Monday 25 October 2010

How Inflation Swindles the Equity Investor by Warren E. Buffett, FORTUNE May 1977

How Inflation Swindles the Equity Investor

The central problem in the stock market is that the return on capital hasn´t risen with inflation. It seems to be stuck at 12 percent.


by Warren E. Buffett, FORTUNE May 1977


It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment. We have been in such an environment for most of the past decade, and it has indeed been a time of troubles for stocks. But the reasons for the stock market's problems in this period are still imperfectly understood.


There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn't going to be a big winner. You hardly need a Ph.D. in economics to figure that one out.


It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their Value in real terms, let the politicians print money as they might.


And why didn't it turn but that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds.


I know that this belief will seem eccentric to many investors. Thay will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company's earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by compa-nies during the postwar years will dis-cover something extraordinary: the returns on equity have in fact not varied much at all.


The coupon is sticky


In the first ten years after the war - the decade ending in 1955 -the Dow Jones industrials had an average annual return on year-end equity of 12.8 percent. In the second decade, the figure was 10.1 percent. In the third decade it was 10.9 percent. Data for a larger universe, the FORTUNE 500 (whose history goes back only to the mid-1950's), indicate somewhat similar results: 11.2 percent in the decade ending in 1965, 11.8 percent in the decade through 1975. The figures for a few exceptional years have been substantially higher (the high for the 500 was 14.1 percent in 1974) or lower (9.5 percent in 1958 and 1970), but over the years, and in the aggregate, the return on book value tends to keep coming back to a level around 12 percent. It shows no signs of exceeding that level significantly in inflationary years (or in years of stable prices, for that matter).


For the moment, let's think of those companies, not as listed stocks, but as productive enterprises. Let's also assume that the owners of those enterprises had acquired them at book value. In that case, their own return would have been around 12 percent too. And because the return has been so consistent, it seems reasonable to think of it as an "equity coupon".


In the real world, of course, investors in stocks don't just buy and hold. Instead, many try to outwit their fellow investors in order to maximize their own proportions of corporate earnings. This thrashing about, obviously fruitless in aggregate, has no impact on the equity, coupon but reduces the investor's portion of it, because he incurs substantial frictional costs, such as advisory fees and brokerage charges. Throw in an active options market, which adds nothing to, the productivity of American enterprise but requires a cast of thousands to man the casino, and frictional costs rise further.


Stocks are perpetual


It is also true that in the real world investors in stocks don't usually get to buy at book value. Sometimes they have been able to buy in below book; usually, however, they've had to pay more than book, and when that happens there is further pressure on that 12 percent. I'll talk more about these relationships later. Meanwhile, let's focus on the main point: as inflation has increased, the return on equity capital has not. Essentially, those who buy equities receive securities with an underlying fixed return - just like those who buy bonds.


Of course, there are some important differences between the bond and stock forms. For openers, bonds eventually come due. It may require a long wait, but eventually the bond investor gets to renegotiate the terms of his contract. If current and prospective rates of inflation make his old coupon look inadequate, he can refuse to play further unless coupons currently being offered rekindle his interest. Something of this sort has been going on in recent years.


Stocks, on the other hand, are perpetual. They have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn. If corporate America is destined to earn 12 percent, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate. In the aggregate, their commitment is actually increasing. Individual companies can be sold or liquidated and corporations can repurchase their own shares; on balance, however, new equity flotations and retained earnings guarantee that the equity capital locked up in the corporate system will increase.


So, score one for the bond form. Bond coupons eventually will be renegotiated; equity "coupons" won't. It is true, of course, that for a long time a 12 percent coupon did not appear in need of a whole lot of correction.


The bondholder gets it in cash


There is another major difference between the garden variety of bond and our new exotic 12 percent "equity bond" that comes to the Wall Street costume ball dressed in a stock certificate.


In the usual case, a bond investor receives his entire coupon in cash and is left to reinvest it as best he can. Our stock investor's equity coupon, in contrast, is partially retained by the company and is reinvested at whatever rates the company happens to be earning. In other words, going back to our corporate universe, part of the 12 percent earned annually is paid out in dividends and the balance is put right back into the universe to earn 12 percent also.


The good old days


This characteristic of stocks - the reinvestment of part of the coupon - can be good or bad news, depending on the relative attractiveness of that 12 percent. The news was very good indeed in, the 1950's and early 1960's. With bonds yielding only 3 or 4 percent, the right to reinvest automatically a portion of the equity coupon at 12 percent via s of enormous value. Note that investors could not just invest their own money and get that 12 percent return. Stock prices in this period ranged far above book value, and investors were prevented by the premium prices they had to pay from directly extracting out of the underlying corporate universe whatever rate that universe was earning. You can't pay far above par for a 12 percent bond and earn 12 percent for yourself.


But on their retained earnings, investors could earn 22 percent. In effert, earnings retention allowed investots to buy at book value part of an enterprise that, :in the economic environment than existing, was worth a great deal more than book value.


It was a situation that left very little to be said for cash dividends and a lot to be said for earnings retention. Indeed, the more money that investors thought likely to be reinvested at the 12 percent rate, the more valuable they considered their reinvestment privilege, and the more they were willing to pay for it. In the early 1960's, investors eagerly paid top-scale prices for electric utilities situated in growth areas, knowing that these companies had the ability to reinvest very large proportions of their earnings. Utilities whose operating environment dictated a larger cash payout rated lower prices.


If, during this period, a high-grade, noncallable, long-term bond with a 12 percent coupon had existed, it would have sold far above par. And if it were a bond with a f urther unusual characteristic - which was that most of the coupon payments could be automatically reinvested at par in similar bonds - the issue would have commanded an even greater premium. In essence, growth stocks retaining most of their earnings represented just such a security. When their reinvestment rate on the added equity capital was 12 percent while interest rates generally were around 4 percent, investors became very happy - and, of course, they paid happy prices.


Heading for the exits


Looking back, stock investors can think of themselves in the 1946-56 period as having been ladled a truly bountiful triple dip. First, they were the beneficiaries of an underlying corporate return on equity that was far above prevailing interest rates. Second, a significant portion of that return was reinvested for them at rates that were otherwise unattainable. And third, they were afforded an escalating appraisal of underlying equity capital as the first two benefits became widely recognized. This third dip meant that, on top of the basic 12 percent or so earned by corporations on their equity capital, investors were receiving a bonus as the Dow Jones industrials increased in price from 138 percent book value in 1946 to 220 percent in 1966, Such a marking-up process temporarily allowed investors to achieve a return that exceeded the inherent earning power of the enterprises in which they had invested.


