Question. What produces a 10% annual return in the equity markets yet loses buying power?
Answer. Any equity product that earns a 10% annual return loses investment purchasing power when equity investment inflation is greater than 10%.
Huh? What the heck is “equity investment inflation”?
We’re all aware of CPI, or the “consumer price index”. CPI measures a representative basket of goods, based upon price, to come up with a quick sense as to the rate of underlying inflation on that basket. CPI measures inflation from a buyers’ point of view.
To a lesser extent, we’ve also heard of PPI, or the “producer price index”. PPI measures a representative basket of inputs required to produce output. This measures inflation from a sellers’ point of view. PPI reports on the purchase of private capital equipment, private capital construction and even private capital transport.
Oddly, neither CPI nor PPI measure inflation on equity investments. So, how do we measure INVESTMENT INFLATION, specifically equity investment inflation? After all, a purchase of equity, such as buying some shares of an ETF, or maybe shares in Amazon, is neither a good that you consume immediately, nor is it a basket of goods used to generate output immediately. It is something else, and that something is an investment.
Any investment is paid for with cash, from the sale of other equities, or from borrowings and therefore is sensitive to inflation of some sort. There are far more trillions invested in equity markets annually than are used towards consumptive purchases. So where is the inflation index on equities?
An inability, or perhaps an unwillingness, of various outlets to calculate and widely report the impact of inflation on equity investments should not be taken as a tacit admission that inflation on investments does not exist. Many, including retail investors or retirement planners, evaluate a specific annualized rate of growth from a stock holding and determine: “your investment grew by 8% and the consumer price index increased by 2%, so you are ahead by 6%”. The owner of that stock, hearing such a pronouncement, walks away with the impression that they are well ahead of the game.
A problem in declaring any investment return which beats consumer inflation to be a net positive return is that the premise is flawed; therefore the conclusion is unlikely to be correct. In the scenario above, you are being given an investment growth report with a non-applicable measurement (consumer price index) as the offset against investment growth. The 8%-2% = 6% calculation ONLY applies to those investments that are sold and used to purchase consumer items; such transactions only cover a fraction of the aggregate moves within equity markets. Most, in fact, an overwhelming number of the equity transactions in stock markets represent substitutions (selling equity to purchase equity) rather than sales and withdrawals from the markets. If you are buying investments with earned income, or are selling investments with the intent of purchasing new investments, the consumer price index is wholly irrelevant; what you need to know, more than anything else, is the underlying rate of investment inflation.
I will say this right now for the record, the modus operandi of deflating investment returns through the application of a consumer price index is stupid, stupid, stupid. It needs to be stopped. In order to accurately, or even reasonably, arrive at an ex-inflation return on investments, one must apply the appropriate measure of inflation. In the previously mentioned 8% return on investments, yes, your investment grew by 8% but what if the underlying market inflated by 10%, or maybe even 20% over the period of holding? Then, you will find, to your chagrin, that you now have LOST actual investment purchasing power.
Useful ex-inflation returns require useful inputs. CPI isn’t the correct index, nor is PPI. So, what is the correct index? Well, at this time, it does not exist; if it does, we’re certainly not hearing about it. Thankfully, an approximation, to help estimate investment price inflation, is readily available. That approximation is money supply growth or M2. Central banks throughout the world print money and continually release it into the economy. Once the money supply hits the general economy, central banks lose control of where it ultimately goes. SOME of that money supply is spent by consumers on the representative basket of goods that is used to determine CPI. SOME of that money supply is spend by producers on inputs for production that will be sold, potentially resulting in PPI inflation.
What about the rest? When consumers and producers cannot fully sop up what is being printed, the remainder will either be deposited or invested. During periods when interest rates represent an attractive alternative to equity yields, then the bulk of this excess money supply will, logically, go towards deposits such as bonds. In periods where fixed income investments become uncompetitive to equity yields (a well understood formula applied liberally in modelling), money will flow from bonds to equities. Lacking alternatives to equities, excess supply of the money results in inflation, but it is a beguiling and well disguised form of inflation almost never noted by the media today; equity investment inflation.
Theoretically, a formula to assess equity investment price inflation would be centered on the underlying growth in M2. From that, one could subtract the M2 used in consumption and the M2 used in production, leaving money that could result in the inflation of equity assets. This would be the basis for an investment price index, or IPI. M2 – (CPI +PPI) = IPI. Going forward, I refer to equity investment inflation as IPI (Investment Price Index).
