Preserving the International Purchasing Power of your Savings

There are 3 levels of investment success that investors can achieve:
1 - Preserving the real value of their savings (2-3% pa growth)
2 - Grow the value of their savings in real terms (4-7% pa growth)
3 - Become rich through investing (achieving 8+% pa growth)

Many investors are fixated on becoming Level 3 investors, but the reality is that a large number of investors fail to even achieve Level 1 outcomes. They take on risks and leverage subscribing to the "no risk no gain" mantra. Some succeed (sometimes by luck, sometimes through skill), but others end up sustaining losses which set them back permanently.

Investors should figure out how to achieve Level 1 returns before thinking of higher level outcomes. Then when they decide to go for Level 2 and Level 3 outcomes, they will be able to only undertake "risks" that even if things don't work out, will allow them to achieve a minimum of a Level 1 outcome. This is essential, because inflation is here to stay, and is the enemy that every saver faces. There is nothing more tragic than watching the value of your savings slowly disappear before your very eyes.


Inflation, the enemy of savers, is inherent in contemporary political-economy

Why? Because:

1. In an economy where money supply is free to grow (e.g. in a fiat money economy, or even in a gold back monetary system if it is in a period where new gold is constantly being discovered and dug out of the ground), it is practically impossible for cash savings (stored work) to maintain or grow its purchasing power. Why? Because in contemporary economic systems, there are always new claim checks (credit) being created for which work has not yet been done. The fractional reserve banking system always extends credit (i.e. creates money via the money multiplier effect) before the underlying productive capacity is created to back this new money that has been created. In such a system, purchasing power is highest for people creating economic value in the here and now. The purchasing power of unclaimed stored work done in the past (i.e. cash savings) is bound to deteriorate over time.
   
   
2. Further, in fiat money economies with societies where the interests of all sectors of society are represented by politicians facing periodic re-election, political forces and human nature tend to create inflation over the long run. Money creation will like be invoked repeatedly to hide the true cost of government deficits, and smooth over financial losses incurred at various times by different segments of society.
   

This of course, does not mean that deflation will never occur. It can occur over short term periods of monetary destruction, for example when a large number of banks fail because they made bad loans, or when people withdraw their deposits out from the banking system and convert it into cash which they stuff into their mattresses. Deflation can also happen during periods of major changes in the structure of economic production. For example, the adoption of new technologies like the steam engine which cause the cost of individual items to drop and overall productivity to increase, which general keeps wages constant so that people end up consuming a larger overall basket of goods (in a sense, this isn't “true deflation” - rather it is a failure of measurement - i.e. it only looks like deflation because the price level is the only thing we are measuring).


2 Strategies to Preserve purchasing power of Savings
under two types of Inflationary environments

Because inflation is inherent, the challenge for savers is that they need to become investors in order to preserve the purchasing power of their savings. The way to do it is conceptually simple but difficult in practice: hold cash during deflationary periods, and hold assets (whose nominal value grows in-line with the inflation rate) during inflationary periods.

The former is simpler to do: simply convert all assets to cash during deflationary periods. This requires us to identify inflection points between periods of deflation and inflation, which requires us to apply qualitative judgment.

The latter is more challenging: we need to figure out what kinds of assets will hold their real value in inflationary periods. Inflation occurs when the money supply changes are not in line with changes in underlying economic production, by exceeding the amount needed for the upcoming amount of production. (I subscribe to the theory that inflation is a monetary phenomenon. Inflation occurs where there is a sustained rise in the general price level. We are not talking about changes in relative prices which are caused by localized supply/demand changes, or changes in the demand/supply chains arising from technological or structural changes; for example the advent of containerization made it cheaper to import tropical fruits, and reduced the price of exotic produce in supermarkets.)

Investors need to respond differently depending on the environment in which inflation occurs:

1. Money supply increases in excess of increasing population/economic production. In this type of inflationary environment, one of the safest things to do is to hold a share of the profits accruing to the economy's underlying productive capacity. We can do this either by owning a share of all the companies in the economy, or own the land which is required to house the population and capital assets in the economy. This of course, assumes that the land in the economy is limited, and that you are not in a wild-west frontier town where available land is in abundance. (This refers to actual land on which we can create value; not an apartment or some strata-titled portion of a building whose earning power depends on factors beyond its control)
   
   A passive index tracking fund is the easiest way to buy a representative share of all companies in the economy. It saves you the trouble of having to buy shares in individual companies in the economy. (If you did this, you would have an additional problem: some of the companies would inevitably go bust as their products become obsolete. New companies with new products would come up. You would have to constantly rebalance to get the money from your existing investments to buy shares in these new companies. A stock index, by periodically dropping off declining companies and adding in new up-and-coming companies, solves this problem for you. It is roughly equivalent to only holding companies that are in their middle age. Dying companies are sold off as they shrink, but before they go bust, and the proceeds are used to buy shares in up and coming companies which are past their youthful growth and maturing into middle-aged big company status.)
   