This heaven-on-earth situation finally was "discovered" in the mid-1960's by many major investing institutions. But just as these financial elephants began trampling on one another in their rush to equities, we entered an era of accelerating inflation and higher interest rates. Quite logically, the marking-up process began to reverse itself. Rising interest rates ruthlessly reduced the value of all existing fixed-coupon investments. And as long-term corporate bond rates began moving up (eventually reaching the 10 percent area), both the equity return of 12 percept and the reinvestment "privilege" began to look different.


Stocks are quite properly thought of as riskier than bonds. While that equity coupon is more or less fixed over periods of time, it does fluctuate somewhat from year to year. Investors' attitudes about the future can be affected substantially, although frequently erroneously, by those yearly changes. Stocks are also riskier because they come equipped with infinite maturities. (Even your friendly broker wouldn't have the nerve to peddle a 100-year bond, if he had any available, as "safe.") Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return - and 12 percent on equity versus, say, 10 percent on bonds issued py the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.


But, of course, as a group they can't get out. All they can achieve is a lot of movement, substantial frictional costs, and a new, much lower level of valuation, reflecting the lessened attractiveness of the 12 percent equity coupon under inflationary conditions. Bond investors have had a succession of shocks over the past decade in the course of discovering that there is no magic attached to any given coupon level - at 6 percent, or 8 percept, or 10 percent, bonds can still collapse in price. Stock investors, who are in general not aware that they too have a "coupon", are still receiving their education on this point.


Five ways to improve earnings


Must we really view that 12 percent equity coupon as immutable? Is there any law that says the corporate return on equity capital cannot adjust itself upward in response to a permanently higher average rate of inflation?


There is no such law, of course. On the other hand, corporate America cannot increase earnings by desire or decree. To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes, (5) wider operating margins on sales.


And that's it. There simply are no other ways to increase returns on common equity. Let's see what can be done with these.


We'll begin with turnover. The three major categories of assets we have to think about for this exercise are accounts receivable, inventories, and fixed assets such as plants and machinery.


Accounts receivable go up proportionally as sales go up, whether the increase in dollar sales is produced by more physical volume or by inflation. No room for improvement here.


With inventories, the situation is not quite as simple. Over the long term, the trend in unit inventories may be expected to follow the trend in unit sales. Over the short term, however, the physical turnover rate may bob around because of spacial influences - e.g., cost expectations, or bottlenecks.


The use of last-in, first-out (LIFO) inventory-valuation methods serves to increase the reported turnover rate during inflationary times. When dollar sales are rising because of inflation, inventory valuations of a LIFO company either will remain level, (if unit sales are not rising) or will trail the rise 1n dollar sales (if unit sales are rising). In either case, dollar turnover will increase.


During the early 1970's, there was a pronounced swing by corporations toward LIFO accounting (which has the effect of lowering a company's reported earnings and tax bills). The trend now seems to have slowed. Still, the existence of a lot of LIFO companies, plus the likelihood that some others will join the crowd, ensures some further increase it the reported turnover of inventory.


The gains are apt to be modest


In the case of fixed assets, any rise in the inflation rate, assuming it affects all products equally, will initially have the effect of increasing turnover. That is true because sales will immediately reflect the new price level, while the fixed-asset account will reflect the change only gradually, i.e., as existing assets are retired and replaced at the new prices. Obviously, the more slowly a company goes about this replacement process, the more the turnover ratio will rise. The action stops, however, when a replacement cycle is completed. Assuming a constant rate of inflation, sales and fixed assets will then begin to rise in concert at the rate of inflation.


To sum up, inflation will produce some gains in turnover ratios. Some improvement would be certain because of LIFO, and some would be possible (if inflation accelerates) because of sales rising more rapidly than fixed assets. But the gains are apt to be modest and not of a magnitude to produce substantial improvement in returns on equity capital. During the decade ending in 1975, despite generally accelerating inflation and the extensive use of LIFO accounting, the turnover ratio of the FORTUNE 500 went only from 1.18/1 to 1.29/1.


Cheaper leverage? Not likely. High rates of inflation generally cause borrowing to become dearer, not cheaper. Galloping rates of inflation create galloping capital needs; and lenders, as they become increasingly distrustful of long-term contracts, become more demanding. But even if there is no further rise in interest rates, leverage will be getting more expensive because the average cost of the debt now on corporate books is less than would be the cost of replacing it. And replacement will be required as the existing debt matures. Overall, then, future changes in the cost of leverage seem likely to have a mildly depressing effect on the return on equity.


More leverage? American business already has fired many, if not most, of the more-leverage bullets once available to it. Proof of that proposition can be seen in some other FORTUNE 500 statistics - in the twenty years ending in 1975, stockholders' equity as a percentage of total assets declined for the 500 from 63 percent to just under 50 percent. In other words, each dollar of equity capital now is leveraged much more heavily than it used to be.


What the lenders learned


An irony of inflation-induced financial requirements is that the highly profitable companies - generally the best credits - require relatively little debt capital. But the laggards in profitability never can get enough. Lenders understand this problem much better than they did a decade ago - and are correspondingly less willing to let capital-hungry, low-profitability enterprises leverage themselves to the sky.


Nevertheless, given inflationary conditions, many corporations seem sure in the future to turn to still more leverage as a means of shoring up equity returns. Their managements will make that move because they will need enormous amounts of capital - often merely to do the same physical volume of business - and will wish to got it without cutting dividends or making equity offerings that, because of inflation, are not apt to shape up as attractive. Their natural response will be to heap on debt, almost regardless of cost. They will tend to behave like those utility companies that argued over an eighth of a point in the 1960's and were grateful to find 12 percent debt financing in 1974.


Added debt at present interest rates, however, will do less for equity returns than did added debt at 4 percent rates it the early 1960's. There is also the problem that higher debt ratios cause credit ratings to be lowered, creating a further rise in interest costs.


So that is another way, to be added to those already discussed, in which the cost of leverage will be rising. In total, the higher costs of leverage are likely to offset the benefits of greater leverage.


Besides, there is already far more debt in corporate America than is conveyed by conventional balance sheets. Many companies have massive pension obligations geared to whatever pay levels will be in effect when present workers retire. At the low inflation rates of 1965-65, the liabilities arising from such plans were reasonably predictable. Today, nobody can really know the company's ultimate obligation, But if the inflation rate averages 7 percent in the future, a twentyfive-year-old employee who is now earning $12,000, and whose raises do no more than match increases in living costs, will be making $180,000 when he retires at sixty-five.