There could be many derivations of IPI; intrepid economist could incorporate ratios that take into account new supplies of equities (stock issues) less equity removals via going private transactions, bankruptcies, etc. Policy setters could choose to assess the money supply that does not go into equity markets, but instead goes towards bond purchases. If a policy bureau went down that route a mechanism would be required to account for changes in interest rates as well as dividend yields; any change in interest rates or dividend rates that would result in money flows to/away from equities during periods of yield substitution would need to be estimated. I could introduce my highly technical calculation, replete with numerous brackets, multiple squiggly lines and stacked with divisors, but I won’t; boring one with minutia obscures the purpose of this article. The point of the blog piece is not the formula itself, rather I seek to illuminate an issue that remains hidden from the public yet is vital to the public interest. This article could, and maybe should, represent a starting point for some keen economist to produce their own viable formula; a Nobel Prize for Economics is up for grabs annually. If nothing else, a compelling PHD thesis, based upon this article, could be advanced to publication. My rudimentary formula serves my purpose and in that sense, it offers a certain utility. An award winning economist, on the other hand, might look at it and consider it to be of limited, or “marginal utility”. (Yes, I studied economics for the jokes).
However one chooses to formulate an equity Investment Price Index, the primary determinant to estimate inflation on equity investments is M2 growth. Everything starts with the amount of money being printed into the system and proceeds from there. Even the most simplistic estimation of M2 growth as a probable inflator of equity prices should, logically, be far more accurate than consumer or producer inflation measurements.
By way of example, M2 in the United States increased by more than 10% annually since 2007. Does that not just blow your mind when you read it? It certainly bakes my gourd. In the first 8 months of 2020, M2 in the United States increased by more than 19% (not annualized, actual). That number is the sort of stuff one normally reads about in inflation ravaged nations such as Iran. The US isn’t alone in this M2 printing, during the SARS-COV2 outbreak, all western governments pushed money supply out the door as fast as they could create it.
In comparison to the growth of US M2 since 2007, CPI averaged just over 1.5% per annum since 2007. The overall GDP growth rate for the US was less 3% annually over that same 13 years. Additionally, interest rates fell sharply in the prevailing period. So, where has all this M2 money supply gone? Well, it seems completely reasonable to suggest that some/much went into the stock market, resulting in a very real and calculable form of investment inflation.
From this point forward, equity readers will become very unhappy, so buckle up. When you take into account the growth in M2 since 2007, every single investor in the United States, and for all practical purposes, worldwide, has earned a fraction, adjusted for M2 growth, of the ex-inflation returns that they think they truly amassed. This fallacy of return applies to me, to you, to everyone with equities. If the premise of investment inflation seems reasonable, then it follows we’ve all been conned into assuming that our investment accounts have grown either somewhat, respectably or possibly like gangbusters. The returns we are being quoted are correct, on their face, but they suffer from an error of omission. The most critical data surrounding our returns has been withheld and that data is the “how” of those returns were earned. Given the massive increase in M2, which appears well on track to fully triple from 2007-2020, it seems abundantly clear that most of the growth in our investment portfolios isn’t due to investment acumen, or excellent business models, it is self-evident, to me at least, that after backing out the money supply growth, the overwhelming percentage of our returns is nothing more than 13 plus years of double digit M2 inflation pushing up the reported value of our investments.
The formal creation of a measurement for investment inflation will NOT be taken well by many in the investment world. I suspect that the lack of detail on equity investment inflation is by design rather than by some centuries old, multitrillion dollar, and glaring economic oversight. Individual stock-pickers, who pride themselves on their acumen in selecting stocks that outperform the CPI, should be mortified if/as/when a more representative, and potentially higher hurdle rate is created. After all, an 8% return on equities sounds good if CPI averages 2%, but just how does an 8% return on equities sound if IPI averages 10%? Mutual funds and ETFS that boast of passive returns exceeding CPI will have a vested interest in suppressing an investment inflation measure. In fact, there are VERY few in the world that would be pleased to obtain an equity investment inflation index.
Detailed IPI reports would be wholly disheartening to consumers squirreling away some disposable income into the equity markets for retirement. Just as new home purchasers bemoan the price of entering the housing market on that initial purchase, newer entrants to the equity investment world are finding investment inflation, in the markets of choice, are hindering their ability to amass their wealth by a meaningful amount. This investment inflation, more so than ANY other competing explanation, might account for the widening of the gap between the rich and the less than rich in this 21st century.