   As the economic pie grows bigger, your assets will not just maintain their purchasing power, their purchasing power will actually grow in real terms. The only thing that will destroy this real return is if you either (a) buy the stock index at an unreasonably high a price, or (b) the economy structurally changes and permanently reduces the corporate sector's profits as a percentage of GDP.
   
   
2. Declining population/economic production; with money supply not declining in line with declining production: Investors in such economies face an insurmountable barrier. Holding cash is futile because inflation diminishes its value, while holding a share of the economy's productive capacity would be futile, since economic production continually declines. To see how this works, imagine that the economy is that of an isolated island. If the people on the island are slowing dying out, then the amount of goods that are being produced will also slowly drop. You could hold 100% of all the profits accruing from economic production, and it wouldn’t mean much over time. Likewise, holding a factor of production like land is also futile, unless you can sell it to foreigners looking for a second home. Investors would do best to move their savings to a country where the population is not shrinking.
   
   Even if deflation were occurring in this dying-out island, investors holding cash would only be delaying their day of reckoning. While their cash holdings would enable them to buy more and more of the local produce, the amount of local produce would eventually drop to a level where it falls below the critical mass needed to support the specialization of labor required for many of the complex products in modern living. Unfortunately, this isn't just an academic exercise - there are many countries in the world where the population is already declining (e.g. Japan) or are soon to decline.
   

The corollary of this analysis is that investing in a passive index-tracking fund, often touted as a simple and safe way to invest over the long run, is actually a bet on macro-economic outcomes. Long term investors of such funds are making macro-economic bets, and it is wise to keep in mind that predicting macro-economic trends is a difficult task.


Investors in small countries need to preserve the
International Purchasing Power of their Savings
by Investing Internationally

Investors living in small economies, where the economy is not broad enough to provide all the goods and services desired for modern living, need to invest internationally to preserve the purchasing power of their savings. (For example, if you are living in a small economy which only produces widgets, it's not a good idea to only buy a share of the profits of local productive capacity, unless you're very sure that widgets will continue to be in demand for the next 100 years. Instead, you'll also need to buy a share of the farming capacity of other parts of the world, a share of the economic production of countries which make bricks, computers etc.)

But investing internationally presents another challenge: foreign exchange exposure. How should we think about this?

Currencies will undergo bouts of over and undervaluation, and in practice, it is incredibly difficult to know whether a currency is over or undervalued, and when this will change. There are a lot of variables involved, and over/undervaluation can persist for decades. For example, growing current account deficits in themselves do not necessarily indicate that a currency is overvalued, since in the world of free flowing capital, the desire for a currency as a safe haven can cause this over valuation which in turn causes a current account deficit by making imports "too cheap". A mercantile explanation for currency movements and current account deficits doesn’t capture the reality of the present economic and financial architecture. With free flowing capital, it's difficult to tell if the tail is wagging the dog or vice versa. (Some would even say that it's hard to know which is the dog and which is the tail!)

There are 2 broad strategies that can be employed to preserve the international purchasing power of savings:

1. Buy the profits of every economy. You can buy a share of the profits of the productive capacity of all countries at the same time, so that over time, overvalued and undervalued currencies cancel each other out. This works as long as long as global production continues to grow (i.e. the global economy continues to grow).
   
   
2. Buy the profits of international products/commodities. You can also buy a share of profits of the productive capacity of an internationally used (and internationally traded/shipped) product or commodity. It is important that the product or commodity chosen be one that will continue to be in greater demand over time. For example, you can buy a share of oil production, but you wouldn't buy a share of natural gas production because natural gas tends to be difficult to transport and is often used locally where it is found (at least until the global infrastructure for handling LNG is built up). For internationally transported products and commodities, the price level is constant across the globe, and real (not nominal) producer profits will generally be unaffected by changes in the value of individual currencies.

