The Great Inflation by Robert J. Samuelson is a must read for any investor or student of economics.  Inflation is a quiet force moving through any economy, until it becomes very loud.  Samuelson clearly articulates how this antagonist grew from infancy to a super loud teenager from 1973 to 1980. His research is quite robust, and it includes interviewing various Fed economists along with inflation-slayer, Paul Volker, himself. 

When we talk about basic macroeconomics, we can quantify most of a country’s economy into two major cycles: expansion and recession.  There are other phases to the economic cycle as well, but most of the time we see these two.  Very simply, expansion is when an economy is growing.  These are typically good times.  Jobs are created and unemployment goes down. However, there comes a point when this expansion naturally slows down and reverses course. Consequently, economies begin to slow down.  This is not fun and inevitably, people lose jobs, and we see unemployment go up.   Historically, this cycle has been in place for many many years; expansion occurs, and unemployment goes down.  Afterwards, a recession develops, and unemployment goes up.  The silver lining is that recessions can tend to help keep inflation from running rampant.   

“In classical economics, business cycles were inevitable but self-correcting. Recoveries would occur spontaneously through automatic shifts in wages, prices and interest rates. Lower prices would spur more buying; lower wages would spur more hiring; lower interest rates would spur more borrowing.” (Page 55) That was the general thought and it appeared that in the early 1900’s this prevailing theory would continue infinitum. 

Unfortunately, the Great Depression changed this entirely.  During this time, self correcting did not happen. British economist John Maynard Keyes came up with an explanation.  He theorized that “wages might be ‘sticky’ and not decline sufficiently in a slump.” [Furthermore], “even at low interest rates, gloomy business and investors might not borrow more. Thus, spontaneous adjustments wouldn’t always correct serious economic downturns.  Unless government intervened, economies might settle into a high-unemployment stagnation.” (page 55-56) 

This idea of “government intervention” birthed a whole new ideology of economic theory.  If a government can intervene and smooth out the bumps along with way, they can engineer the economy to avoid any type of impactful economic downturn while maximizing employment. 

Due to advances in technology post World War 2, and specifically with the growth in computers, economic theory took on a whole new life.  Blending the idea of economic engineering, computer models were optimized to this new goal; maximize employment at all times without the negative consequences of inflation.

You could imagine, any President who wants to be remembered as one who helps facilitate job growth during their tenure would embrace this optimization.  Consequently, from 1965 through 1979 Lyndon Johnson, Richard Nixon, and Jimmy Carter all focused on this end result.  And they put pressure on the Fed to accomplish this.

 “The Fed didn’t’ light the fire but it did supply the oxygen that kept the fire burning….” (Page 76) The famous economist Milton Friedman, quantified inflation as a general rise in the supply of money in the economy, above economic output.  In other words, too much money going after the same amount of goods and services.  “In the 1950’s and 1960’s money supply was defined as circulating cash and checking accounts in banks. In the 1950’s money-supply growth was of 23%, which mainly accommodated the needs of an expanding economy.  By contrast, (money) supply growth was 44% in the 60’s and 78% in the 70’s.” (page 76-77) Not surprisingly, inflation got worse as the money supply grew during this time.

Arthur Burns, the Fed Chairman from 1970-1979 conceded in his speech “Anguish of Central Banking” that the Fed had failed in getting rid of inflation.  Unfortunately, they allowed the money supply to grow too large.  Even though the Fed, during 1966, 1969 and 1974, raised interest rates, they did not have the will power to maintain a tight monetary policy by keeping interest rates high.  Instead, they reduced their monetary pressure, when it started to slow the economy down and consequently raise unemployment.  This was not acceptable due to the economic engineering mindset that had dominated the economic and political world.  As a result, we saw inflation move from 3.5% in 1966 to an all-time peak of 13.3% in 1979 (Source: Bureau of Labor Statistics).  Clearly something different needed to be done.

As they say in the old Western movies, “there is a new Sheriff in town.”  Paul Volker was appointed as the new Fed Chairman in August 1979 by President Jimmy Carter.  After listening to Arthur Burn’s speech one month later, Chairman Volker, had his new mandate in place.  He absolutely needed to reduce the money supply.  It was the central important element he needed to focus on.  And this time, he emphatically understood if he does not get it under control, it was going to be economically catastrophic. But it wasn’t going to be easy.  Within a couple months, it was clear that a new President had been elected and it potentially could be another obstacle in this challenge.

