellow at Stanford’s Hoover Institution and a founding member of the Library of Economics and Liberty. Roberts reads a new book each week, and interviews the author on Monday. Some of the conversations fly over my head, but hey; this is college.
Recently Roberts interviewed Jason Zweig who writes The Intelligent Investor every Saturday for The Wall Street Journal.
Zweig’s new book, The Devil’s Financial Dictionary, is a glossary of financial terms inspired by Ambrose Bierce’s masterpiece, The Devil’s Dictionary, a collection of witticisms published more than 100 years ago. The definitions are witty, at the edge of cynicism, yet grasp hold of essential truths.
Here are a couple of definitions to give you the flavor. First from Bierce:
Liberty, n. One of Imagination’s most precious possessions.
Politics, n. A strife of interests masquerading as a contest of principles. The conduct of private affairs for public advantage.
Now from Zweig in The Devil’s Financial Dictionary:
Downside Protection, n. A tactic put in place by a financial advisor to protect against whatever hurt the value of a portfolio last time. The portfolio will be hurt by something entirely different next time, however.
Hedge Fund, n. Expensive and exclusive funds numbering in the thousands, of which only about a hundred might be run by managers talented enough to best the market with consistency and low risk. “The rest,” says the financial journalist Morgan Housel, “charge ten times the fees of mutual funds for half the performance of index funds, pay half the income-tax rates of taxi drivers, and have triple the ego of rock stars.”
In a recent podcast, Roberts engages Zweig in a great conversation on Wall Street, Psychology, Behavioral Finance and the personal qualities necessary for successful investing.
Fans of Zweig know his skepticism for Wall Street’s latest products. Zweig was raised on a farm in Upstate New York. There is nothing like the farm to refine one’s nose to the smell of bull manure. I have been reflecting on my good fortune of a farm upbringing. From my first job at age five or six, I banked my pay with a passbook account and watched the interest grow. By age nine or ten, my brother and I had a small business buying piglets in the spring, working off the feed expense over the summer and selling them at the fair in August. Nearly fifty years later I can see the seamless connection to those early lessons. And yes, I can smell manure from a mile away.
Like Zweig, my father was an investor. Zweig talks about the wisdom that he gained from his father who never held an investment for less than a few years and never made a decision based on the current news. They invested without regular price information since the local paper didn’t publish stock prices and long distance phone calls were very expensive. My family had a subscription to the Wall Street Journal, but we were also long-term investors.
Zweig and Roberts contrast those times with today’s challenge to resist acting on the unending flow of instantaneous data. That data leads many to seek out the essential tidbit, the equation to analyze it, or the speed to out-trade it. Those pursuits will likely be fruitless. Zweig implores us rather to work on the qualities of humility and self-control.
The need for self-control in Zweig’s own words from the podcast:
“As Benjamin Graham wrote in The Intelligent Investor, the investor’s biggest obstacle is likely to be himself. Actually, he said: The investor’s biggest obstacle and worst enemy is likely to be himself. And it’s so true. Because you can have well-informed principles; you can do thorough research; you can have access to the best quality information; and then, you know, you get some tip at your country club that, you know, Tesla shares are cheap and you run out and put all your money in Tesla right before it tumbles. And you let go of your self-control for that one moment; and that moment of weakness is what takes you from outperformance to underperformance. And self-control is what has made Warren Buffett and Charlie Munger, and certainly what made Benjamin Graham into great investors. But most investors spend all their time and energy sort of pursuing other objectives. Like, getting the fastest information first, or finding the best software, or using some new analytical method that nobody else had thought of. And none of those things will get you where you need to go if you do not have self-control.”
I will take you to a beautiful quote on humility from Zweig, but first back to the farm. Farming requires humility if you want to keep from going broke. There can be a great temptation to put all of the ground in a seed crop, but the successful farmer recognizes that a late summer hail storm could put him out of business. The farmer knows that he is dealing with uncertainty and forces of nature beyond his control.
