And yet another inflation illusion post...

Another inflation illusion post.  This time with math.

Again the issue here is that you can't just increase the discount rate when you are valuing a stock without paying attention to the top line growth rate.   

https://www.barrons.com/articles/tesla-is-cratering-this-is-how-much-interest-rates-hurt-51614973530?mod=article_inline

Inflation is coming and so is inflation illusion.

Inflation illusion is a favorite topic of mine, read prior posts here.   It's a topic that comes back time and time again, usually whenever there is a hint of inflation.   Case in point - this article in Barrons

https://www.barrons.com/articles/inflation-driven-stock-market-selloff-51622470534?mod=article_inline

The key line: "Both higher yields and inflation itself erode the value of future cash flows, which makes stocks less valuable. "

This is basically inflation illusion - the idea that when bond yields increase, the discount rate for stocks should also increase, thus lowering the value of the cash flows generated by the stocks.

Here's why this is flawed logic:

The value of a firm's equity can be given as: Value=FCFE(1+g)/(R-g)

Where R = the nominal discount rate, FCFE is the free cash flow to equity and g = the nominal growth rate.   

When inflation increases, R will increase.  This alone will result in a reduction in the value of the stock.  However, inflation will also act upon g, the growth rate.  Across the economy we would expect, on average for g to increase by the increase in the inflation rate.   The net effect of R-g is that the impact of inflation gets cancelled out.

Ironically, the article above contains the line:

"That noise includes supply-chain constraints, which bring the cost of materials higher, incentivizing companies to raise prices."

Which basically says that the FCFE will increase - because prices are rising and therefore FCFE moves with inflation.

To be clear - I am not trying to beat up on a single, short, Barrons article.  Instead my point here is to show how common this mistake is.

The Fed Model is not dead...but really should be.

The Fed Model (not endorsed by the Fed) is one of those rules of thumb that investors use to value stocks, that while being intuitively appealing, is fundamentally flawed.  Recently, one of my MBA students shared another example of its application (which I'll get to in a moment).

First - what is the "Fed Model"?  Simply put, it argues that there is a relationship between the medium term Treasury yield (or some other interest rate) and the earnings yield or forward earnings yield for some basket of stocks (such as the S&P 500).

The idea is this:   Say the 10-year Treasury is yielding 4%, and the forward earnings yield of the S&P 500 is 4%, then stocks are fairly priced. (Note: the earnings yield is the inverse of the Price - earnings ratio).

If, due to inflation, the Treasury yield increases to say 5%, the Fed Model suggests that the earnings yield of the S&P 500 must adjust to 5% also.   This will result in the PE ratio of the S&P 500 falling from 25 (1/0.04) to 20 (1/0.05).   As earnings haven't changed, the price of the S&P 500 must fall from 25 to 20 or 20%.  Ouch!  You can see why investors who subscribe to the Fed Model get so upset about inflation.  In my example, a 1% increase in inflation takes 20% off the stock market.

But, it turns out that this is entirely flawed logic and suffers from my favorite behavioral finance error - "Inflation Illusion".    This is because the Fed Model ignores a key fact.   When inflation increases, the cash flows from a bond don't change.   The bond coupons are fixed.  But, the cash flows from stocks DO change.  Earnings will, on average, increase at roughly the rate of inflation.   The reason is simple - inflation occurs because companies that sell stuff put up prices, which results in higher sales (Sales = Price*Quantity) and are passed down to the bottom line.   As an exercise for the reader - make a simple income statement and increase all the costs and revenues by 1% and see what happens to the Net Income.

So when inflation increases, future earnings of the stocks will increase also.  The stock price will also adjust up to reflect inflation.  The result is that PE ratios and earnings yields stay the same, because both the price and earnings of the stock move in accordance with the higher inflation rate.  This means that the PE of the stock market can stay at 25 even if the Treasury yield is at 5%.   There's no misvaluation, because there is no fundamental reason why the Earnings yield must track the Treasury yield.

You may be wondering - why does the stock price increase in the presence of inflation?

Consider a simple dividend discount model.   Inflation is 0%, dividends grow at 2% a year and the discount rate is 5%.  Dividend today is $1.

Price = 1*(1+0.02)/(0.05-0.02)=34

Now assume 1% inflation.  Inflation increases the discount rate to 6% and the growth rate to 3%.

Price = 1*(1+0.02+0.01)/(0.05+0.01-0.02-0.01) = 34.33

The price change is:  34.33/34 -1 = 1% (rounded because we didn't compound the growth rates).

The takeaway:   When inflation occurs, all else equal, stock prices rise.

So on to that article.  It's here on CNBC and is firewalled , but the gist, according to Ned Davis Research, is that if the current 10-Year Treasury goes from 1.6% to 2%, this will result in a decline of as much as 20% in the Nasdaq index.   Unfortunately, this is exactly the Fed Model.   I've done the calculation, and yes, I get roughly the same number.  If you assume the following:

Nasdaq forward PE = 37, implying an E/P = 2.7%.  An increase of 0.4% in the E/P would result in a new Nasdaq forward PE of 32, and a price decline of about 13%.  

