tag:blogger.com,1999:blog-6704573462403312459.post7094715478860569817..comments2024-03-29T02:53:03.321-04:00Comments on Moneyness: A stock portfolio is a bad hedge against inflationJP Koninghttp://www.blogger.com/profile/02559687323828006535noreply@blogger.comBlogger29125tag:blogger.com,1999:blog-6704573462403312459.post-1089793933400342872013-05-21T12:30:31.564-04:002013-05-21T12:30:31.564-04:00I checked with one of my accountant friends and he...I checked with one of my accountant friends and he said that I was wrong--the IRS code mandates that if you use LIFO for tax purposes then you have to use it for financial accounts as well.<br /><br />On a separate point, according the NIPA, "inventory profits" accounted for nearly 15% of pre-tax corporate income (for nonfinancial corporations) in the decade of the 1970s compared with the 50-year average of about 5%. So, a huge portion of the profits in the 1970s was simply not "sustainable" and investors would have seen through it. I think the tax angle is relatively minor--the accounting literature's findings are mixed on the tax angle. srininoreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-56968752805964366942013-05-21T10:36:36.350-04:002013-05-21T10:36:36.350-04:00Prof J, thanks for stopping by. I like your point ...Prof J, thanks for stopping by. I like your point about investing in Israel. Companies that are familiar with the negative effects of inflation will be better equipped to deal with these problems as they arise. JP Koninghttps://www.blogger.com/profile/02559687323828006535noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-59826860475890497452013-05-21T10:32:08.148-04:002013-05-21T10:32:08.148-04:00You bring up a good point that it is the tax books...You bring up a good point that it is the tax books that are the relevant variable, not accounting books as dictated by IFRS. The IRS allows LIFO, for instance, whereas Revenue Canada doesn't.<br /><br />I did ignore the fact that inflation reduces the real value of debt and interest payments, as you point out, therefore cushioning the negative effect from COGS and depreciation. The Summers paper finds that the debt effect was not sufficiently strong to fully compensate investors. JP Koninghttps://www.blogger.com/profile/02559687323828006535noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-33361536657046213302013-05-21T08:57:46.691-04:002013-05-21T08:57:46.691-04:00Ramanan,
It is not true that firms are better off...Ramanan,<br /><br />It is not true that firms are better off with mild inflation than zero inflation or deflation. As long as firms' expectations of future inflation/deflation are accurate (i.e. no firms are suffering from money illusion), then it doesn't matter what the actual future inflation rates will be. Firms will invest in the present accordingly, given those (assumed correct) expectations.<br /><br />The problem of course is that perfect foresight is a chimera. Nobody can know for certain how a given OMO from the central bank will affect their own particular nominal incomes, and when. The only reason mild inflation *seems* to "work", is because of money illusion. But as I am sure you realize, any investment activity founded upon money illusion will not be solely representative of actual consumer preferences. It will be a combination of preferences and the price and interest rate effects of inflation that arise apart from real savings patterns. This generates malinvestment and recessions/depressions.Major_Freedomnoreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-52222003259678148782013-05-20T21:59:56.811-04:002013-05-20T21:59:56.811-04:00Here's something I wrote a couple years ago on...Here's something I wrote a couple years ago on the issue:<br /><br />http://crankyprofj.blogspot.com/2011/08/equity-strategies-for-inflationary.htmlProf Jhttps://www.blogger.com/profile/16539902592080231165noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-78669291882628534722013-05-20T21:53:28.321-04:002013-05-20T21:53:28.321-04:00JP,
