Thinking about the deficit as you invest

by Pop on February 18, 2011

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The “crisis” that never comes

The recent deficit talk has people rightly concerned about whether or not Congress and the President have the cojones to bring our fiscal house in order. There are basically four ways to cut the deficit: grow the economy, cut spending, raise taxes, or print money.

Option one is the fun way to get out of it. If we sell more goods and services, government collects more taxes while citizens make more money, and everybody’s happy. However, the economy right now is growing slowly.

Options two and three are where all the debate is happening. However, political risk is frightening most politicians from addressing the beasts of healthcare and Social Security that need to be tamed for any real progress to be done.

Which leaves option four as the default way to pay. If Congress does nothing to fix the deficit, the government can “print money” to devalue those debts, which drives interest rates up and the dollar down. Bad for savers. Good for debtors.

While you might understand how all that could eventually affect inflation and the prices you pay for goods, you might be left scratching your head about just how much of a knock on your savings that last solution could translate to.

Here’s an attempt to explain it without getting too wonky or insulting your intelligence. But first, let’s set one thing straight.

Inflation is not here yet.

I’m kind of tired of the “is there or isn’t there” inflation debate going on right now. The government’s official inflation measure showed that prices rose by about 1.6% over the last 12 months. Food and energy prices accounted for more than two-thirds of the increase.

Inflation of less than 2% is extremely low, especially when you’re including food and energy prices, which swing up and down sharply based on crop yields, hurricanes, etc. Critics like to counter with nice-sounding anecdotes about how their personal grocery bills are rising. But even if we were to accept anecdotal evidence as valid, there’s reason to think those anecdotes are wrong.

Here’s the average grocery store purchase at a Hy-Vee in Des Moines, according to Mint:

This chart is based on data aggregated anonymously from over 4 million Mint.com users.

Go to Mint’s data feed yourself and play around. Grocery bills aren’t going up. Unless people are eating less, or deciding to make multiple trips to the store in order to keep their average order down (diabolical!), it’s simply not true that grocery prices are already on the upswing.

But it could happen soon. As the WSJ points out today, the prices for some things are rising faster, and inflation is already much worse in places like China, where there’s not a bad economy to weigh against price increases.

I’ve written before about good and bad inflation fighters. But today, I want to write specifically about how rising interest rates could affect stock prices.

Starting with a risk-free rate of return

If you wanted there to be no chance for your investment to lose money, where would you put it? FDIC-insured bank accounts come to mind, but you’d do slightly better by investing in 10-year Treasury bonds, which yield about 3.6% a year right now. Don’t get me wrong. If interest rates rose while you had your bond, the price would go down in the interim. But as long as you held onto them for the entire 10 years, you couldn’t lose a dime unless the federal government were to default.

That’s about as close to risk-free as investors can get right now. And that means that anything they invest in that carries more risk needs to pay out more than 3.6% a year to make sense as an investment.

The bonds of Warren Buffett’s Berkshire Hathaway, for example, would seem to be extremely safe. It’s a big, established company that’s generating a lot of cash. But the yield of a Berkshire bond I’m looking at that matures in 2021 is 4.2%. That means that as safe as Berkshire is, investors want another 0.6 percentage points to take on the ever-so-slight risk that Berkshire goes belly-up before the bond matures.

As you can imagine, once you start getting down to auto companies, those bond yields start to get really high.

What it means for stocks

Stocks also have a yield, though personal finance magazines like to make it appear more complicated than it actually is. The “price-to-earnings” ratio that you read about all the time is really just an earnings yield in reverse. A stock with a P/E of 15, for example, has an earnings yield of 6.7% (1 divided by 15).

Since stocks are more risky than bonds, investors want to pay a price on a company’s stock that reflects the additional risk they have to take on. The price-to-earnings ratio of Berkshire Hathaway, for example is 17.6, which translates into an earnings yield of about 5.7%. (Admittedly, a P/E isn’t the best way to evaluate a holding company like Berkshire.)

So, what happens when the interest rates on Treasury bonds rise? Let’s say the interest rate on a 10-year Treasury bond went to 10%, as it was in the early 1980s.

An investor could earn 10%, while taking no risk, by buying Treasury bonds. So if he considered buying a stock, which carries a lot more risk, instead, he’d want to get a yield that’s better than that.

