Tuesday, March 31, 2009

The Color of Money

I think it is appropriate that my first post pertain to the inherent value of money. Putting aside the debate on the intrinsic value of fiat currency, I’m referring to the way that the value of any given currency can fluctuate contingent on where we are in the economic cycle. I have been startled lately to find that many people either do not grasp the concept of real returns, or have overlooked it in their investing strategies. Simply put, in an inflationary, monetary expansion, the value of a constantly held fixed pool of dollars diminishes. This should come as no surprise to many, since it is a topic commonly discussed in the mainstream. What I don’t understand is why so few evaluate the other side of the coin: in a deflationary, monetary contraction, the opposite is true.

Again, casting aside the debate around the manipulations of indexing data, one way to measure this is through the rate of inflation. Various sources exist for this data on the monetary base (such as M1) with relevant shortcomings. Since most utilize (wrongly) CPI as their gauge because they look more to price inflation, I’ll present an example from that. Michael Shedlock and TC have constructed a more accurate CPI tracking mechanism, substituting the more legitimate Case Shiller house price index data for the absurd Owners’ Equivalent Rent (OER) component in the CPI that the government uses.

Based on that, price inflation was massively understated from 1998 until mid-2006, and since massively overstated. In late 2005, the actual rate of price inflation touched 8% on an annualized basis. In February of this year, it is now negative 5%.

Let me show why this is of the utmost importance to making prudent choices. If you were flying high during the boom years, earning 15% per year, your real rate of return was only the amount by which you exceeded the rate of devaluation of your money, 7% at the inflationary peak. So, let me ask, how many have looked a 2%, 3%, or 4% interest rate in the face and trembled lately? Now, why? As deflation picks up steam, the rates could fall even farther negative, contingent on the impact that inventory slack being worked off will have on goods (not assets). Deflation causes the value of money to increase. If you are sitting in cash at merely a 2% rate you would be earning that same 7% real return – in a far more risk averse investment than equities as we know. This is a time where capital protection – and cash – is king, and chasing additional yield is not as important.

To effectively evaluate investment options, understanding real returns is a centerpiece.