"By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens."
- John Maynard Keynes
I was at a dinner party and asked if anyone knew who the chairman of the Federal Reserve is. One person out of 12 said yes. Just because the other eleven could not answer the question does not reflect poorly on their intelligence, but rather the fact that one of the most powerful entities in the world operates behind the curtain. By a process of money creation, those who control the money supply effectively dilute the purchasing power of every dollar you and I earn and save.If you look at the chart below, taken directly from the Saint Louis Federal Reserve’s website₁, that would be $8.942 trillion in cash as of May 11th, 2022, compared to $877 billion in 2007. More money chasing the same number of goods results in higher prices. Ice cream used to cost a nickel: a movie cost a quarter: a house cost $10,000.
"Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output."
- Milton Friedman
As these price increases take hold, expectations of future price increases go up and the Federal Reserve Board raises rates to combat the inflation (caused by their own money creation) and slow down the economy. This exacerbates boom and bust cycles. As stock pickers, this poses two issues. One: high prices in grocery stores leads to employees asking for higher wages, which results in higher cost of goods to the business owner and thus less profit margin. Plenty of investors don’t like this and sell, but other companies can still generate stellar cash flows assuming they have a good product or service. However, this leads us to our second problem which is that stocks are valued based on the present value of those future cash flows. Dividing these cash flows by a higher discount rate (a derivative of the interest rates set by the Fed) results in lower present values. As can be seen on the chart below, periods of inflation result in lower PE multiples. If inflation is brought under control, markets can bounce back quickly, if not corrections can last longer. In the current environment, the jury is still out.
"I care not what puppet is placed upon the throne of England to rule the Empire on which the sun never sets. The man who controls the British money supply controls the British Empire, and I control the British money supply.”
- Nathan Rothschild