Of course, there is a marvelously precise figure in many annual reports each year, purporting to be the unfunded pension liability. If that figure were really believable, a corporation could simply ante up that sum, add to it the existing pension-fund assets, turn the total amount over to an insurance company, and have it assume all the corporation's present pension liabilities. In the real world, alas, it is impossible to find an insurance company willing even to listen to such a deal.


Virtually every corporate treasurer in America would recoil at the idea of issuing a "cost-of-living" bond - a noncallable obligation with coupons tied to a price index. But through the private pension system, corporate America has in fact taken on a fantastic amount of debt that is the equivalent of such a bond.


More leverage, whether through conventional debt or unbooked and indexed "pension debt", should be viewed with skepticism by shareholders. A 12 percent return from an enterprise that is debt-free is far superior to the same return achieved by a business hocked to its eyeballs. Which means that today's 12 percent equity returns may well be less valuable than the 12 percent returns of twenty years ago.


More fun in New York


Lower corporate income taxes seem unlikely. Investors in American corporations already own what might be thought of as a Class D stock. The class A, B and C stocks are represented by the income-tax claims of the federal, state, and municipal governments. It is true that these "investors" have no claim on the corporation's assets; however, they get a major share of the earnings, including earnings generated by the equity buildup resulting from retention of part of the earnings owned by the Class D sharaholders.


A further charming characteristic of these wonderful Class A, B and C stocks is that their share of the corporation's earnings can be increased immedtately, abundantly, and without payment by the unilateral vote of any one of the "stockholder" classes, e.g., by congressional action in the case of the Class A. To add to the fun, one of the classes will sometimes vote to increase its ownership share in the business retroactively - as companies operating in New York discovered to their dismay in 1975. Whenever the Class A, B or C "stockholders" vote themselves a larger share of the business, the portion remaining for Class D - that's the one held by the ordinary investor - declines.


Looking ahead, it seems unwise to assume that those who control the A, B and C shares will vote to reduce their own take over the long run. The class D shares probably will have to struggle to hold their own.


Bad news from the FTC


The last of our five possible sources of increased returns on equity is wider operating margins on sales. Here is where some optimists would hope to achieve major gains. There is no proof that they are wrong. Bu there are only 100 cents in the sales dollar and a lot of demands on that dollar before we get down to the residual, pretax profits. The major claimants are labor, raw materials energy, and various non-income taxes. The relative importance of these costs hardly, seems likely to decline during an age of inflation.


Recent statistical evidence, furthermore, does not inspire confidence in the proposition that margins will widen in, a period of inflation. In the decade ending in 1965, a period of relatively low inflation, the universe of manufacturing companies reported on quarterly by the Federal Trade Commission had an average annual pretax margin on sales of 8.6 percent. In the decade ending in 1975, the average margin was 8 percent. Margins were down, in other words, despite a very considerable increase in the inflation rate.


If business was able to base its prices on replacement costs, margins would widen in inflationary periods. But the simple fact is that most large businesses, despite a widespread belief in their market power, just don't manage to pull it off. Replacement cost accounting almost always shows that corporate earnings have declined significantly in the past decade. If such major industries as oil, steel, and aluminum really have the oligopolistic muscle imputed to them, one can only conclude that their pricing policies have been remarkably restrained.


There you have, the complete lineup: five factors that can improve returns on common equity, none of which, by my analysis, are likely to take us very far in that direction in periods of high inflation. You may have emerged from this exercise more optimistic than I am. But remember, returns in the 12 percent area have been with us a long time.


The investor's equation


Even if you agree that the 12 percent equity coupon is more or less immutable, you still may hope to do well with it in the years ahead. It's conceivable that you will. After all, a lot of investors did well with it for a long time. But your future results will be governed by three variable's: the relationship between book value and market value, the tax rate, and the inflation rate.


Let's wade through a little arithmetic about book and market value. When stocks consistently sell at book value, it's all very simple. If a stock has a book value of $100 and also an average market value of $100, 12 percent earnings by business will produce a 12 percent return for the investor (less those frictional costs, which we'll ignore for the moment). If the payout ratio is 50 percent, our investor will get $6 via dividends and a further $6 from the increase in the book value of the business, which will, of course, be reflected in the market value of his holdings.


If the stock sold at 150 percent of book value, the picture would change. The investor would receive the same $6 cash dividend, but it would now represent only a 4 percent return on his $150 cost. The book value of the business would still increase by 6 percent (to $106) and the market value of the investor's holdings, valued consistently at 150 percent of book value, would similarly increase by 6 percent (to $159). But the investor's total return, i.e., from appreciation plus dividends, would be only 10 percent versus the underlying 12 percent earned by the business.


When the investor buys in below book value, the process is reversed. For example, if the stock sells at 80 percent of book value, the same earnings and payout assumptions would yield 7.5 percent from dividends ($6 on an $80 price) and 6 percent from appreciation - a total return of 13.5 percent. In other words, you do better by buying at a discount rather than a premium, just as common sense would suggest.


During the postwar years, the market value of the Dow Jones industrials has been as low as 84 percent of book value (in 1974) and as high as 232 percent (in 1965); most of the time the ratio has been well over 100 percent. (Early this spring, it was around 110 percent.) Let's assume that in the future the ratio will be something close to 100 percent - meaning that investors in stocks could earn the full 12 percent. At least, they could earn that figure before taxes and before inflation.


7 percent after taxes


How large a bite might taxes take out of the 12 percent? For individual investors, it seems reasonable to assume that federal, state, and local income taxes will average perhaps 50 percent on dividends and 30 percent on capital gains. A majority of investors may have marginal rates somewhat below these, but many with larger holdings will experience substantially higher rates. Under the new tax law, as FORTUNE observed last month, a high-income investor in a heavily taxed city could have a marginal rate on capital gains as high as 56 percent. (See
"The Tax Practitioners Act of 1976.")


So let's use 50 percent and 30 percent as representative for individual investors. Let's also assume, in line with recent experience, that corporations earning 12 percent on equity pay out 5 percent in cash dividends (2.5 percent after tax) and retain 7 percent, with those retained earnings producing a corresponding market-value growth (4.9 percent after the 30 percent tax). The after-tax return, then, would be 7.4 percent. Probably this should be rounded down to about 7 percent to allow for frictional costs. To push our stocks-asdisguised-bonds thesis one notch further, then, stocks might be regarded as the equivalent, for individuals, of 7 percent tax-exempt perpetual bonds.


The number nobody knows

Which brings us to the crucial question - the inflation rate. No one knows the answer on this one - including the politicians, economists, and Establishment pundits, who felt, a few years back, that with slight nudges here and there unemployment and inflation rates would respond like trained seals.