In Jason Zweig’s words:
“If there’s one overriding theme to the book, one of the things I tried to get across in The Devil’s Financial Dictionary is the importance of just being humble before the financial markets. I mean, people are humble before nature. Think about when you stand on the brim of the Grand Canyon or you walk to the edge of the ocean or you look up at the stars. People feel this sense of awe and wonder and smallness, because we are small when we compare ourselves with the natural world. Well, individuals, and for that matter policy makers are small when we compare ourselves with the financial markets. But most of us forget that. And we think, ‘Oh, well we have better data,’ or ‘We know something the other guy doesn’t.’ And in fact we should have that same sense of just being a speck of sand on a long beach, and just remember that whatever we know is very small compared to the totality of the information that’s out there.”
I am comforted to have the overarching investment philosophy of Rathbone Warwick reinforced by these thoughtful and eloquent words. I am also humbled.
“Those who cannot remember the past are condemned to repeat it.”
– George Santayana
August snapped a nearly four year-long streak of consecutive months without a 10% correction in the S&P 500 Index. This ranked as one of the three longest streaks going back to 1965. We were prepared with snow-tire equipped portfolios that are structured with volatile markets in mind.
We welcome volatility in stocks and view it as healthy for the markets. Like overgrown forests susceptible to devastating wildfires, smooth markets driven by leveraged speculators become vulnerable and top heavy.
Historically the market has sustained a correction of 10% about once per year. There have been fourteen market declines of about 20% or more since World War II, or roughly one every five years. The average of those drops was approximately 30%.*
As investors, we are willing to accept these temporary declines to capture the long term uptrend of markets. In 1946 the price of the S&P 500 Index was 19. As of this most recent quarter’s end, the S&P 500 traded at 1,920.* Despite regular declines of meaningful magnitude, the index is currently 100 times higher than where it began seventy years ago.
Given the nearly four year-long hiatus from such corrections, the third quarter’s top to bottom decline of about 14% in the S&P 500 felt worse than it actually was. Volatility is normal and to be expected. Erratic market behavior creates opportunities for us as long-term investors, while wreaking havoc on speculators.
In last quarter’s newsletter, we touched on how the market continues to show meaningful divergence in performance among asset classes (U.S. stocks, international stocks, small stocks, large stocks, etc.) and styles (value, growth). Asset classes like small cap growth, heavily weighted toward exciting sectors like social media and bio-technology, continue to defy gravity and plod higher despite nosebleed valuations.
Small cap value companies, which are weighted toward industries viewed as boring, like insurance or equipment manufacturing, have realized negative returns over the last year. Even though these companies are far more profitable and relatively inexpensive from our point of view.
The divergence over the last year has us thinking about the performance of the markets in the late 1990’s and early 2000’s. High-tech fliers were a “must own” and “old economy” value stocks were destined for certain obsolescence. The tide turned in 2000 and proved to be fatal for many of the once high fliers. The mundane and inexpensive value companies had a banner year.
At Rathbone Warwick Investment Management we are value investors at our core. Despite the recent outperformance of the growth-oriented indices, we take comfort in our contrarian philosophy of buying what is inexpensive and unloved. Fundamental research shows these “value” factors tend to outperform over extended periods of time. With the humility to know we cannot predict short term market behavior, we work to control the risks we can and adhere to the principles of our long term strategy. Patience, discipline, and value will prevail.
*Behavioral Investment Counseling, Nick Murray, 2008
Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.
Only buy something that you’d be perfectly happy to hold if the market shut down for ten years.
Why hasn’t my account performed in line with the S&P 500? Performance reviews have gone out for the second quarter and many of you may be wondering just that. We remember similar questions from 1999 and 2000 as technology led the index higher and higher. This time the index is being led by healthcare stocks, especially the riskiest companies in that sector.
Here is the bottom line: Your portfolio is being managed as an all-weather and all-terrain vehicle (“Have You Put Snow Tires on your Portfolio?”) You have tremendous diversification across economic sectors and across national borders. Think of your portfolio as a heavy four-wheel drive truck. It may feel a little slow at times but it will be the vehicle of choice when the storms blow less diversified portfolios off the road.