The earnings yield of the S&P 500 right now is about 4.3% (which is a P/E of about 23). So to get even close to the 10% yield of a Treasury bond, you’d need stock prices to fall by more than half.

In reality, the drop would be much less sharp—earnings would rise, too. But P/E compression, as the phenomenon I just described is called, is a very real fear that investors haven’t had to face for 20 years, since during that time bond rates kept dropping.

Long story short…

If investors fear inflation, and start to demand higher yields from Treasury bonds, that will mean that stock prices will have to make a corresponding drop, all else being equal. Stocks have benefited from a 20-year or so long-term drop in Treasury yields. But that party’s over.

Is there anything you can do to protect yourself from it? Not really. You could choose stocks that already have low P/Es, with the idea that those prices won’t compress as much when interest rates rise. However, buying individual stocks carries so many other risks, that it’s probably not worth your time, effort, or emotional fortitude to go through all that.

It’s just one of those things that you should save more to prepare for and to understand once it does start to happen. This deficit monster is probably going to extend its tentacles into more aspects of our finances than we can even conceive of.

I, for one, am hoarding piles and piles of gold bullion in an undisclosed location. So when Zimbabwe-like inflation causes food riots, I can…eat it…or something.

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{ 67 comments… read them below or add one }

Dangerman February 19, 2011 at 8:09 am

“Is there anything you can do to protect yourself from it? Not really. ”

Why no TIPS/I-bonds recommendation?

Barry February 19, 2011 at 10:03 am

I shop the grocery stores with a list and a calculator .Before I go I compare 3 weekly circulars so that I know where I am buying what . The battle plan is analysed to the point that gas costs are figured into the store farthest away. Do not drink the kool aid over the last 3 months prices have been taking significant jumps on the order of 10-20% with most price jumps leaning to the high end of the scale .Package size reduction is also taking place 13% reduction on one item 2 weeks ago.I think the fact that wages have stagnated on the low end of the scale as debt load increased is a recipe for tougher times when you try to inflate your way out of a problem .You can strip food prices out of the cpi but in the end a fixed amount of food has to go through the register to feed a family.

Jan February 19, 2011 at 11:55 am

You will eat…gold?
Better to buy crop land and get loads of seed:>)

Len Penzo February 19, 2011 at 12:45 pm

Nice analysis, Pop. I think food prices have been inflating for some time now. I suspect average grocery store purchases is probably not a very reliable indicator of inflation. As you mention, people could be buying less (quite possible), or as Barry said, it more likely reflects smaller package sizes (which is very true — it is a widespread phenomenon now).

All the best,

Len
Len Penzo dot Com

Pop February 19, 2011 at 12:45 pm

@Dangerman – Felt like I’d beaten those horses to death and wanted to focus on what you could do to protect your stock portfolio (Check out The best tools to fight inflation if you’d like to read about it though.

@Barry – While the Fed says it doesn’t regard food prices when deciding monetary policy, they put out an inflation index that does include it, which is what I referenced above. You can use that Mint Data tool to see if people are spending more at your own grocery store. I tested 5 to 10 out, and none of them are showing significant increases in the average receipt. So like I said, either people are eating less or making more trips to the store.

@Len – Thanks for stopping by…but if package sizes are smaller, you eventually have to buy more to get the same amount of food, right? Or are people just becoming healthier by eating less? But anyway, I still think the best measure of food inflation is the government measure, which is showing relatively small increases so far. If anyone knows a better measure, throw it out there!

Rob Bennett February 20, 2011 at 7:05 am

Since stocks are more risky than bonds

I wish people would stop saying this (I understand that it is by no means only you, Pop).

If you consider valuations when setting your stock allocation, stocks are no longer a risky asset class. Stocks have never performed poorly when purchased at times of moderate or low prices. Which makes them a lot less risky than bonds because stocks offer far better protection from inflation than bonds.

The trick with stocks is to avoid purchasing them when prices are high (like today). All of the risk of this asset class is concentrated in the stocks purchased at those times. The way I think about it is that stock risk is optional. Stocks can be a high-risk asset class but they become this only for those who insist on following a Buy-and-Hold strategy.

I would be moving my money someplace safe so that I could obtain the super returns that will be available to stock investors as soon as prices again become reasonable.

Rob

eva March 8, 2011 at 9:51 am

Interesting. But I would be cautious of using Mint’s data for more than a grain of salt–it only comes from Mint’s users, who are almost assuredly not representative of the entire American population.

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