But many signs seem negative for stable prices: the fact that inflation is now worldwide; the propensity of major groups in our society to utilize their electoral muscle to shift, rather than solve, economic problems ; the demonstrated unwillingness to tackle even the most vital problems (e.g., energy and nuclear proliferation) if they can be postponed; and a political system that rewards legislators with reelection if their actions appear to produce short-term benefits even though their ultimate imprint will be to compound long-term pain.


Most of those in political office, quite understandably, are firmly against inflation and firmly in favor of policies producing it. (This schizophrenia hasn't caused them to lose touch with reality, however; Congressmen have made sure that their pensions - unlike practically all granted in the private sector - are indexed to cost-of-living changes after retirement.)


Discussions regarding future inflation rates usually probe the subtleties of monetary and fiscal policies. These are important variables in determining the outcome of any specific inflationary equation. But, at the source, peacetime inflation is a political problem, not an economic problem. Human behavior, not monetary behavior, is the key. And when very human politicians choose between the next election and the next generation, it's clear what usually happens.


Such broad generalizations do not produce precise numbers. However, it seems quite possible to me that inflation rates will average 7 percent in future years. I hope this forecast proves to be wrong. And it may well be. Forecasts usually tell us more of the forecaster than of the future. You are free to factor your own inflation rate into the investor's equation. But if you foresee a rate averaging 2 percent or 3 percent, you are wearing different glasses than I am.


So there we are: 12 percent before taxes and inflation; 7 percent after taxes and before inflation; and maybe zero percent after taxes and inflation. It hardly sounds like a formula that will keep all those cattle stampeding on TV.


As a common stockholder you will have more dollars, but you may have no more purchasing power. Out with Ben Franklin ("a penny saved is a penny earned") and in with Milton Friedman ("a man might as well consume his capital as invest it").


What widows don't notice


The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation. Either way, she is "taxed" in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax, but doesn't seem to notice that 6 percent inflation is the economic equivalent.


If my inflation assumption is close to correct, disappointing results will occur not because the market falls, but in spite of the fact that the market rises. At around 920 early last month, the Dow was up fifty-five points from where it was ten years ago. But adjusted for inflation, the Dow is down almost 345 points - from 865 to 520. And about half of the earnings of the Dow had to be withheld from their owners and reinvested in order to achieve even that result.


In the next ten years, the Dow would be doubled just by a combination of the 12 percent equity coupon, a 40 percent payout ratio, and the present 110 percent ratio of market to book value. And with 7 percent inflation, investors who sold at 1800 would still be considerably worse off than they are today after paying their capital-gains taxes.


I can almost hear the reaction of some investors to these downbeat thoughts. It will be to assume that, whatever the difficulties presented by the new investment era, they will somehow contrive to turn in superior results for themselves. Their success is most unlikely. And, in aggregate, of course, impossible. If you feel you can dance in and out of securities in a way that defeats the inflation tax, I Would like to be your broker - but not your partner.


Even the so-called tax-exempt investors, such as pension funds and college endowment funds, do not escape the inflation tax. If my assumption of a 7 percent inflation rate is correct, a college treasurer should regard the first 7 percent earned each year merely as a replenishment of purchasing power. Endowment funds are earning nothing until they have outpaced the inflation treadmill. At 7 percent inflation and, say, overall investment returns of 8 percent, these institutions, which believe they are tax-exempt, are in fact paying "income taxes" of 87½ percent.


The social equation


Unfortunately, the major problems from high inflation rates flow not to investors but to society as a whole. Investment income is a small portion of national income, and if per capita real income could grow at a healthy rate alongside zero real investment returns, social justice might well be advanced.


A market economy creates some lopsided payoffs to participants. The right endowment of vocal chords, anatomical structure, physical strength, or mental powers can produce enormous piles of claim checks (stocks, bonds, and other forms of capital) on future national output. Proper selection of ancestors similarly can result in lifetime supplies of such tickets upon birth. If zero real investment returns diverted a bit greater portion of the national output from such stockholders to equally worthy and hardworking citizens lacking jackpot-producing talents, it would seem unlikely to pose such an insult to an equitable world as to risk Divine Intervention.


But the potential for real improvement in the welfare of workers at the expense of affluent stockholders is not significant. Employee compensation already totals twenty-eight times the amount paid out in dividends, and a lot of those dividends now go to pension funds, nonprofit institutions such as universities, and individual stockholders who are not affluent. Under these circumstances, if we now shifted all dividends of wealthy stockholders into wages - something we could do only once, like killing a cow (or, if you prefer, a pig) - we would increase real wages by less than we used to obtain from one year's growth of the economy.


The Russians understand it too


Therefore, diminishment of the affluent, through the impact of inflation on their investments, will not even provide material short-term aid to those who are not affluent. Their economic well-being will rise or fall with the general effects of inflation on the economy. And those effects are not likely to be good.


Large gains in real capital, invested in modern production facilities, are required to produce large gains in economic well-being. Great labor availability, great consumer wants, and great government promises will lead to nothing but great frustration without continuous creation and employment of expensive new capital assets throughout industry. That's an equation understood by Russians as well as Rockefellers. And it's one that has been applied with stunning success in West Germany and Japan. High capital-accumulation rates have enabled those countries to achieve gains in living standards at rates far exceeding ours, even though we have enjoyed much the superior position in energy.


To understand the impact of inflation upon real capital accumulation, a little math is required. Come back for a moment to that 12 percent return on equity capital. Such earnings are stated after depreciation, which presumably will allow replacement of present productive capacity - if that plant and equipment can be purchased in the future at prices similar to their original cost.


The way it was


Let's assume that about half of earnings are paid out in dividends, leaving 6 percent of equity capital available to finance future growth. If inflation is low - say, 2 percent - a large portion of that growth can be real growth in physical output. For under these conditions, 2 percent more will have to be invested in receivables, inventories, and fixed assets next year just to duplicate this year's physical output - leaving 4 percent for investment in assets to produce more physical goods. The 2 percent finances illusory dollar growth reflecting inflation and the remaining 4 percent finances real growth. If population growth is 1 percent, the 4 percent gain in real output translates into a 3 percent gain in real per capita net income. That, very roughly, is what used to happen in our economy.


Now move the inflation rate to 7 percent and compute what is left for real growth after the financing of the mandatory inflation component. The answer is nothing - if dividend policies and leverage ratios Terrain unchanged. After half of the 12 percent earnings are paid out, the same 6 percent is left, but it is all conscripted to provide the added dollars needed to transact last year's physical volume of business.


