1993 was a brand new era for me and gaming - NBA Jam was released, and man, I wonder how many pennies I dropped into the slot of this machine. For any NBA Jam fans out there, you will remember the game's charming commentary - and boomshakala was by far the exclamation, it would express dominance, triumph, and excitement when you shattered that backboard.
And last week US inflation did just that - boomshakalaka! We saw the highest reading of inflation for over a decade with both monetary and fiscal stimulus driving up the cost of goods and services. I think we need to take this number with a grain of salt. We're coming off a number that fell off the face of a cliff when the pandemic hit - it's super clear on the chart below. There is still so much noise in the data, and it will be some months before we can really see the true effect of the lockdowns and supply chain bottle necks. I think a lot of what is going on is transitory, time will tell as to whether or not inflation is transitory.
Following the inflation headline, market pundits' attention has moved to what this means for the stock market. They say inflation is bad for stock markets. I don't know any better market that has the ability pass on costs to it's customers and fend off inflation* from eating into operating costs than the stock market itself. Sure it's not perfect, but nothing ever is.
Don't take my word for it, I've crunched the numbers going back to 1913, and here's what it looks like by decade:
Source: Refinitiv Datastream, Baharian Wealth Management
Over the entire data set, the average inflation rate per decade was 3.45% and the corresponding real stock market return was 46.95%. I think these returns are pretty good, considering the booms and busts we've lived and invested through during these times.
As you can see, the stock market has been an absolute rollercoaster ride. There have been some really great periods to invest, and some really poor periods to invest. I guess that's the nature of the stock market - bad times follow good times, and bad times are followed by good times. It's just super difficult to 1) know with any certainty where we are in the cycle, and 2) when to get in and when to get out.
I then drilled down into what happens to stocks when inflation is below the Fed's target of 2%, below the average rate of 3.45% (and above 0), and over the average rate of 3.45%. Here what happens to stocks during these times (real return):
Inflation Stocks Returns
<2% 107%
<3.45% 87.30%
>3.45% -0.02%
The takeaway for me from these numbers is that over the short-term the numbers are all over the place. The moment you stretch out your time horizon, the numbers start to become more consistent and make a lot more sense.
What is clear is that when inflation is low, stocks do well. In fact the lower the rate, the better stocks do. Even when inflation reaches the per decade average of 3.45%, stocks historically have returned solid figures. It's when inflation begins to creep higher is when stocks don't seem to be a great place to be. Having said this, the negative figure isn't as insane as what most pundits make it out to be, at -0.02% - I mean c'mon.
The challenge for investors is going to be to try and avoid the overreactions to the data and headlines.
In the short-run, the market is a voting machine. In the long-run, it is a weighing machine. - Benjamin Graham
We've got a long way to go before we hit a decade average inflation rate of 3.45%. For the last 30 years we've been living in a period of deflation. Think about the cost of energy, computers, mobile phones, cars, whitegoods, travel, I could go on but you get my drift. The productivity and efficiencies we've gains through technological enhancements has been mind blowing. This article was spot on.
Today, we're making things faster than we ever have, better than we ever have, cheaper than we ever have, and smaller than we ever have. There is so much that goes on in the world with much of these enhancements largely invisible. I think we are living in a period of low inflation/deflation with periods and spikes of inflation. The deflationary forces in the world today are so significant that the world we live in today is very different to the world that was.
Just like in NBA Jam, I think inflation is giving us a big head fake right now - 5% inflation YoY, cool your jets folks.
*I'm talking about good, healthy level of inflation here, in and around the long-term target, not Zimbabwean style hyperinflation.