I would argue that investment inflation is what Thomas Piketty, in his 685 page tome, “Capital in the 21st Century”, was really striving to point out. He noted that:
“The inequality r > g implies that wealth accumulated in the past grows more rapidly than output and wages. Once constituted, capital reproduces itself faster than output increases.”
To quote Billy Eilish: ‘Duh!” Of course, wealth accumulates more rapidly than output and wages. The wealthy control a disproportionate amount of the planet’s capital and always have. Of COURSE capital reproduces faster than output increases. We all know that’s the way of the world; an insight into how we can benefit from it would have been nice. Was that too much to expect? Now, I am out of pocket $50 on Piketty’s output when I could have readily substituted and bought the output of a restaurant, perhaps un bifteck aux pommes frites, with that cash. Merci, Capitaine Obvious.
Piketty is scoffed at in certain western circles, derided by some as a leftist and anticapitalistic. While his opus has been purchased by many, I suspect that few have even broken the spine of the hardback. After all, the work of Piketty is longer than Volume 1 of the Gutenberg Bible and provides an observation, of surprise to few, that I have described to you in just a few paragraphs. Inexplicably, economists are generally less than economical when it comes to written works; why reach a quick conclusion when an arduous, drawn out one will serve? It has been suggested that perhaps his book deal was paid for “by the page”; that makes little sense because if the assertion was true, why stop at 685, why not just keep going to at least 1000 pages? Titles are everything in economics, so I blame myself; I purchased a book entitled “Capital in the 21st Century”, when I was truly interested in digesting a treatise entitled “Capital in the 21st Century, Challenges and Opportunities”. Whomever writes THAT work will get my next $50 and it won’t need to be biblical in length: a concise and opportunistic brief is far more useful than a book railing upon us to charge at windmills atop swayback nags.
Style issues aside, keen capitalists should not be so quick to cast aspersions on Piketty; his data, going back hundreds of years and concluding that investment wealth has accumulated faster than wages or production, is of utmost importance to those that seek to allocate capital. Let us assume, for the purpose of this article, that Piketty has reached the correct conclusion: I believe it to be so. Now, let us follow on and identify some challenges and choices one will face, based upon his insight. Persistent INVESTMENT PRICE INFLATION means that prior wealth accumulations do grow more rapidly than output at the producer level, or wages at the employment level. Such a revelation MUST have use to the everyday consumer and the everyday investor.
What are the implications of applying an IPI model on SAVERS? One challenge immediately leaps out; one can no longer merely be “in the market”, investments owned must prove capable of earning a sustained economic return above the rate of IPI in order to grow wealth. Any number lower than IPI and one is, at best, maintaining wealth. For the last 13 years, as M2 growth has exceeded 10% per annum and as CPI has averaged roughly 1.53%, then the most basic calculation would suggest IPI to have been somewhere in the range of 8.47% per year. An economic return above IPI will be expected in order to maintain investment purchasing power and simultaneously produce surplus income, to be used to supplement consumer purchases, in retirement years.
What are the implications of adopting IPI for CONSUMERS? To start, the determination that IPI exists has important ramifications upon those that sell equities to supplement spending. For those that sold equities over the last 13 years and used those funds for consumer spending, they were depleting a pot of investments inflating by 8.5%, in order to buy consumer goods only inflating by 1.5%. Intuitively, that represents the antithesis of efficiency. During times when IPI exceeds CPI, any dollar taken from a pot of investment capital and used towards consumption is unproductive.
What are the implications of adopting IPI for MONEY MANAGERS? The use of IPI utterly neuters all return data promoted by the investment industry. Most ETF product would have failed to serve a purpose since the turn of the century; surprisingly few passive investment funds have earned a positive return, adjusted for my estimation of M2 investment inflation, or IPI, over time. I estimate that roughly two thirds of existing ETF industry posted returns in the United States, appraised against an IPI measure to deflate returns, will have come about, not due to investment growth, but was due to money supply growth inflation over the past 13 years. If even partially accurate, that is a sobering realization indeed.