I've followed your comments on MacroMania...JP,<br /><br />I've followed your comments on MacroMania and Free Advice, and I like your blog. I feel I have something to add here, since I've done research on this topic. It is true that in countries where inflation has been low and steady for a long time (e.g. US, UK, Canada... most industrialized countries) stock returns do not adjust for inflation (contra Irving Fisher). But, when inflation is high and/or volatile, investors do appear to require compensation for equity investments, and stock returns include an inflation premium. What is at the root of this I didn't study, but I think it's possible that when inflation is low and stable, people don't notice it and therefore don't require the compensation.Prof Jhttps://www.blogger.com/profile/16539902592080231165noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-51192285818949310432013-05-20T16:51:55.319-04:002013-05-20T16:51:55.319-04:00IFRS applies only to financial reporting. Taxes (a...IFRS applies only to financial reporting. Taxes (at least in the US) are determined by IRS rules. Companies do keep separate tax and financial accounting books. And it is quite possible to have FIFO for your financial reporting and LIFO for your tax reporting, thereby minimizing the impact of inflation on taxes.<br /><br />As for capital investments, the issue is complicated by accelerated depreciation and other tax incentives that change the tax depreciation profile quite significantly from the historical depreciation profile.<br /><br />Ultimately, the higher tax liabilities can be viewed as a tax on the inflationary capital gains on assets. So, to the extent that taxes eat away part of the inflationary gains, stock are indeed an imperfect hedge, but they are still an hedge. <br /><br />I am really not sure what data Summers used--I am generally skeptical of economists when they use financial data, they are often blissfully unaware of the difference between tax and financial reporting. (I speak from personal experience and I am an economist who happens to have training in accounting.)<br /><br />Secondly, are you talking about a permanent rise in the rate of inflation or a temporary surge that may last for a while but will eventually subside? Because the implications for dividend discount model are different for each. Also, you have completely ignored the fact that inflation reduces the likelihood of default--after a stock is a call option on the assets of the firm and the delta of the option with respect to the inflation has to be positive.<br /><br />The issue is quite complicated because it is generally difficult to isolate inflationary episodes that are also associated with political turmoil and heightened uncertainty, both of which undoubtedly weigh on stock valuations.<br /><br />So, really if the question is are stock an good hedge against troubled times with inflation, then the answer is no. Are stocks a good hedge against inflation with complete tranquility otherwise? The answer is we don't know because there are no such periods in history. srininoreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-19767939132676246762013-05-19T04:05:08.486-04:002013-05-19T04:05:08.486-04:00What would be the best way to profit from a high i...What would be the best way to profit from a high inflation? Long stocks, short bonds or short currency? Dan https://www.blogger.com/profile/14228383423254118263noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-46080746866450549632013-05-17T14:41:28.973-04:002013-05-17T14:41:28.973-04:00Invest in companies with pricing power relative to...Invest in companies with pricing power relative to their customers and suppliers. In an inflationary environment, this kind of company can raise prices on its customers more than its suppliers can raise prices on it. This does not solve the tax problem, but can offset its impact on the bottom line. Buffett outlined this in one the Berkshire annual reports from late 70's or early 80's.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-5856876353829802042013-05-17T10:08:57.913-04:002013-05-17T10:08:57.913-04:00After some sleep, I see now what your point is. A ...After some sleep, I see now what your point is. A company that puts money in the bank is taxed on the nominal interest return they make, not the real return. So at 0% interest & 0% inflation, firms are taxed on a nominal 0% return and end up at where they started. But at 100% interest & 100% inflation, they are taxed for the 100% nominal return, despite earning nothing on a real basis, and therefore end up with less.<br /><br />Let's say the tax system was changed to prevent taxation of fictitious capital gains. Companies and their shareholders would still suffer from the historical cost effects (COGS + depreciation) that I talked about in this post. In other words, we're talking about several different interactions between inflation and taxes. JP Koninghttps://www.blogger.com/profile/02559687323828006535noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-87323290588259993572013-05-17T09:08:31.786-04:002013-05-17T09:08:31.786-04:00Accelerated depreciation will somewhat mitigate in...Accelerated depreciation will somewhat mitigate inflation tax effects. (See <a href="http://www.nber.org/papers/w0395" rel="nofollow">here</a> and here). Replacement cost depreciation will help shield from the effect too. <br /><br />High turnover should help shelter from COGS effects, since costs get updated more quickly, saving the firm from the necessity of using stale and lower costs.