Many companies, faced with no real retained earnings with which to finance physical expansion after normal dividend payments, will improvise. How, they will ask themselves, can we stole or reduce dividends without risking stockholder wrath? I have good news for them: ready-made set of blueprints is available.


In recent years the electric-utility industry has had little or no dividend-paying capacity. Or, rather, it has had the power to pay dividends if investors agree to buy stock from them. In 1975 electric utilities paid common dividends of $3.3 billion and asked investors to return $3.4 billion. Of course, they mixed in a little solicit-Peter-to-pay-Paul technique so as not to acquire a (Con Ed reputation. Con Ed, you will remember, was unwise enough in 1974 to simply tell its shareholders it didn't have the money to pay the dividend, Candor was rewarded with calamity in the marketplace.


The more sophisticated utility maintains - perhaps increases - the quarterly dividend and then asks shareholders (either old or new) to mail back the money. In other words, the company issues new stock. This procedure diverts massive amounts of capital to the tax collector and substantial sums to underwriters. Everyone, however, seems to remain in spirits (particularly the underwriters).


More joy at AT&T


Encouraged by such success, some utilities have devised a further shortcut. In this case, the company declares the dividend, the shareholder pays the tax, and - presto - more shares are issued. No cash changes hands, although the spoilsport as always, persists in treating the transaction as if it had.


AT&T, for example, instituted a dividend-reinvestment program in 1973. This company, in fairness, must be described as very stockholder-minded, and its adoption of this program, considering the folkways of finance, must he regarded as totally understandable. But the substance of the program is out of Alice in Wonderland.


In 1976, AT&T paid $2.3 billion in cash dividends to about 2.9 million owners of its common stock. At the end of the year, 648,000 holders (up from 601,000 the previous year) reinvested $432 million (up from $327 million) in additional shaves supplied directly by the company.


Just for fun, let's assume that all AT&T shareholders ultimately sign up for this program. In that case, no cash at all would be mailed to shareholders - just as when Con Ed passed a dividend. However, each of the 2.9 million owners would be notified that he should pay income taxes on his share of the retained earnings that had that year been called a "dividend". Assuming that "dividends" totaled $2.3 billion, as in 1976, and that shareholders paid an average tax of 30 percent on these, they would end up, courtesy of this marvelous plan, paying nearly $730 million to the IRS. Imagine the joy of shareholders, in such circumstances, if the directors were then to double the dividend.


The government will try to do it


We can expect to see more use of disguised payout reductions as business struggles with the problem of real capital accumulation. But throttling back shareholders somewhat will not entirely solve the problem. A combination of 7 percent inflation and 12 percent returns with reduce the stream of corporate capital available to finance real growth.


And so, as conventional private capital-accumulation methods falter under inflation, our government will increasingly attempt to influence capital flows to industry, either unsuccessfully as in England or successfully as in Japan. The necessary cultural and historical underpinning for a Japanese-style enthusiastic partnership of government, business, and labor seems lacking here. if we are lucky, we will avoid following the English path, where all segments fight over division of the pie rather than pool their energies to enlarge it.


On balance, however, it seems likely that we will hear a great deal more. as the years unfold about underinvestinent, stagflation, and the failures of the private sector to fulfill needs.



About Warren Buffett


The author is, in fact, one of the most visible stock-market investors in the U.S. these days. He's had plenty to invest for his own account ever since he made $25 million running an investment partnership during the 1960's. Buffett Partnership Ltd., based in Omaha, was an immensely successful operation, but he nevertheless closed up shop at the end of the decade. A January, 1970, FORTUNE article explained his decision: "he suspects that some of the juice has gone out of the stock market and that sizable gains in the future are going to be very hard to come by."

Buffett, who is now forty-six and still operating out of Omaha, has a diverse portfolio. He and businesses he controls have interests in over thirty public corporations. His major holdings: Berkshire Hathaway (he owns about $35 million worth) and Blue Chip Stamps (about $10 million). His visibility, recently increased by a Wall Street Journal profile, reflects his active managerial role in both companies, both of which invest in a wide range of enterprises; one is the Washington Post.

And why does a man who is gloomy about stocks own so much stock? "Partly, it's habit," he admits. "Partly, it's just that stocks mean business, and owning businesses is much more interesting than owning gold or farmland. Besides, stocks are probably still the best of all the poor alternatives in an era of inflation - at least they are if you buy in at appropriate prices."

http://www.rbcpa.com/WEB_Fortune_May_1977_How_inflation_swindles_the_equity_investor.html

Saturday 23 October 2010

What does this comparison mean when it comes to non-dividend stocks?

"I believe non-dividend stocks aren’t much more than baseball cards. They are worth what you can convince someone to pay for them."
–Mark Cuban, Billionaire businessman

Based on what you learned about dividends, why are non-dividend stocks compared to baseball cards?
i don’t know how to answer that.. please help!


wertyu_24 5:02 pm on October 22, 2010 Permalink

With non-dividend stocks, you never get a share in the company’s profits. The only benefit you might see from a non-dividend stock is a voting right, but besides that, the value of the stock will only grow with the value of the company.

For dividend paying companies, stocks are usually valued using the dividend payout, so no dividend equals no value. It will only have intrinsic value, like baseball cards.


Read more: What does this comparison mean when it comes to non-dividend stocks?

http://investing.hirby.com/what-does-this-comparison-mean-when-it-comes-to-non-dividend-stocks/

The Great Investing Wisdom Wall Street Forgot

By Matt Koppenheffer
October 22, 2010

When you hear the phrase "value investing," Warren Buffett most likely comes to mind. But hopefully, you also think of Ben Graham -- the father of value investing. Considering that some of the world's most successful investors carry Graham's flag, there's good reason for Fools like us to be obsessed with the concept.

Graham had a plan
But with thousands of stocks out there, how do we separate the value plays from the throwaways? In The Intelligent Investor, Graham lays out a basic framework for winnowing through the sea of stocks to get to the good stuff.

1. Financial stability. Graham wanted investors to be sure they weren't investing in castles made of sand, so he put requirements on prospective investments' balance sheet strength and record of past earnings.

2. Growth. You wouldn't have caught Graham dead chasing the high-flying stocks of the day, but he did want to see that over the long haul, earnings were at least moving in the right direction.

3. Valuation. This, of course, is what Graham is probably best known for -- requiring that a stock be selling for less than it's really worth. While a simple valuation ratio can't tell you the whole story, it may signal a stock that's definitely not a deal.

4. A dividend.

Did you catch that last part?
That wasn't a typo; whether you are a defensive or enterprising investor, Graham thought it necessary that you stick to companies that pay a dividend.