NASDAQ based equities, for the most part HAVE earned a positive return after the IPI inflation adjustment; this seems to suggest a selection of investors “in the know” are already applying some form of money supply based inflation adjustment to their portfolio tests, and are doing so quietly. Even the portfolio managed by this author, the global large cap portfolio, looks far more ordinary after harmonizing IPI inflation as an offset against returns. In the case of the model account, a 20% annualized, compounded return since inception declines to an 11.5% IPI adjusted annualized return; still an acceptable return, but no longer earth shaking.
Broadly applying, for the last 13 + years, a 10%+ overall annualized increase in money supply against all investment returns reveals another jaw dropping determination: an overwhelming number of active investment portfolios have failed to outperform, after proper inflationary money supply additions are backed out of the gross returns.
There is one final implication of note when it is determined that equity investment inflation is rampant. A subcategory of equity capitalist exists, sometimes called a “trader”, occasionally a “market timer” or, more kindly, an “asset allocator”. This class of equity owner moves money in and out of equities and sits, from time to time, in cash. During periods when equity investment inflation is persistent, the opportunity cost of being out of the market becomes too high for this stratagem to be effective. Those who lose during periods of inflation are those that are sidelined, either by choice or by lack of funds, from holding inflating equities. There is little benefit to try to “wait out” an inflationary asset with the hope of entering at a lower price, because inflation makes the asset more expensive over time.
What are the implications of IPI on corporations? Most individual companies in the world today failed to earn an after tax capital return above IPI. Corporations rely upon capital return models (ROC or ROIC) to determine where and when they should invest in the underlying business. Those ROC and ROIC models use interest rates as a base assumption and add an equity computation into the mix. However, when they include ANY equity component to their business model, then an accurate measurement of investment capital inflation needs to be applied; lacking that deflator, they are failing to apply it. Equity price inflation makes excellent companies appear extraordinary, makes ordinary companies look good, and permits poorly run companies to appear acceptable. This adds investment risk to portfolios because in non-inflationary periods, corporations that are badly managed or that do not serve a useful function in a well organized capitalist economy are often locked out of capital markets for equity underwritings; a period of artificially low rates subject to high equity investment inflation keeps these bad companies alive. I will go out on a limb and state that a lot of zombie firms have been propped up, insofar as share pricing is concerned, for more than a decade as a result of the M2 inflation.
A 21st century program, being universally undertaken by central banks, centered on inflating global money supplies while utilizing offsets to hold down consumer inflation has perpetrated, based upon a working hypothesis of this author, an illusion of prosperity for those in the equity markets. Factoring in the massive inflationary aspects of M2 upon investments, I estimate that more than half, perhaps as much as two thirds, of the global equity returns earned for the past 13 years are merely the result of investment price inflation. The degree of M2 stimulus (10% annualized, persistent, growth in money supply is abnormal under any developed nation central bank scenario) is such that the excess supply has produced persistent inflation in investment prices, specifically equities and to a lesser extent, farmland.
This inflation in investments, so long as it persists, widens the gulf between the rich and the not-rich. Those with sufficient wealth invested in equities are not required to redeem securities to fund daily consumption. These “haves” are in the driver’s seat during periods of coordinated global central bank actions to boost money supply. Those with an insufficient percentage of their net worth in either equity investments or investment inflation sensitive assets are failing to close the gap. In an inflationary market, those holding assets benefitting from inflation are far better served than either those observing from the sidelines, or those with inadequate representation in the inflating asset class. My compiled data infers that investment inflation has been here for a considerable period of time. A reported growth rate in US M2 of more than 19% in just the first 8 months of 2020 indicates acceleration, rather than a deceleration of the trend.
Equity investment price inflation seems to be the logical answer to the burning question asked by the public at large:
“just how are the markets holding up so well in 2020, when the true economy has been devastated by the covid pandemic?”
The investment industry at large applies a somewhat unsatisfactory set of answers: “the markets look forward”, “the recovery will be v-shaped or perhaps u-shaped and strength will be apparent in the coming months”, etc.
Those responses seem pat, trite and contrived. Here’s an alternative riposte that seems tight, clean, and therefore, could be plausible.
“The markets are holding up, and in the case of NASDAQ, setting records, because the massive increase in money supply, in just 8 months, has produced meaningful investment inflation.”
In conclusion, when is a 10% annualized return earned on investments not enough? When M2 has grown by more than 10% per annum for almost 14 years and when M2 growth has been almost twice that level, in just over the first half of this year; that’s when 10% isn’t enough.