<br /><br />Another way to approach the problem is to think about what sorts of businesses don't have much depreciation to begin with, since these businesses will be less likely to pay excess taxes during inflation. JP Koninghttps://www.blogger.com/profile/02559687323828006535noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-45258679660540104522013-05-17T08:41:12.936-04:002013-05-17T08:41:12.936-04:00If all inventory (and receivables) is financed (at...If all inventory (and receivables) is financed (at floating, current rates), does it matter (ie debt is indexed to inflation)? <br /><br />Slightly off-topic: a few years ago I tried to check whether the US NIPA accounts for corporate profits compensated for this effect (i.e. CPATAX series). I found some vague citations that it used to be historic cost accounting and then it changed in ~1969(?) to replacement value accounting; but it wasn't clear whether the whole series is the latter. Anyone know any references to that?jtunoreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-53781250683954883652013-05-17T05:24:15.829-04:002013-05-17T05:24:15.829-04:00Sorry, my post should have read "to invest in...Sorry, my post should have read "to invest in companies using the weighted average COGS method rather than in those using the FIFO method", not the LIFO method!<br /><br />LIFO is still the best method in this situation.JNnoreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-12186923538280160772013-05-17T01:05:31.504-04:002013-05-17T01:05:31.504-04:00Now you've got me completely confused :)
If t...Now you've got me completely confused :)<br /><br />If the company has capital, it will attempt to get the best possible return on it (given its risk tolerance), whether the after-tax return is positive or negative..<br /><br />In this situation, there's nothing the company can do to get around the real loss..DOBhttp://catalystofgrowth.com/noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-14495247418644489832013-05-16T23:58:44.561-04:002013-05-16T23:58:44.561-04:00Fascinating stuff, Diego. You must have learned a ...Fascinating stuff, Diego. You must have learned a lot from your experience. The presence of inflation surely adds a whole extra dimension to security analysis, one that we simply don't grasp or appreciate in North America.JP Koninghttps://www.blogger.com/profile/02559687323828006535noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-12946237805581471232013-05-16T23:54:11.498-04:002013-05-16T23:54:11.498-04:00If the economy-wide expected real rate of return i...If the economy-wide expected real rate of return is positive, I don't think a company would accept an interest rate that resulted in a real loss. Say the natural interest rate is 5%. Companies will require that the bank provide them with a nominal rate sufficient to compensate them for any expected rate of inflation such that the net real return is 5%.<br /><br />But I do like your point on Ricardian equivalence. That certainly introduces some interesting twists.<br /><br />JP Koninghttps://www.blogger.com/profile/02559687323828006535noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-62529233362597403752013-05-16T23:45:32.122-04:002013-05-16T23:45:32.122-04:00Yes, if you think inflation will rise, investing i...Yes, if you think inflation will rise, investing in companies that use weighted average cost accounting is better than those using FIFO. LIFO is still the best, assuming the jurisdiction in which you invest allows it.JP Koninghttps://www.blogger.com/profile/02559687323828006535noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-87783897952722780652013-05-16T15:20:59.279-04:002013-05-16T15:20:59.279-04:00As far as the depreciation expenses go, I'm gu...As far as the depreciation expenses go, I'm guessing an investor would prefer geometric to straight-line depreciation for tax reasons (expenses are front-loaded under geometric and the company thus gets more money in more present and time valuable ways)<br /><br />Other than this, I'm stumped. High turn-over?John Hawkinsnoreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-18008624999013956512013-05-16T13:43:32.944-04:002013-05-16T13:43:32.944-04:00JP,