Unfortunately this analysis is entirely flawed.   It assumes Nasdaq earnings don't adjust with inflation.

So, to conclude - the Fed Model is still being peddled by Wall Street Firms, even though they may not call it as such.   But it's still wrong.   For an excellent take down of the model, see Cliff Asness's post at AQR here:  https://www.aqr.com/Insights/Research/Journal-Article/Fight-the-Fed-Model - full article here: https://images.aqr.com/-/media/AQR/Documents/Journal-Articles/JPM-Fight-the-Fed-Model.pdf

Why stocks are good hedges for inflation.

I was quoted yesterday in the Wall Street Journal on why stocks are good hedges for inflation.
Article is here: https://www.wsj.com/articles/which-is-the-better-inflation-hedge-stocks-or-gold-11560132361?mod=searchresults&page=1&pos=8

Quoting from the article:

The reason stocks are a decent inflation hedge is because corporate earnings grow faster when inflation is higher, and grow more slowly when inflation is lower, according to Richard Warr, a finance professor at North Carolina State University. Consider the growth rate of corporate earnings over all 10-year periods since 1871, according to data compiled by Yale University finance professor (and Nobel laureate) Robert Shiller. The volatility of those growth rates was 21% less on an inflation-adjusted basis than it was on a nominal basis, which Prof. Warr says is a good indication of the extent to which equities are able to hedge inflation.

To be sure, Prof. Warr adds, higher inflation does reduce the present value of the otherwise higher future earnings. But these two effects should more or less cancel each other out over time.

Prof. Warr acknowledges that, over shorter periods of a year or two, stocks often suffer when inflation heats up. His research suggests that is because many investors are guilty of what economists refer to as “inflation illusion.” That is, they focus only on the reduction in the present value of future earnings to which inflation leads, while ignoring the tendency for nominal earnings to grow faster when inflation is higher. So when inflation spikes upward, they sell stocks.

Since the inflation illusion is irrational, it is difficult to predict whether investors will be guilty of it the next time inflation heats up. But Prof. Warr says that if they do and their selling causes the stock market to drop, investors should treat it as a buying opportunity."

What's the best way to protect against inflation?

I was recently interviewed by Mark Hulbert for this article in Barrons:
http://www.barrons.com/articles/whats-the-best-way-to-protect-against-inflation-1482943455

Are we still talking about the Fed Model?

Yes, but not in a very nice way.

A great quote:

The fallacy of the model is quite simple. THERE IS NO SUCH THING AS EARNINGS YIELD. The earnings yield is simply the inverse of the P/E ratio whereby corporate earnings are divided by the price of the market. However, as an investor in a stock you do not receive the earnings yield in the form of a cash payment.   However, YOU DO receive the interest yield from bonds.

If you don't know what the Fed Model is - you can check an earlier post on the subject.

Damadoran on the current low risk free rate.

Aswath Damadoran has put together an excellent post on the current low risk free rate and the effect that it has on valuation.  His main point is that the risk free rate must be considered with the current expected risk premium.  When these are combined the result is relatively low valuations.   He also touches on another point which I'd like to emphasize.   In an equity valuation model we normally think of the risk free rate as only affecting the discount rate - so a lower risk free rate should result in a lower discount rate and thus a higher valuation.  But - and this is very important - the risk free rate also tells us a lot about the growth rate of the cash flows.  A low risk free rate implies low real growth and also low inflation.  Thus it will also reduce the level of future cash flows.  Failure to account for the two edges of the risk free sword is an example of inflation illusion.

People just don't understand inflation.

A recent article on Yahoo Finance talks about "Hedging 7 Big Retirement Risks"

The article is OK overall, but demonstrates a serious misunderstanding of the effect of inflation on stock prices (something that I am particularly interested in).  The offending paragraph states that:

To guard against inflation, you can invest in inflation-protected securities or other investments that will gain value as overall prices climb. For instance, stocks in your portfolio aimed at growth rather than income will provide a hedge against inflation, says Michael Reese, Certified Financial Planner and founder of Centennial Wealth Advisory based in Traverse City, Mich

 It is incorrect that growth stocks (low dividend paying high P/E stocks) will be a better inflation hedge than dividend paying stocks.   The value of both stocks derives from the present value of the cash flows generated by the underlying business.   Growth stocks reinvest this cash flow, income stocks tend to pay it out.  Either way, on average, the cash flow will grow at the rate inflation.  Thus the expected return on both types of stock is directly correlated to the expected inflation in the economy.  They are both "real" assets and should provide a hedge against inflation.

The "Fed Model"

The so called "Fed Model" (not endorsed or used by the Federal Reserve) postulates that there should be a relation between the earnings yield on a broad stock index and the yield on medium term Treasuries.  Proponents of the model claim that when the earnings yield on stocks exceeds that of Treasuries, then one should buy stocks.

