When Fears of Inflation Are More Pronounced

What’s happening on the ground here in Australia? Are businesses turning over new earth and beginning new projects? “Construction activity falls for 16th month,” reports today’s Age. So that would be a “no.”

“Building and construction activity has weakened for a 16th straight month as firms grappled with delayed projects and difficult credit conditions…The Australian Industry Group-Housing Industry Association performance of construction index (PCI) fell by 4.3 index points in June to 42.6 points. The index has been below the 50 level, which separates expansion from contraction, since March 2008.”

But let us not be accused of being pessimists. Take a look at the chart below. It’s from a 2002 book called Triumph of the Optimists by Elroy Dimson, Paul Marsh and Mike Stanton of Princeton University. It shows that over the last one hundred years-and importantly, prior to the blow-off phase of the credit bubble in 2000-dividends accounted for half of your total return in U.S. and U.K. common stocks.

The Power of Reinvested Dividends

Dividends went out of fashion in the tech boom. To be fair, many companies had no earnings at all from which to draw a dividend. But as you can see from a second chart (below), the dividend yield on the S&P 500 is coming off a historic-low in 2000. Even so, the current yield on the S&P is just 2.4%, compared to the 3.5% yield on ten-year Treasury bonds.

Source: Bespoke Investment Group

The yield on Aussie stocks, for whatever reason, has tended to be higher than U.S. stocks. For example, let’s say you read the APRA report on Super we mentioned yesterday and decided your best approach was to passively track the ASX/200, thereby reducing management fees and not trying to beat the market with your own skill. How would you do it?

Well-we’re not recommending it-but this is precisely what Exchange Traded Funds are for. The SPDR S&P/ASX 200 Fund (ASX:STW) tracks the ASX. It’s also going to sport a yield near 10%, based on 2009 earnings projections. So for investors interested in “one-decision” stocks, this one decision on the whole market that pays a surprising high-yield.

That’s not to say there’s no risk, or that you couldn’t do better picking your own high-yield stocks. And that’s only if you thought yield was the way to go. But the idea occurs to us because we believe that with financial assets anyway, the name of the game in the coming years is to find a rate of interest (or yield) that exceeds the inflation rate.

Come to think of it, that’s always the name of the game. It’s just particularly the case when fears of inflation are more pronounced. And incidentally, this also bears on the housing market. That is, it’s possible Aussie house prices will stay the same or even rise nominally, but fall in real terms as the rate of inflation in the rest of the economy far exceeds the rate of price appreciation homes (homes propped up by government aid and reluctant sellers, but not powered higher by new buyers because of rising rates and affordability issues.)

But leaving the housing debate aside, we turn the case for dividends over to none other than Ben Graham in The Intelligent Investor. Chapter two of that must-read is called “The Investor and Inflation” and in it Graham writes the following (emphasis added is our own):

Inflation, and the fight against it, have been very much in the public’s mind in recent years. The shrinkage in the purchasing power of the dollar in the past, and particularly the fear (or hope by speculators) of a serious further decline in the future, have greatly influenced the thinking of Wall Street.

It is clear that those with a fixed dollar income will suffer when the cost of living advances, and the same applies to a fixed amount of dollar principal. Holders of stocks, on the other hand, have the possibility that a loss of the dollar’s purchasing power may be offset by advances in their dividends and the prices of their shares.

It’s an intriguing statement, isn’t it? We have every reason to believe that deleveraging in the economy is generally bearish for stocks. But Graham is looking past debt-deflation and toward the moment when monetary excess begins driving prices up again (inflation).

In that environment, Graham reckons you hedge against inflation best with common stocks that pay dividends. At least, that’s our reading of it. And if it’s correct, it means you need a two-stage plan. Stage one is to survive further deleveraging by being more in cash and tangibles than shares. The second-again speaking generally-is to be ready to deploy your cash into assets going up faster than the rate of inflation.

That is enough on the subject today. More tomorrow. And we meant to discuss another 100-year trend, that of global energy production per capita. But it will have to wait. Until then, we’ve published some more reader mail on property and adolescence.


Your newsletter today includes the sentence:

‘In an ominous sign for the commercial real estate sector, ratings agency Standard & Poor’s may downgrade $US 235 Billion worth of bonds backed by commercial real estate mortgages. The rating agency has changed its criteria for mortgage-backed securities.’

Why does anyone still pay attention to the ratings agencies? Weren’t these the people who gave AAA ratings to CDOs, CDS and the other toxic financial products that precipitated the financial crisis?

I am truly disappointed to see you give any credence whatsoever to these clowns.

A fair cop. We’re not saying the ratings agencies are going to get it right. But in the aftermath of their complicity in subprime crime, we expect them to err on the side of caution going forward. And correct or not, the downgrades-if they come-will have an impact on what pension funds and other institutions can own debt that is not investment grade. It will have consequences.

–Just read your Monday report. What a load of Crap! Didn’t anyone tell you if you have nothing worth saying, then keep your mouth shut.

You remind me of a 16 year old child who thinks because he can read a newspaper he has the answers to the world’s problems. Everything you said had a negative connotation and I am looking for your recommendations, surprise surprise you don’t have any.[sic]

You seem to like using old sayings…..here’s one for you “*&%$ or get off the pot” …I personally have enough crap to read to try and keep up to date, without having to sift through your stuff for something intelligent and come up with “land and cattle” boy are you clever!!!!

Finally for someone you is critical of fund managers and their responsibilities, your rag leaves a lot to be desired with all the “teasers” structured throughout it. What can’t you back your own horses?

David P.

We’re afraid you misunderstand the purpose of the DR David. It’s not to tell you what to do with your money. It’s to make you think-or at least share in our own thoughts. If you’re not enjoying it, we suggest you get off the pot. And if you want analysis of specific shares, that’s for paid subscribers to Diggers and Drillers and Australian Small Cap Investigator.

–Dear Dan,

With regards to your explanation on the fall in building approvals, the answer is not so much market driven as it is funding driven.

Financial institutions have been re-assessing the risks on their loan books in relation to property exposure. They are concerned with the de-leveraging process and the affect it has on the asset prices and hence the loan to value ratio. Property like other assets can be graded according to risk, those A-Grade premium office buildings in capital cities with a steady income stream look better than the regional shopping centres in the suburbs, but they look better than warehouses on the outskirts of town. The point being, land that is able to be developed is the highest risk because the outcome is unknown. Bank lending has slowed to a trickle, if not stopped for such property, especially those that are not income producing from a steady cash flow. The property industry has also stopped in pursuing approvals for their land if they cannot obtain funding.

This is still not a terrific outcome for the economy as the financial institutions still have a very big say in how it is run! If more companies continue to fail, the lending criteria will tighten dramatically and the shortage of housing will continue.



Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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1 Comment on "When Fears of Inflation Are More Pronounced"

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Pat Donnelly

The yield on Aussie stocks is higher because we tend to fraud to a lesser degree than the US ….. part of this is because the population is smaller and we know the pedigree of promoters better!

The cost of money is also higher hence only the better projects get financed. Remember Lang?

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