Having been an analyst for Latin companies in ...JP,<br />Having been an analyst for Latin companies in the 90's, I can shed some light on an additional reason for inflation hurting P/E multiples. Inflation tends to affect relative prices, and sometimes in a volatile way. Abrupt changes in relative prices make profit margins volatile. A business facing high and variable inflation will thus find it hard to forecast returns to long-term expansion projects. Instead, they tend to look at inflation-driven arbitrage opportunities, such as increasing working capital (i.e. extending days receivable, pre-buying inventories, etc) and buying foreign exchange. The net effect of all this is that long term investment stagnates, and with it real growth. As a result, P/E's decline. Diego Espinosanoreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-45576002197021203762013-05-16T11:34:03.392-04:002013-05-16T11:34:03.392-04:00The TV is almost a distraction in the example:
Im...The TV is almost a distraction in the example:<br /><br />Imagine your company starts $200 in the bank and the natural real rate is 5% and the tax rate is 50%:<br /><br />If inflation is expected to be 0% and realizes at 0%, a year later, the company has $205 after collecting interest and paying taxes, and they're worth $205 starting dollars.<br /><br />If inflation is expected to be 100% and realizes at 100%, a year later, the company has $315 in the bank after interest and taxes, and they're worth $157.5 of the starting dollars.<br /><br />Taxation of capital is "unfair" when it comes to inflation.<br /><br />However, one in effect you haven't mentioned is that if the state doesn't spend anymore in real terms than it used to, it has no use for the extra tax income so it could lower the tax rates which would at least partially offset the additional burden. Yeah, I know.. I'm dreaming...DOBhttp://catalystofgrowth.com/noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-29223999547899143392013-05-16T10:14:26.209-04:002013-05-16T10:14:26.209-04:00JP,
It seems to me that the "weighted averag...JP,<br /><br />It seems to me that the "weighted average cost" method is allowed under IFRS.<br />Therefore, following your solution, it would also mitigate inflation risk to invest in companies using the weighted average COGS method rather than in those using the LIFO method, if you want/have to invest in IFRS companies.JNnoreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-87800162718823230402013-05-16T08:47:25.235-04:002013-05-16T08:47:25.235-04:00That's right. As I was writing this I couldn&#...That's right. As I was writing this I couldn't help wonder how much of the huge increase in corporate cash hordes, and the decline in government revenues, has been due to the combination of FIFO and lower than expected prices.JP Koninghttps://www.blogger.com/profile/02559687323828006535noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-81883535453811575212013-05-16T08:45:54.866-04:002013-05-16T08:45:54.866-04:00When I responded it was after looking up the Rober...When I responded it was after looking up the Robertson reference. The section you refer to has some money illusion-ish things going on:<br /><br />"Of course the stimulus of rising prices is partly founded in illusion. The salaried official and the Trade Unionist have been beguiled into accepting employment for a lower real reward than they intended. Even the business leader is the victim of illusion : for he is spurred on not only by real gains at the expense of his debentureholders and his doctor and even (with a little luck) of his work people, but also by imaginary gains at the expense of his fellow business men."<br /><br />I don't deny that these sorts of things can occur. I suppose its the tax effects that I find most interesting since I assume them to be more regular and consistent.JP Koninghttps://www.blogger.com/profile/02559687323828006535noreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-79313297125007615012013-05-16T02:18:28.350-04:002013-05-16T02:18:28.350-04:00Don't think the argument depends on the existe...Don't think the argument depends on the existence of money illusion. <br /><br />I agree with you about general analysis except that it isn't the case that inflation always makes firms worse off because mild inflation is better for firms than a situation with zero inflation and/or deflation. Ramananhttp://www.concertedaction.comnoreply@blogger.comtag:blogger.com,1999:blog-6704573462403312459.post-30749162209264233722013-05-16T00:16:42.452-04:002013-05-16T00:16:42.452-04:00And FIFO would be a similar hedge against secular ...And FIFO would be a similar hedge against secular deflation, right?John Hawkinsnoreply@blogger.com