Dividends have largely been relegated to a dark corner on Wall Street, but Graham didn't equivocate. The safest stocks would have "uninterrupted payments for at least the past 20 years," but every investment should have "some current dividend."

When you think about it, this makes perfect sense. Graham's whole approach to investing in stocks revolves around thinking and acting like a businessperson, and treating your stock holdings as ownership shares in a business, not gambling slips. When businesspeople buy a piece of a business, they expect to know how much profit will be sent back their way.


http://www.fool.com/investing/general/2010/10/22/the-great-investing-wisdom-wall-street-forgot.aspx

How the GFC pushed businesses to the wall

Chalpat Sonti
October 22, 2010

Just how badly, or well, businesses survived the global financial crisis and other economic turmoil of the past two years is evident from new official figures.

Australian Bureau of Statistics data shows in the two years from June 2007 - encompassing the boom and subsequent bust - more than half a million Australian businesses shut up shop.

Nationwide,there was a 73.6 per cent survival rate in the two years, with the number of businesses falling from 2.07 million to 1.52 million.

In Western Australia, about 57,000 businesses, including 10,100 new businesses, were forced to the wall.

That is an attrition rate of 28.3 per cent of all new businesses in the period, but the figures also tell a tale of two distinct years.

In June 2007, there were 211,000 businesses with an ABN and registered for GST in the state. One year later, just before the economy headed south, that had dropped to about 178,000.

A further year on, the number was about 154,000, an overall survival rate of 73.1 per cent.

The public administration and safety sector was the worst performer, with a survival rate of 65.3 per cent. The mining industry saw a 76.5 per cent survival rate, while health care and social assistance did best, at 81.2 per cent.

The number of small businesses (up to 20 employees) fell 24,931 nationally in the period, with more than 80 per cent of the fall occurring during the worst of the financial crisis, in 2008-09.

Most of the fall was in businesses employing between one and four people.

But federal shadow parliamentary secretary for small business Scott Ryan said the national drop in small business numbers was worrying on other future fronts.

"Small business is the economy's canary, a key leading indicator," Mr Ryan said.

"The (federal) Labor government's stubborn intention to saddle small business with extra costs such as the superannuation levy increase and the paperwork burden of being a 'pay clerk' for (a) flawed parental scheme will only ensure this worrying trend worsens in coming years."

Meanwhile shadow small business minister Bruce Billson has confirmed his intention to introduce a private members bill which would see Centrelink take over the running of the government's proposed parental leave scheme.

As it stands, Centrelink will fulfil that role for the first six months of the scheme, before the responsibility for much of the scheme falls to employers.

They will be required to distribute the payments under the scheme to staff, after being forwarded the money by Centrelink.

"Despite strong objection from every corner of this continent, from Gladstone to Esperance and from every organisation that has any concern whatsoever about the compliance and red tape obligations on businesses large and small, the government seems to steadfastly want to persist in imposing this pay clerk obligation... on employers, despite the fact that it has offered no compelling reason for doing so," Mr Billson told Parliament on Wednesday night.

He will need the support of independents or the Greens to make the changes to the scheme, due to start at the beginning of next year.

It will see eligible parents receive the minimum wage ($569.90 a week) for 18 weeks.


http://www.smh.com.au/small-business/how-the-gfc-pushed-businesses-to-the-wall-20101022-16wrx.html

Investors get back into top gear

Investors get back into top gear

Annette Sampson
October 23, 2010

IF one good thing has come out of the global financial crisis it's that investors are thinking twice before risking their shirts through rampant speculation. At least for the moment. But if you have the appetite and nerves to handle a bit of risk, gearing is re-emerging as an option.

While many investors were turned off the idea of borrowing to invest when prices were tumbling, a recovering sharemarket - and the realisation that keeping your money in cash might keep it safe but it won't build wealth - is slowly re-igniting interest in gearing. But the new style of gearing is much different to what we saw during the boom.

The saga of Storm Financial has highlighted the hazards of aggressive one-size-fits-all gearing strategies - and the shonks that promote them. But smart investors are using gearing strategically, as a complement to their other investment strategies. Instead of diving in boots and all they are weighing the risks and using gearing where it has the best potential to enhance returns.

ING's technical services manager, Graeme Colley, has been talking to advisers and says there is much more focus on the potential downside. As well as understanding what a fall in investment values would mean to a gearing strategy, he says more attention is being paid to issues such as double gearing, where you borrow to invest in a geared investment.

Double gearing can be overt - such as the aggressive strategies where borrowers were encouraged to draw on their home equity to use as collateral for something like a margin loan. But it can also be less obvious, such as when you borrow to invest in companies that may also be heavily geared. The classic example occurred with listed property trusts. These trusts were popular with investors as they generated a healthy income, which could be used to help fund interest payments. But many of them were heavily geared and among the biggest losers when the market fell.

Colley says it is important for investors to know the gearing levels of their underlying investments and to consider the total gearing level - not just their own borrowings. This may mean avoiding stocks with higher gearing, or reducing your own borrowing to avoid a risk blowout.

Colley says how you borrow is also critical. The cheapest way is often to draw on home equity. It also has the advantage of not being subject to margin calls if your investments drop in value. But it is important to consider the borrowings in terms of your overall financial strategy.

One strategy that can be used, Colley says, is debt recycling where you gradually replace non-deductible mortgage debt with tax-deductible investment debt. Let's say you owe $300,000 on your mortgage and are comfortable with that. You can continue making repayments, but progressively draw on your home equity up to that $300,000 limit to invest (so long as it is properly documented for tax purposes). You should have extra income to accelerate your loan repayments thanks to the income from your investment and the tax deduction on the investment component of your borrowings.

Colley says this is also a prudent approach as you are drip feeding your borrowings into the investment market, rather than doing it all at once, and you can pay off the loan as a lump sum when you sell your investments.

With lower tax rates and more interest in positive rather than negative gearing (with positive gearing, the income from your investment exceeds the borrowing costs so you are making a profit from day one) careful tax planning is also a priority. As a rule of thumb, Colley says if your investment is going to be negatively geared (that is, generating a loss) it is better for the borrowings and investment to be held by someone on a higher marginal tax rate as they will get a bigger tax deduction. But if the investment is positively geared (or likely to become profitable in the shorter term), it may be better done by a lower earner.

However, Colley warns that if you get too smart and put the borrowings in the higher earner's name and the investment in those of the lower earner, you will get the worst of both worlds as the borrowings will not be deductible but the income and capital gain will be taxed.

