Swedroe: Final Lessons From 2018

January 25, 2019

Every year, the markets provide us with lessons on the prudent investment strategy. I’ve so far covered what they taught us in 2018 in lessons one through three and then lessons four through seven. We’ll finish up today with lessons eight through 11.

Lesson 8: Inflation wasn’t, and isn’t, inevitable.

One of the most persistently asked questions I’ve received since 2009 is some version of the following: “What should I do about the inevitable rampant inflation problem we’re going to face because of the huge fiscal and monetary stimulus that’s been injected into the economy?” While that risk has existed, the fact is, since 2008, we haven’t had a single year in which the CPI exceeded 3%. In fact, 2011 is the only year it exceeded 2.5%.

A related myth persists among many investors as well. I frequently hear concerns about the exploding growth rate of our nation’s money supply. This belief likely has been fueled by certain commercials—the ones that recommend buying gold because central banks are printing money like we’re experiencing Weimar Germany all over again.

The fact is that M2, a broad measure of the money supply, hasn’t been growing at rates that suggest rampant inflation should be expected. For the 10-year period from Dec. 8, 2008 through Dec. 7, 2018, the Federal Reserve Bank of St. Louis reports that the rate of growth in M2 was 5.9%.

Since, as Milton Friedman, one of our greatest economists, noted, “inflation is always and everywhere a monetary phenomenon,” the factual data doesn’t support the view that we should have expected rampant inflation. In fact, despite the fears of many investors who seem certain that we will see massive inflation, neither the bond market nor professional economists are expecting anything of the kind.

We can at least get an estimate of the market’s forecast for inflation by looking at the difference between the year-end 2.68% yield on 10-year nominal bonds and the roughly 0.97% yield on 10-year Treasury inflation-protected securities, or TIPS. The difference is just 1.71 percentage points.

Clearly, investors, in aggregate, don’t appear concerned about rampant inflation. As for economists’ expectations, the Federal Reserve Bank of Philadelphia’s Fourth Quarter 2018 Survey of Professional Forecasters has a 10-year forecast of inflation averaging just 2.2% at an annual rate. Again, they don’t believe rampant inflation is likely, let alone inevitable.

Don’t get the wrong idea—the risk that inflation could increase dramatically is still present. It hasn’t happened so far because, even though the monetary base has been increasing rapidly (as the Fed’s balance sheet expanded through its bond-buying program), the velocity of money (as measured by M2) has fallen pretty persistently from about 2.0 at the end of 2007 to about 1.5 at the end of 2018, a drop of approximately 25%.

That said, there remains the risk that if or when the velocity of money begins to rise, inflation could increase. Of course, the Fed is well aware of this risk and would likely act—reverse its bond-buying program and raise interest rates—to prevent inflation from taking off.

Lesson 9: They are called “risk premiums” for a reason.

Many investors have been bemoaning the fact that the value premium—the excess return of value stocks relative to growth stocks—seems to have disappeared, turning negative for the past 10 years in the U.S. (although value has outperformed growth in international markets).

The trouble with this line of thinking, however, is that stock returns are extremely noisy from a statistical perspective. Thus, even a time frame as long as 10 years isn’t long enough to make a definitive statement about any strategy that invests in an asset class or investment factor.

For example, consider the 10-year period from 2000 through 2009, when the S&P 500 Index returned -0.9% a year and underperformed riskless one-month Treasury bills by 3.7 percentage points a year.

Even over the longer 13-year period 2000 through 2012, they underperformed, with the S&P 500 returning 1.7% and one-month Treasury bills returning 2.1%. The S&P 500 also underperformed one-month bills over the 15-year period ending in 1943, and over the 14-year period ending in 1982. Hopefully, such long periods wouldn’t prove long enough to convince you that stocks shouldn’t be expected to outperform Treasury bills. Or consider the even longer 40-year period from 1969 through 2008, when the U.S. total stock market returned 8.8% and underperformed the 8.9% return of long-term U.S. Treasuries.

Consider also the performance of international and emerging market stocks, which have underperformed over the most recent 10-year period. For the period 2009 through 2018, and using data from Portfolio Visualizer, the Vanguard Total Stock Market ETF (VTI) returned 13.3% per year, outperforming both the Vanguard FTSE Developed Markets ETF (VEA) and the Vanguard FTSE Emerging Markets ETF (VWO), which returned 6.1% per year and 7.5% per year, respectively.

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