Inflation Hides the Truth About Economies, Companies & the Stock Market

November 30th, 2007

This article is only a theory of mine (it may be wrong and that wouldn’t bother me a bit as it would be a relief to know!). We all know inflation sucks our wealth away if it is left around to be waisted (ie, sitting around in a 4% bond). Everyone hears things like “the middle class is shrinking” and “buying power of the dollar is decreasing” and knows Grandpa bought a coke for a nickel. Fiat currencies and our economy are built upon inflation and the “growth” that occurs because of it. Here’s how it works (at least how I think it works):

Every country creates a way to track inflation. The core vehicle to track inflation (called CPI (core price index) where I live) is often made up a basket of goods that are considered normal goods that must be bought in order to live comfortably - the price of this basket is compared each year to determine the official rate of inflation. The CPI includes things like milk, sugar, food, etc, etc. The key is that the price of milk and sugar are highly regulated and controlled and have less price increases than other goods and services in the economy. Even farmers are subsidized by the governments to help keep food prices lower than they should be! Also notice there are MANY items that are not counted in the inflation number. This hides the true inflation in a country and paints a rosy ‘all-is-well’ and ‘economy-is-growing’ image, even when it may not be true.

Hows This Work?

Governments typically aim for about 4% inflation per year (or less). Even when inflation of many goods and services is in the 6% to 10% range, the core products are regulated enough to make it look like inflation is JUST 4%. If the fake inflation (as tracked by CPI) is 4%, and the economy grew by a total of 6%, it would like like the economy is 2% up year-over-year after inflation is counted (everyone rejoices and all is well in the world!); What they don’t tell you is the true inflation of the money supply is 8% (just an example, not the actual inflation as that is rumoured to be in the 10% to 15% range if you factor in the new dollars being printed!) and so the true wealth created by the country actually decreased by 2% (The buying power decreased by 2% if economy grew by 6% and real inflation was 8%). The economy is shrinking but the number of dollars people earn is increasing and they don’t realize it as this all slowly occurs over the years.

My Pay Went Up… But I Struggle More Than Ever, To Pay The Bills!

A 4% increase in pay (to keep in line with official inflation) is actually a 4% decrease in buying power (if the true hidden inflation is 8% that year), which means a 4% decrease in pay (though you don’t notice it as your pay went up!). Ironically, you eventually get put into a higher tax bracket where the government takes a larger percent of earnings - a slap in the face. If this same process of decreasing buying power but increased dollar earnings occurs slowly for twenty years, losing between 1% and 4% buying power per year… well you end up seeing a shrinking middle class! It all happens so slowly, nobody realizes it - a few percent a year! Then you end up struggling to buy a 2nd hand home that needs repairs (and costs a whopping $400k).

I believe that some countries (not all) hide their shrinking and poorly performing economies with inflation.

This helps the stock market continue to grow for years and years and everyone in the economy fails to recognize the slow loss of wealth until one day they realize they used to be able to buy way more things in the past, even though they make way more money now; all those salary raises haven’t kept pace with the true inflation and buying power is decreasing!

A quick example:

Company A

2006 Profits: $10 B
Shares: 1,000,000,000
Profit/Share: $10
P/E: 20
2006 Share Price: $200
Official Rate of Inflation: 4%
True Rate of Inflation (hidden): 8% (just an example number!)

Now lets assume the profits for the company increased 7% in 2007. If the p/e ratio and number of shares stays the same, the new share price would be $214. That is a 7% increase even though the company only actually grew 3% after taking official inflation into account! (Funny how we get taxed on the entire 7% gain if we were to sell, even though most of that isn’t a gain if you factor inflation!) However, because this is a company that normally only grows at 4% a year (same as official inflation), and this year it grew at 7% (above official inflation), the p/e increased from 20 x earnings to 22 x earnings on news of this quicker than expected growth and an outlook for a 7% growth next year as well. So with the new 22x p/e, the share price is now $235.40, a 17.7% increase, even though the company only grew 3% above official inflation.

Some people sell their shares, brokers make more money and hedge funds rake in bigger fees for their good performance. Politicians get re-elected for having given (as if they give it) the population such a healthy economy (why is it the politician takes credit?). Notice how rosy things can be when share prices increase due to a ‘bull’ market? Everyone is happy.

The story that isn’t told is that the true inflation of ALL goods and services was 8% (if you take into account the inflation of all goods and services in the economy and the new money being printed). The company is actually earning less TRUE WEALTH (its profits have less buying power) than it did in 2006. The company, in reality, is earning 1% less than it did the year before based on true wealth and the purchasing power. Yet, because of the power of inflation and the ability to mask it, the share price has went up and is now staying higher because they expect to continue to grow faster than they used to (even though they are really shrinking buying power!). In other words, the $10.7 B in profits buys less STUFF than $10 B a year ago did.

Think about it!

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