There will also be situations where a company operating within a foreign country looks undervalued (or an entire corporate sector, e.g. the S&P 500, looks undervalued). The question then is: is the currency of the country of the intended company undervalued or overvalued? If it is overvalued, then any investment there may be a Sisyphean one - when the foreign currency drops from its overvalued position, any gains in foreign currency terms could be negated in international currency terms. For example, buying a share of the electricity production of an island nation that only exports bananas won't help you if bananas experience a permanent drop in value in the global market (perhaps because scientists discover that eating bananas causes premature aging). You'd be a prominent “tycoon” on that little island and the villagers would fete you like a king to keep their electricity supply on, but it wouldn't give you the means to buy cars from Japan, wine from France, a trip to San Francisco, and so on.

Making investments in a foreign country requires a qualitative assessment of the country: its social, legal and economic structure, and its long term economic relevance to the world. You'll also need to determine the probability that the currency is over or undervalued, the forces driving the apparent over/under valuation of its currency, and what will probably cause this to change.

No country is truly self sufficient, so Investors in big countries should also think about preserving International Purchasing Power

There is a case to be made that no country in the world today is truly self sufficient. Given the extensive specialization and division of labor, and large scale of production needed to support the complex products and technologies that we use in daily life, it is entirely possible that our modern standard of living can only be accomplished if all of humanity is involved in its production (so that we can achieve the needed scale of size and specialization). So preserving the international purchasing power of savings may be a concern of all investors, not just those living in seemingly small economies.

When buying assets (to preserve purchasing power of your savings), only buy at a fair/cheap price

This entire discussion presupposes that investors only buy those assets we've discussed when their prices are at fair-value or lower. No matter how intrinsically good an investment is at preserving real purchasing power, buying it at an overpriced level can make it an unprofitable venture. Buying at a fair price is an essential rule for successful investing.

Image by Martin Kingsley, via Wikimedia Commons, licensed under the Creative Commons Attribution 2.0 License

Are U.S. stocks cheap? (October 2008, S&P 500 at 860)

The Natural Cadence of the U.S. Economy:

Between 1950 and 2000, corporate after tax profits have averaged 5% of GDP (historically they have hovered between 4% and 6% of GDP source1, source2 ), out of which approximately 40% of the profits have been paid out as dividends (net dividends) and 60% retained for reinvestment (source: using data from the BEA for nominal GDP and Corporate Profits).

The historical risk-free interest rates (1 year treasury bill) between 1950 and 2000 have averaged approximately 5%. (This also seems to be the case going back to 1900 in the modern industrial economies of Europe, the U.S. and Japan)

Nominal GDP growth during this time has averaged 7.3% per annum. As a rough approximation, corporate profits after tax should also have increased at this rate. Given that corporations retain 60% of their profits, this implies that the historical ROE is about 12% on average.

In other words, the structure and cadence of the modern U.S. economy suggests that over the long run, the natural order of things is for the economy to grow at 7.3% per annum in nominal terms and have a risk-free interest rate of 4.8%. Looking at each year's GDP by income, the corporate sector's post-tax profits account for 6% of GDP, of which it distributes 2.4% of GDP to its owners, and reinvests 3.6% of GDP for corporate sector fixed capital formation. The natural cadence of interest rates, risk premium and economic activity has allowed the corporate sector to this with an average ROE of 12%.


With this natural cadence, stocks are fairly priced when
the Market Capitalization to GDP ratio is around 80%

If we believe this economic cadence will continue into the future, then we can calculate the NPV of the U.S. corporate sector using the nominal growth, ROE, and profit as a % of GDP figures we have observed.

(a) Estimate 1: Given a required discount rate of 8%, the NPV of Book Value of all corporations after 40 years + NPV of all dividends received over 40 years is approximately = 18.64 times the current corporate profits, which = 93.2% of GDP (the average corporate profits is about 5% of GDP, this means that the NPV of the corporate sector is 5 x 18.64 = 93.2 % of GDP)

(b) Estimate 2: Given a required discount rate of 8%, half the NPV of Book Value of all corporations after 40 years + NPV of all dividends received over 40 years is approximately = 15.75 times the current corporate profits = 78.75% of GDP (the average corporate profits is about 5% of GDP, this means that the NPV of the corporate sector is 5 x 15.75 = 78.75 % of GDP)


Stocks are now fairly priced
(Oct 2008, S&P 500 at 860)

As of Oct 25, 2008, the Market Capitalization of the US stock market (based on the Wilshire 5000 index) is about 74% of 2007 GDP.

