This is MoneyClub

Stocks for the Long Run
Part 3: HOW THE ECONMIC ENVIRONMENT IMPACTS STOCKS

Chapter 11 Chapter Guide

• MONEY AND PRICES
• THE GOLD STANDARD
• THE ESTABLISHMENT OF THE FED
• THE FALL OF THE GOLD STANDARD
• POSTDEVALUATION MONETARY POLICY
• POSTGOLD MONETARY POLICY
• THE FED AND MONEY CREATION

HOW THE FED’S ACTIONS AFFECT INTEREST RATES

STOCKS AS HEDGES AGAINST INFLATION

WHY STOCKS FAIL AS A SHORT TERM INFLATION HEDGE

• Higher Interest Rates
• Nonneutral Inflation: SUpply-side effects
• Taxes on Corporate Earnings
• Inflationary Biases in Interest Costs
• Capital Gains Taxes

CONCLUSION

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Chapter 11 Chapter Takeaways

Prelude: The lessons from history: liquidity and easy credit feed the stock market, and the ability of the central banks to provide liquidity at will is a critical plus for stock values (referring to reactions to the GOld Standard in UK and US before the depression)

• MONEY AND PRICES
  -In the last 60 years there has never been a year where the CPI declined. What changed? control of the money supply has shifted from gold to the government. With this shift, a new system. The key? Money Supply. see your favorite economics text of choice for more details.
• THE GOLD STANDARD
  -Adherence to the Gold Standard was why the world experienced no overall inflation during the 19th and early 20th Century. However this meant the central bank had no control over money supply during economic or financial crises or in economic growth.
  -Interesting fact: When the governemnt issued non-gold-backed money during the Civil War, the notes were caled greenbacks because the only backing was the green ink printed on the notes. Yet just 20 years afterward, the govt redeemed each of those notes in gold, completely reversing the inflation of the Civil War period.
• THE ESTABLISHMENT OF THE FED
  -Liquidity crises caused by the gold standard led to the Federal Reserve Act of 1913 to provide liquidity to enable depositors to withdraw deposits without forcing banks to liquidate loans and other assets. Yet the Fed was never given guidance on how to determine the right quantity of money.
• THE FALL OF THE GOLD STANDARD
  -In 1929, the Fed failed to provide extra reserves in the face of several bank panics. this caused a widespread, further panic spreading to continental Europe. the gold standards were eventually suspended, rallying confidence in stocks but killing bonds because of inflationary expectations.
• POSTDEVALUATION MONETARY POLICY
  -Bretton Woods: the US governement promised to exchange all dollars for gold held by foreign central banks at the fixed rate of $35 per ounce as long as those countries fixed their currency to the dollar. This backing was removed in 1968 and central banks arbitraged gold prices between market rates and the US $35 price, depleting US reserves from $30billion to $11 billion. President Nixon closed the gold window in 1971 with his New Economic Policy and the link between gold and money was finally broken.
• POSTGOLD MONETARY POLICY
  -The first oil shock from 1973 to 1974 coincided with the relaxaiton on monetary expansion, causing inflaiton. Congress mandated Fed presentations to Congress with the Humphrey-Hawkins Act. In 1979 Paul Volcker announced that the Fed would no longer set interst rates, it would exercise control over the suply of money without regard to interest rate movements. This meant higher interest rates necessary to tame inflation. Inflation had become the world public enemy number 1.
• THE FED AND MONEY CREATION
  -Changing the money supply is straight forward: open market operations.

HOW THE FED’S ACTIONS AFFECT INTEREST RATES
-Fed funds rate: when the Fed buys govt securities, it affects the amount of reserves in the banking system. Banks trade these among themselves in the federal funds market, and the interest rate of these funds is caled the Fed funds rate.
-although the FF rate is an overnight rate, it is an anchor to all short term interest rates. Including the prime rate, th ebenchmark for most consumer and commercial lending.
-Changes in fed funds rates have been a very good predictor of future stock prices: folowing increases in the rate, subsequent returns on stocks in the following 12 months are significantly less than average, and vic versa. (data from 1955-1990s) Yet, Since 2000, the opposite has applied. In June 1999, the Fed raised rates but the market only started to fall in Sept 2001. In 2004, the fed increased rates 17 times but stocks continued to rise through 2006.
-possible reasons to the above: investors have good predictive abilities? Siegel does not have a good answer, but has the data to show the significant disconnect.

STOCKS AS HEDGES AGAINST INFLATION
-The ability of an asset such as stocks to maintin its purchasing power during periods of inflation makes equities an inflation hedge.
-As noted in CHapter 7, many investors stayed with stocks in the 1950s despite seeing the dividend yield on equities fal below the interest rate on long term bonds.
-Figures show neither stocks nor bonds nor bills are good short term hedges against inflaiton. But real returns on stocks are virtually unaffected over long horizons.

WHY STOCKS FAIL AS A SHORT TERM INFLATION HEDGE

• Higher Interest Rates
  -Theory: Inflation could increase interest rates on bonds, and higher interest rates on bonds depres stock prices. Verdict: Incorrect. Higher inflation also means high future cashflows available to stockholders. Future cashflows will also rise with the rise in price levels.
• Nonneutral Inflation: SUpply-side effects
  -Theory: Earnings cannot keep up with inflation i.e bcause restriction in OPEC oil supplies increased energy costs faster than firms could raise prices of their own outputs. Also Inflation has been closely linked to government budget deficits and spending – it is a sign that the govt has too large a role in the economy, meaning lower growth/profits.
• Taxes on Corporate Earnings
  -Corporate profits and capital gains.
  -Depreciation is based on historical costs – during inflation, depreciation allowances are understated since allowances for rising cost of replacing capital are not reportaed. thus Taxable earnings are overstated.
  -Also, in inflation, the gap between inventory prices and selling prices widens, producing inflationary profits for the firm which does not represent a real increase in earning power.
• Inflationary Biases in Interest Costs
  -Ther is a downward bias in earnings due to interest costs. Firms funded with debt are affected. Nominal interest costs rise but real interst costs remain unchanged, overstating the real interest cost to the firm and depressing corporate profits.
• Capital Gains Taxes
  -CG Taxes are paid on the difference between cost and sale price of assets with no adjustment for the impact of inflation. This reduces real returns in inflaitonary times.

CONCLUSION

Before WW2, persistent inflation worldwide was nonexistent. During the Great Depression, the gold standard was thrown out and control passed to central banks. Banks now came to fear inflation and not deflation. The message of this chapter is that stocks are not goodhedges against increased inflation in the short run. No financial asset is. However, they are very good hedges in the long run, while bonds are not. Still, inflation is not good for equity holders.