A superstorm hit in March of 2000 and the NASDAQ Composite Index lost more than 78% of its value in 18 months.* The index did not return to the high of 2000 for a full fifteen years. That is the type of loss that happens when investors chase markets; it is the type of loss that we work hard to protect you from.
We love to make money, but heeding Buffett’s Rule #1, you won’t find us chasing returns in companies whose valuations don’t make sense to us. Ever on the stormwatch, our Board of Scholars contributor Dr. Peter Crabb has a great piece on the growth in government debt around the world (“The Global Credit Bubble”).
Meanwhile, we find the courage to follow our discipline of holding on to a globally diversified portfolio that is biased to what we believe are the best companies at the best price. Our objective is to protect and prepare so that clients can enjoy a financially secure future.
Please also help us welcome Andy Clements as a Client Associate. Andy graduated from the University of Idaho in May. Andy earned a degree in business economics and was the Vice President of Services for Vandal Solutions, a student-run marketing organization.
Robert W. Rathbone
Interest rates are the price of money.”
With interest rates near zero percent, the central bank may now be deciding the economy is too weak to raise interest rates. Too weak? Not for those able to tap into low cost money. A look out of my window this morning evidences a building boom with four cranes erecting new buildings. Developers are vying for new hotels; all of which promise to leap to heights similar to the recent move in the biotech index. Booms are created when the price of money is artificially low.
It has been four years now since the Investment Forum where I proposed that the “main story” underpinning the stock market is the government printing press. The effect was demonstrated at the event by ripping a facsimile of our legal tender showing the debasing effect of government money printing.
Where it will end, nobody knows. We are focused on not paying too much for stocks, keeping your portfolios well diversified, and maintaining a cash reserve in most accounts. We do this without losing sight of the “main story.” We own stocks to keep up with the government printing press. In the hundred odd years since the creation of the Federal Reserve Bank, the most trusted currency in the world has lost 96% of its purchasing power.* Stocks are the alternative currency that has kept up.
When the politicians talk about the one percent, they mean you. Taxes have been going up. We have been managing your portfolios to keep realized gains and your corresponding tax bill to a minimum. Accounts have risen in this bull market which means larger required minimum distributions from retirement accounts. Dividends have also been rising which means more taxable income. The run up in the market means that changes to portfolios often result in realized gains; we are dedicated to low turnover and keeping your taxes and fees to a minimum.
We have created a client portal for you on our website. Your client portal is where you can view your account Quarterly Performance Report (now available), holdings, and allocation online. We emailed a link with a temporary password that will direct you to a login page. If you did not receive the email, please contact us. You may also access your portal through the “Clients Only” page on our website at www.rathbonewarwick.com. We look forward to your feedback on this new technology.
Next month, we will host our 2015 Investment Forum on Thursday, May 14, 11:30 am – 1:00 pm at the Stueckle Sky Center, Double R Ranch Club Room. This year we will hear from Apollo D. Lupescu, V.P., Dimensional Fund Advisors LP and L. Dwayne Barney, Ph.D., Professor Emeritus of Finance, Boise State University. It promises to be a lively discussion on the economy, money supply, and investments. Lunch will be served, and we will stand to publicly answer your difficult questions.
We like to call this a working lunch and we keep the topics at a high level to qualify for continuing education credit for our friends in the accounting and legal community. Please call us for reservations or go to our website to register online today.
Remember, do not lose sight of the “main story.”
Thank you for your business.
Robert W. Rathbone
*Source: US Dept. of Labor Bureau of Labor Statistics
“The first thing you have to know is yourself. A man who knows himself can step outside himself and watch his own reactions like an observer.”
-Adam Smith, The Money Game
I was thinking about the markets and our portfolios last week on an early morning drive up to McCall. Fresh air and sunshine to clear the brain. Driving a solid, if eight-year-old, rig; ready for the season with studless snow tires and traction control, I found myself pulling over to let an empty logging truck charge past.
The road was wet, the temperature was 29º, black ice may have materialized in any corner. The logger was driving faster. His old Peterbilt was leaning hard in the turns. I wondered if he considered the risks.