For those considering a margin loan, positive gearing can also reduce the risks of a margin call. As the graph shows, if you borrow the maximum allowed with a margin loan, a fall of less than 10 per cent in investment values can result in a call from your lender asking you to stump up extra cash or collateral to reduce your loan ratio. Ten per cent movements are not unusual in the current market.

But if you borrow less, not only is the income more likely to cover your borrowing costs, but you can set yourself up so there is no whisper of a margin call unless the market crashes by 30 per cent or more.

It's all about borrowing smarter, if you're sure you should be borrowing at all.


http://www.brisbanetimes.com.au/business/investors-get-back-into-top-gear-20101022-16xtk.html

How to invest like Warren Buffett

The author's book on Warren Buffett, "The Midas Touch", summarises the favourite investing principles of the "Sage of Omaha".
Warren Buffett - How to invest like Warren Buffett
Fanatical: offered a glass of good wine at a dinner, Warren Buffett said: 'Just hand me the money' Photo: AFP/GETTY
My book on Warren Buffett, "The Midas Touch", has just been published in Britain. It contains most of his favourite investing principles. Although time has passed since its original appearance, his ideas today are much the same.
Here is a handful of the central ones. They aren't easy: this is a competitive game.
1. The key to investing is found in this rule: buy a share as though you were buying the whole company.
To do that, you have to know what the enterprise is worth. Therefore, the investor should live in the world of companies, never of mathematical formulae.
In the latest annual meeting of Berkshire Hathaway, Buffett's company, his partner Charles Munger put it this way: "The worst decisions are often made with the most formal projections. They look so professional that you begin to believe the numbers are reality.
"You are taken in by the false precision. Business schools teach this stuff because they have to teach something."
2. A recent heresy is that market volatility equals risk. Quite the contrary!
For a serious investor, volatility creates opportunity. To use my own language, investment opportunity consists of the difference between reality and perception. High volatility increases that difference, and thus increases opportunity for the knowledgeable investor.
Mr Buffett says sardonically that he favours the dotty "efficient market theory" because it creates more opportunities for him.
3. As to growth versus value, Mr Buffett observes that "value" should include projected growth, notably "growth at a reasonable price" or Garp.
He looks for companies with a business "moat" around them that should have steady, reasonably predictable growth.
Perhaps a better phraseology for the growth versus value dichotomy might be "high growth" versus "bargain hunting". The analytical techniques, and investor temperaments, in the two approaches are quite different. One calls for a futurologist, the other for an accountant.
That said, for a taxpaying investor long-term growth is more convenient and more tax-efficient than seeking one bargain after another.
4. High technology, most emerging markets, leveraged buyouts, real estate and other hard to appraise exotica might as well not exist for Mr Buffett.
He follows the safest approach: stick to what you know best. However, many approaches are valid. Your advantage will be the extent to which your knowledge of a valid situation exceeds the market's.
It makes little difference how broad your knowledge is. One correct investment decision is as valuable as another. Mr Buffett says that one should only seek a handful of really big ideas in one's investing career. The key is to be right when you do decide, not to flutter about spreading yourself thin.
5. Investing in bad industries, or turnarounds, usually doesn't work.
A skilled surgeon can excise a tumour but to revive a moribund patient requires a magician. The princess hopes that when she kisses the toad a beautiful prince will spring up. In fact, alas, she will probably end up awash in toads.
6. Businesses that generate cash that they can reinvest at high rates of return over long periods are particularly attractive holdings.
Low-margin businesses that periodically call for more cash from their investors, which they can only invest at a modest rate of return, are a dismal affair. Differently put, if all else is the same, feel free to marry an heiress rather than a pauper.
7. Don't sell a great stock just because it has doubled.
It could be better value afterwards than it was before. The greatest stocks may go up 20 or even 100 times in a generation or two.
Peter Lynch, who built up Fidelity's Magellan fund, points out that the deluded policy of "rebalancing" more or less automatically because a stock has risen is a lot like pulling out the flowers in the garden and watering the weeds. Don't do it!
8. A grave corporate folly is offering your own underpriced stock for the fully valued stock of an acquisition candidate.
In that scenario, instead of paying 50p for £1 of value, you are paying £1 for 50p of value. Lunacy! Still, such situations are often generated by the megalomania of chief executives.
9. Avoid long-term bonds.
"We are bound to have inflation, given current policies. There are a lot of incentives for politicians in all countries to inflate their currencies," Mr Buffett says.
10. To do superlatively well, an investor, like a company manager, must be a fanatic.
By relentless concentration, Mr Buffett has moved billions of dollars from other people's pockets into his own. Alas, he doesn't enjoy what money can buy. He's a miser.
Once, offered a glass of good wine at a dinner, he said: "Just hand me the money." So, it may be helpful in business terms to be that focused, but not necessarily in human terms.
Still, to preserve capital, which is difficult, one should understand the principles, and Mr Buffett's are all good ones.
"The Midas Touch" by John Train is published by Harriman House. Mr Train founded Train Smith Investment Counsel and he has written hundreds of columns for the Wall Street Journal, the New York Times and Forbes magazine. Apart from "The Midas Touch", his best-selling books include "The Craft of Investing", "The Money Masters" and "The New Money Masters".



http://www.telegraph.co.uk/finance/personalfinance/investing/5708407/How-to-invest-like-Warren-Buffett.html

Why I'm with Warren Buffett on bonds versus equities

Follow the herd or follow Warren Buffett? That sounds like it should be a pretty simple choice for most investors given the average investor's consistent ability to buy and sell at the wrong time and the sage of Omaha's ranking as one of the world's richest men.

