Clarification of Inflation according to Forbes

Question

On 9/17/2014 Simon Moore argues the S&P 500 valuation may not matter. Mr. Moore points out the deviation of stock and bond values from historical norms. He blames this deviation on low inflation (2.7% globally). He then goes on to say:

"if inflation is high, then the value of money in the future is worth less, but if it falls then the value of money in the future increases."

We just established two things:

  1. The future value of money goes up in low inflation.  
  2. We are experiencing low inflation.   

Holding cash sounds like an attractive and extremely low risk alternative to a highly priced market.

Further, he backtracks on his core argument that recent history is a weak indicator of the future due to low inflation:

"You may think cash is an attractive asset class in this environment, but one of the few reliable tenets of investing historically is that the return on holding cash has been negative"

This strikes me as a straw man argument. Can someone explain to me what I am missing here?

Answer 1

I think you're missing Simon Moore's point. His point is that, due to low inflation, the returns on almost all asset classes should be less than they have been historically, so we shouldn't rebalance our portfolio or withdraw from the market and hold cash based on the assumption that stocks (or any other asset) seem to be underperforming relative to historical trends.

His last paragraph is written in case someone might misunderstand him, he is not advocating to hold cash, just that investors should not expect as good returns as has happened historically, since those happened in higher inflation environments.

To explain:

If the inflation rate historically has been 5% and now it's 2%, and the risk-free-market return should be about 2%, then historically the return on a risk-free asset would be 7% (2%+5%), and now it should be expected to be 4% (2%+2%). So, if you have had a portfolio over some time you might be concerned that the rate of return is worsening, but Simon's point is that before you sell off your stocks / switch investment brokers, you should try to figure out if inflation is the cause of the performance loss.

On the subject of cash: cash always loses value over time from inflation, since inflation is a measure of the increase in prices over time-- it's a part of the definition of what inflation is. That said, cash holdings lose value more slowly when inflation is lower, so they are relatively less worse than before. The future value of cash doesn't go up in low inflation (you'd need deflation for that), it just decreases at a lower rate, that is, it becomes less expensive to hold- but there still is a price.

As an addendum, unless a completely new economic paradigm is adopted by world leaders, we will always see cash holdings decrease in value over time, since modern economics holds that deflation is one of the worst things that can happen to an economy.

Answer 2

Inflation can be a misleading indicator. Partly because it is not measured as a function of the change in prices of everything in the economy, just the basket of goods deemed essential. The other problem is that several things operate on it, the supply of money, the total quantity of goods being exchanged, and the supply of credit.

Because the supply of goods divides - as more stuff is available prices drop - it's not possible to know purely from the price level, if prices are rising because there's an actual shortage (say a crop failure), or simply monetary expansion.

At this point it also helps to know that the total money supply of the USA (as measured by total quantity of money in bank deposits) doubles every 10 years, and has done that consistently since the 1970's.

USA Total Bank Deposits

So I would say Simon Moore manages to be right for the wrong reasons. Despite low inflation, cash holdings are being proportionally devalued as the money supply increases. Most of the increase, is going into the stock market. However, since shares aren't included in the measures of inflation, then it doesn't influence the inflation rate. Still, if you look at the quantity of shares your money will buy now, as opposed to 5 years ago, it's clear that the value of your money has dropped substantially.

The joker in the pack is the influence of the credit supply on the price level.