It looks like it is fairly valued (it's not overpriced, but neither is it a fire-sale price), but only if:

(a) you are a long term 20-30 year investor willing to accept 5-6% per annum returns (you should conservatively estimate expect returns to be less than the discount rate or economic growth rate, because your purchase price and selling price may be at different valuation multiples), and

(b) the cadence of US economy over the next 40 years will be similar to the period since 1950, so that the historical averages we are using in the valuation will remain valid over the next 40 years. This assumption would require that economic cadence is determined by the legal and capitalistic free-market structure of the U.S. economy, combined with the socio-political norms in the U.S. and universal human/psychological factors (all of which look likely not to change) and not by technology (which is improving at an accelerating pace as futurists such as Ray Kurzweil suggest).

(c) you think a 8% discount rate is sensible.


Will stock prices go down further?
(Historically, what is the cheapest that stocks have gotten?)

Yes, it's certainly possible. Investor psychology can cause markets to be severely undervalued or overvalued for prolonged periods of time. In the 1940s, the US stock market has at times had a capitalization as low as 40% of GDP. In the 1980s, during the high interest rates of the Volcker era, it was trading at about 50% of GDP (see Nick Nejad's blog post). So if history is a guide, investor psychology could make the markets could go down another 33%. (Historically, those two periods were also times when equities were out of favor with the public at large. The period between the 60s and 1974, and the period between the late 80s and 2000, were periods when equities were extremely popular.)

If we are moving into a period when equities are out of fashion in the zeitgeist, then it is conceivable that the market could fall till its value is only 50% of GDP (i.e. S&P 500 at around 580; or it could just stay stagnant as GDP grows until the ratio is about 50% (GDP would have to increase by 50%, ie. grow at 7% for another 6 years for this to happen).

The Wall Street Journal also has a neat table showing historical PE ratios of the market. Though PE ratios of the market in any one-two year period are not indicative of historical averages (because corporate profits as a % of GDP swing from year to year), they do suggest the possibility of the market going down by 35% if we return to the market PE ratios common in the 1980s. (2008 market PE ratio: approx 12; 1974 market PE ratio: approx 7)


Can we use this market capitalization to GDP ratio to assess the value of other equity markets?

This approach works for the U.S. equity market, because (a) the U.S. economy is extremely broad, robust, and resilient, and (b) the U.S. equity market is well developed and the publicly listed companies are representative of the overall U.S. corporate sector.

This is not true for all countries. For example, Brazil has a broad and deep economy, but a disproportionate amount of its market capitalization is for natural resource companies. Buying the index tracking fund there would not give you exposure to the underlying economy. As another example, Singapore has a small niche economy and a stock market that hosts many companies with businesses outside of the Singaporean economy. The market capitalization to GDP ratio in Singapore would tell you nothing about whether Singapore listed equities are overpriced or underpriced.


Buying stocks (or an index tracking fund) is a bet on the U.S. economy.
So should investors be concerned about the huge (and growing) U.S. current account deficits?

The 2007 current account deficit was about USD 731 billion, or about 5% of GDP. The impact of this to investors is that as the U.S. imports more stuff every year, the U.S. dollar will be under constant devaluation pressure.

(Side Note 1: The 2007 U.S. Net International Investment Position was about negative USD 2.4 trillion dollars, or about 15% of GDP. The NIIP has been deteriorating at a slower rate than the growth in cumulative current account deficits, suggesting that foreign holders of US dollars have been buying US assets whose prices generally decline over time, and/or that US investors have generally been buying overseas assets which generally appreciate in price over time. [see the BEA's "changes in selected major components of the international investment position" for details] But the U.S. NIIP is deteriorating nonetheless.)

(Side Note 2: As a comparison, Australia has a negative net international investment position of about 68% of GDP. This could theoretically be due to Australia borrowing more to fund its gross fixed capital formation which is about 25% of GDP, as compared to the gross fixed capital formation of about 18% of GDP in the U.S.)

If you are U.S. based investor who uses USD for day-to-day living, then this won't matter as long as the U.S. economy is able to start domestic manufacturing of items that were previously imported. My bet is that it will be able to do so. The resourcefulness and ingenuity of the capitalistic U.S. economy will rise to the occasion. You US dollar investments will return you US dollar dividends which will maintain their real value.

If you are a overseas based investor who used another currency for day-to-day living, then you would be concerned that even if you own all the companies the US, the US dollar dividends would be worth less and less, in real terms, in your local currency. However, my bet is that if the US dollar depreciates excessively, US companies will begin manufacturing things that used to be imported, and also export their wares as the depreciating dollar makes them more price competitive. This should limit the decline in the real value of your US dollar investments. But the quantum of the decline in real value of your US investments is hard to determine.