The model has been widely discredited by academics because it mixes apples and oranges.  Treasuries are nominal assets whereas stocks are real assets (their returns are a function of inflation).   The fact that these two series seem to move together doesn't prove that they have predictive ability over the mispricing of stocks compared to bonds.  For a great discussion of the Fed Model, see Cliff Asness's article "Fight the Fed Model"  I've also discussed this issue in my 2002 JFQA paper with Jay Ritter.

So why bring all this up today?   Well, my favorite finance blogger, Felix Salmon appears to be making the Fed Model mistake all over again, long after I thought that the model was dead and buried.  Felix doesn't refer to it as the Fed Model directly, but his presumption is that Treasury yields and earnings yields should track each other.  After 2002 they don't.

While it looks like you'll earn a higher yield on stocks rather than bonds, this is very misleading.  First earnings are not cash flows - something that we hammer home at the beginning of any stock valuation class.   Second, whereas bond cash flows are pretty secure, the cash flows from stocks are much more uncertain - the risk premium is zero for bonds and who knows what stocks!   Finally, the bond cash flows are fixed in nominal terms, while the stock cash flows are real - they change with inflation.

Again: apples to oranges. 

Inflation linked bonds are back in the spotlight

With global concerns about inflation, the attention turns, predictably, to asset classes that are good inflation hedges.  The FT has a good article on the topic.   Mechanically, inflation linked bonds will provide inflation protection.  But they have a problem - only part of their nominal return comes from inflation - the other part is a real return.  Currently the real return on US inflation linked bonds is basically zero.  If demand for TIPs increases this could go negative (it has in the past).  

Alternatives to TIPs include any real asset.  For example, in the long run, stocks are excellent inflation hedges, although in the short run they often do poorly, in large part because investors don't understand that they are real and not nominal assets.  Commodities are good hedges - but very volatile.  

At the end of the day, trying to bet on inflation is a risky business.

Is gold at a record high? Actually, no.

A nice take down in the NYT about the current gold frenzy.   Gold isn't at a record high after you adjust for inflation.   And as the author of the article says "you should always adjust for inflation".

Personally, I think there is a gold bubble forming.  I predict prices below $1000 in a year.

Money Illusion and a new blog added

With the fall semester rapidly approaching, it's time to get back into blogging.

The Finance Professor blog posted a link on Money Illusion from the Psy-Fi blog. The Psy-Fi blog is new to me, but looks pretty interesting - with a focus on behavioral finance.

Money Illusion, as I've discussed before, is the act of failing to incorporate inflation into financial decisions. Research (including some of my own) has shown that money illusion affects stock prices and house prices. Despite the phenomenon being well documented, new cases of money illusion are always cropping up.

Inflation Illusion

People don't get inflation. Case in point - another blogger cites a recent communication from the AARP (the American Association for Retired Persons). Apparently, this year because inflation was zero, there will be no cost of living increase in Social Security. The AARP is very upset about this...

We’re already months into 2010, and seniors still haven’t seen any relief because of the lack of a cost-of-living adjustment to their Social Security. For the first time in 35 years, the regular payment update they’ve depended on did not occur.

Congress must act quickly. Will you help us flood their offices with letters, demanding that lawmakers make relief a priority?

.

Presumably, they'd be happier if we had high inflation and they got a larger cost of living increase.

Inflation and stock prices.

I've been checking out a new blog on Reuters by a Rolfe Winkler. It's pretty good, although his recent posting on inflation and stock prices makes the common mistake of confusing nominal and real growth rates. In economics parlance, we call this inflation or money illusion.

The basic error of inflation illusion is that a nominal discount rate is used to present value a firm's cash flows while a real growth rate is used to grow them. The result is that when inflation increases, the discount rate goes up and the present value of cash flows declines. This leads to the oft-cited conclusion that stock prices will decline when inflation increases.

In fact, stocks are natural hedges against inflation because the cash flows are real. This means that they increase with inflation. As prices go up, the firm's revenue and cash flows increase accordingly.

At the simplest level, consider the Dividend Discount Model.

P = D1/r-g

D1 is the dividend expected next year. r is the nominal discount rate and g is the growth rate. An increase in inflation will increase r through the risk free rate. g will also increase at the rate of inflation. Because the numerator is r-g, the effect of inflation will cancel out.

Mr Winkler is not alone in suffering from inflation illusion. The effect has been well documented. The original idea of inflation illusion affecting stock prices was proposed by Franco Modigliani and Richard Cohn in 1979. Since then, numerous academics have studied the issue and found evidence of inflation illusion. For example, John Campbell and Tuomo Vuolteenaho find evidence in their American Economic Review paper in 2004. Yours truly also found evidence for inflation illusion in my 2002 Journal of Financial and Quantitative Analysis with Jay Ritter.

Inflation illusion also affects house prices, but that's a topic for another day...