We put the snow tires on our portfolios last year. The fund models were rebalanced to bring the bond allocation back to target. Investments in markets that have run up were trimmed to add to those which have been out of favor. We increased our bias towards value stocks and companies with consistent profitability versus those that have been on a tear.
These moves were not designed to “get there” first. These adjustments were made with the idea of staying on the road. As measured by the S & P 500, stock prices have increased by more than 200% from their lows of 2009,1 our balanced portfolios made new highs in 2011 and have continued to grow.
With this sunny road behind us, what lies ahead? Hopefully the deicing machine works as hoped and we have a nice smooth ride. Unfortunately, unlike the trip to McCall, we are on a brand new road. There is no map and no one has driven it before. The unprecedented growth in the Fed’s balance sheet coupled with the Zero Interest Rate Policy has not yet produced the desired result of a strengthening global economy. The desire for a little bit of inflation is still threatened by the deflationary pressure of the huge public debt which holds back the economy and crowds out private investment.
The way forward as discussed in the October newsletter is tax and regulatory reform, lower corporate income tax rates and a rework of our byzantine tax structure.
Happily, we have received the equivalent of a tax cut through lower fuel prices. This market driven event is a very positive development for the main street economy.
At Rathbone Warwick Investment Management, we are driving forward into 2015 on this new road. Nothing was ever gained by staying home. We are optimistic that it is going to be a good trip, but we have our snow tires on and are ready in the event the road becomes slick. If you would rather ride in the logging truck, we should talk about that now.
Robert W. Rathbone
1The S&P 500 Index returned 13.69% for 2014, while the Russell 2000 Small Cap US Index was up 4.89%. The international index MSCI EAFE lost 4.90% for the year. Emerging markets, as measured by the MSCI EM index, declined 2.19% (Bloomberg).
“I believe the best social program is a job!”
With the third quarter of 2014 in the history books, this is a good time to take “stock” of the market’s year to date performance. So far, large companies have outperformed small and the US has outperformed international markets. Stocks measured by the S&P 500 Index returned 8.34% through the first three quarters. The Russell 2000 Small Cap US Index was down 4.41%. The international index MSCI EAFE lost 1.38%. Emerging market’s, MSCI EM index gained 2.43%.
Evidence of modest growth in the US economy continues with an average of 224,000 new jobs being created in each of the last three months. While the unemployment rate has declined to 5.9%, this headline number masks the fact that the share of the population that is working stands at 59%, the lowest level since 1978 under the Carter Administration.
The revolution in technology continues to bring change to our society at an accelerating rate. It echoes the Industrial Revolution, an event so portentous that our labor force went from 90% farmers in 1790 to half of that percentage in the first 100 years. That drop was followed by a 95% decline in the number of farmers as a percentage of population over the next 100 years. If you had told this to a farmer at the time, they would have worried that nobody would have anything to do.
This modern industrial revolution is in its fourth wave: Mainframes 1960’s, personal computers 1980’s, internet 1990’s, and mobile 2000’s. The rate of change has been accelerating since at least 1980, the year freshmen began showing up at college with desktop computers.
The Technology Revolution is certainly a partial explanation of the low labor force participation rate. The future is bright for those who have skill interfacing with technology, whether they are a machinist or a developer; but
in the same way that the Industrial Revolution dislocated farmers to factories, the Technology Revolution is dislocating people who are unskilled in computers. The job future is bleak for those who do not interface with technology. Those computer games we wouldn’t let the kids play probably did have a purpose.
This dislocation, a polite economic term for lost jobs, has opened the political door to populism: ”If you’ve got a business, you didn’t build that.” This misadventure is an echo of another Illinois lawyer and populist orator William Jennings Bryan, who promised government relief to farmers and railed against the Gold Standard in the election of 1896.
It is a sad irony that the populist progressive policies of printing money, high taxes and business impeding regulations hurt most those whom they claim to champion.
The way forward for the US economy is to get past fighting over pieces of the pie, and get on with growing the pie. Tax and regulatory reform are the policies that will eventually lift all boats. Meanwhile, let’s keep smiling. We had the big story right. Government policies have led to low growth and low interest rates, making the markets the most attractive investment opportunity over the last five years.
Robert W. Rathbone