 
Warren Buffett told a conference he couldn't imagine anyone having bonds in their portfolio when they could have equities Photo: GETTY
Curious then that Mr Buffett is doing a passable imitation of Cassandra – she who was cursed so that she could foretell the future but no one would ever believe her.
Here's Buffett, speaking last week to Fortune magazine's Most Powerful Women Summit: "It's quite clear that stocks are cheaper than bonds. I can't imagine anyone having bonds in their portfolio when they can have equities ... but people do because they lack the confidence."
And here's what everyone else is doing. According to Morgan Stanley, the speed of inflows to bond funds is even greater than retail inflows into equity funds at the height of the technology bubble in 2000 – $410bn (£256bn) in the 12 months to April 2010 in the US versus $340bn into equities in the year to September 2000.
Over here, too, investors can't get enough fixed income. According to the Investment Management Association, net sales of global bonds and corporate bonds both exceeded £600m during August. Only absolute return funds were anywhere close to these inflows. The staple British equity fund sector, UK All Companies, saw £291m of redemptions and even the previously popular Asia ex-Japan sector raised a paltry £22m.
So, is this a bubble waiting to burst or a logical investment choice in a deflationary world where interest rates could stay lower for longer as governments adopt more desperate strategies to prevent another slump?
The case for bond prices staying high has received a boost in recent weeks as speculation has grown that the US government is contemplating a second round of quantitative easing. Printing yet more money to buy bonds creates a buyer of last resort and would underpin the price of Treasuries even at today's elevated levels.
Indeed, the talk on Wall Street has turned to a measure the US government has not employed since the Second World War when a target yield for government securities was set with the implied promise that the authorities would buy up whatever they needed to keep the cost of money low.
Ben Bernanke, the Fed chairman, referred to this policy in his famous "Helicopter Ben" speech of 2002 when he reminded financial markets of the US government's ultimate weapon in the fight against deflation – the printing press. It really is no wonder that the price of gold is on a tear.
For a few reasons, however, I'm not convinced that the theoretical possibility that interest rates could go yet lower Ã  la Japan makes a good argument for buying bonds at today's levels.
First, to return to fund flows, extremes of buying have in the past been a very good contrarian indicator of future performance. Equity flows represented around 4pc of total assets in 2000 just as the bubble was bursting. At the same time, there were very significant outflows from bond funds just ahead of a strong bond market rally.
My second reason for caution is illustrated by the chart, which shows how little reward investors are receiving for lending money to the US government (and the UK, German or Japanese governments for that matter). Accepting this kind of yield makes sense only if you believe the US economy is fatally wounded and that the dragon of inflation has been slain. I don't believe in either thesis.
History shows very clearly that investing in bonds when the starting yield is this low has resulted in well-below-average returns if and when rates start to rise. Between 1941 and 1981, when interest rates last rose for an extended period, the total return from bonds was two and a half times lower when the starting point was a yield of under 3pc than when it started above this level. Investing when yields are low stacks the odds against you.
My final reason for caution is that there is no need to put all your eggs in the bond basket. Around a quarter of FTSE 100 shares are yielding more than 4pc while the income from gilts is less than 3pc. More income and the potential for it to rise over time too. I'm with Warren on this one.
Tom Stevenson is an investment director at Fidelity Investment Managers. The views expressed are his own.

http://www.telegraph.co.uk/finance/comment/tom-stevenson/8052896/Why-Im-with-Warren-Buffett-on-bonds-versus-equities.html

Why government bond markets have become the latest mad and bad asset bubble


The five-year gilt  (Photo: AP)
The five year gilt yield has fallen to a new low (Photo: AP)
The benchmark five year gilt yield fell to a new low of 1.43 per cent on Thursday, which astonishingly takes it to a 25 basis point discount to that of its German bund counterpart. The UK Government likes to think of the record lows to which gilt yields have sunk to be a vote of confidence by international investors in its plans for fiscal consolidation, and no doubt there is a small element of truth in this contention. But the main factors driving government bond yields ever lower, not just here in the UK, but in the US too, are much more worrying and have little to do with the bravery of George Osborne’s deficit reduction programme.
In essence, both the UK and US government bond markets have become giant bubbles which are now largely divorced from underlying realities and almost bound to end badly. Yes, for sure if the UK Government hadn’t done something about the deficit, then we might be looking at far less benign conditions in the gilts market, but just to repeat the point, it’s not really enhanced credit worthiness which is causing these abnormally low yields.
The US is experiencing much the same phenomenon, even though its public finances are in just as big a mess as the UK’s and it has virtually no plan that I can discern for deficit reduction, besides the wing and a prayer hope that growth will eventually come to the rescue.
So what’s really driving this dash for government debt? One possibility is that bond markets are already pricing in a depression, or at least a Japanese style lost decade of deflation. Despite ever more mountainous quantities of public debt, bond yields in Japan have been at abnormally low levels for years. Indeed, in Japan the abnormal is now normal. If you think the price of goods and services will soon be deflating, then even bonds on 1 per cent yields offer a healthy rate of return.
But no, the real reason lies in the market distortions that result from ultra easy monetary policy and the demands being put by regulators on banks to hold “riskless” assets. This is leading to a profound mis-pricing of government bonds, which now take virtually no account of significant medium term inflation risks.
If you think markets are always right, then bond prices are indeed signalling the inevitability of a depression, but if there is one thing we have been forced by the events of the last three years to relearn about markets it is that they are prone to episodes of extreme mispricing. The bond phenomenon is very likely one of them.
There are a number of ways in which bond markets are being distorted. One is regulatory demands on banks to hold bigger “liquidity buffers”. The asset of choice in boosting these buffers is government bonds. These have already been proved by Europe’s sovereign debt crisis to be very far from the “riskless” assets of regulatory supposition. Even so, banks are still being forced to max out on government debt.
A second distortion is caused by the “carry trade” opportunities of exceptionally low short term interest rates. Put crudely, you can borrow from the central bank for next to zero, lend the money out at a higher rate further up the yield curve, and pocket the difference. In a sense, that’s the purpose of ultra-easy monetary policy – to create a generally low interest rate environment – but the dangers of it are obvious. Central banks are creating a bubble in government debt.
5yr-30yrsgiltspread
And so to the biggest reason of the lot. Look at the chart above (created from Bloomberg data), which shows the yield gap between the five and thirty year gilt, and you can see that it has widened substantially over the past year. The reason is that investors are anticipating another bout of quantitative easing from the Bank of England. In the last round of QE, the Bank concentrated purchases initially on UK gilts in the five to 25 year range, but then widened this to include three year gilts and some 25 year plus bonds after running up against supply constraints. Investors are buying up the five year gilt because they know this is where the Bank, if it does more QE, will find most scarcity. Exactly the same thing is happening in the US, where more QE is already pretty much a done deal.
Anyone with half a brain can see that Germany is a rather more credit worthy and naturally inflation proofed country than either the UK or the US, yet the cost of five year money in Germany is now higher. How can this be? The explanation lies in the absence of overt QE in the eurozone. There have been no purchases of German bunds by the European Central Bank.
In fighting the aftermath of the last bubble by flooding the market with ultra-cheap liquidity, the Fed and the Bank of England seem only to be inflating new ones. There are others besides government bonds, commodities and emerging market assets being the most obvious. I’m not saying these policies are as a consequence flawed and wrong. That wider debate involves an altogether more complex and diverse range of issues. But the risks are self evident.

http://blogs.telegraph.co.uk/finance/jeremywarner/100008271/why-government-bond-markets-have-gone-mad-and-bad/