The election of 1980 was a game changer.  Fortunately for Chairman Volker it was a tailwind.  Ronald Reagan won and recognizing this glaring inflation issue, did not pressure Paul Volker to retreat.  Instead, President Reagan defended Volker during the darkest days of him trying to break the back of inflation.  It was a very calculated risk.  A deep recession ensued after Volker began his aggressive interest rate moves in November of 1980.  Reagan recognized that this recession would probably cost him his reelection in 1984.  But, he was willing to wager this for the betterment of the economy.

In October of 1980, the Fed Funds rate was approximately at 12.81%*.  While that sounds high, he had not gotten started yet.  He moved fast and over the course of 8 months, Paul Volker had increased the overnight lending rate to 20% by June of 1981*.  Not only was this unprecedented in its increase, it was also unprecedented in its speed.  Basically, rates went from just under 13% to 20%* in less than a year.  As you can imagine, he was persona non grata. 

Unfortunately, because inflation was so imbedded in the U.S. economy, it wasn’t until July of 1982, over a year later before the money supply finally shrank.  This was definitely a huge relief….for everyone.  And within a few short months, Volker began to reduce interest rates by the December of 1982.  It worked.  By the end of 1982 inflation was back down to 3.8%.  Volker had slayed the dragon. 

What was so evident from this book were two important lessons.  One, as much as a society would like to engineer itself away from natural economic cycles, it’s impossible to completely avoid recessions in its quest for maximum employment.  All these things must be balanced along the way.  And second, when inflation does naturally appear, it is very important to recognize it as such and begin the process of combating it until it is clearly resolved.  It will not self correct and If left on it’s own, it will only get worse once inflation becomes more embedded in our society.  Eradicating inflation may be unpopular in the short term, but it is the long-term that is at stake.

*Source (Federal Reserve)     

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In the investment world, investors talk about two types of markets: bull markets and bear markets.  A bull market is seen where prices are in an uptrend while a bear market sees prices in a down trend. Or at best, the market goes up and down in a very volatile manner.  When we look back in history, we can see both.  And it’s possible they can each last five, ten, or sometimes twenty years! 

How can investors see when each of these markets are in place?  How do investors operate in these different markets so they can accomplish their individual financial goals?  Ed Easterling tackles these very important questions in his book: Unexpected Returns, Understanding Secular Stock Market Cycles. 

The author began his research after we went through the dot.com bust.  The NASDAQ went down approximately 78% from March 2000 through November of 2002.   He began by asking two questions, “Has this happened before and what caused it?” 

I was first introduced to this book back in 2009 and have read it multiple times.  Since then, Ed and I have become friends and we have spent hours discussing this book.  His curious mind and research have helped me better understand the financial markets. 

Ed goes back to the year 1900 and looks at each year to see what recognizable patterns emerge that might allow investors to better understand market behavior.   

From 1900 on, he finds that the average economic growth rate in the U.S. is a “fairly consistent” 3.5% per year. Conventional wisdom speculates that stock market returns are predicated on economic growth.  If that is true, and historically our economic growth is consistent, then why does the stock market go down….sometimes in a big way? 

Ed found that stock market performance may not necessarily be tied to economic growth.  He discovered that times of fantastic economic growth were some of the most challenging periods in stock market history.  “For example, from 1966 to 1981, the economy grew on average at a rate of 9.6% per year….”The Dow Jones Industrial Average not only failed to grow, but declined across this period of strong economic growth.” (page 85). Conversely, from 1982 to 1999, the economy grew at a lesser rate of 6.2% per year.  If we relied on conventional wisdom to direct us, we would expect the Dow Jones Industrial Average to do even worse.  However, from 1982 to 1999, “the DJIA grew an astounding 15.4% a year on average during this period of slower economic growth.” (Page 85). 

How can this be?  By looking at the bigger financial picture, which includes the rate of inflation, Ed points out a correlation.  For example, the rate of inflation in 1966 was 3.5% and in 1981 it trended upwards to 8.9%.  This was after it peaked at 14.7% in 1980 (Source: U.S. Bureau of Labor Statistics).  From there, we saw just the opposite.  By 1999, we saw inflation trend down to 2.7% from the highs reached in 1980. (U.S. Bureau of Labor Statistics) 

In other words, while economic growth was extremely high between 1966 and 1981, inflation was trending up, huge.  And the inverse happened between 1982 and 1999…slower economic growth while inflation was trending down. 

Because Ed went back to the year 1900, he was able to see similar correlations between inflation and stock market performance.  When inflation was trending up, it seems to correlate with a very challenging period for the stock market, as a whole.  Conversely, when inflation was trending down, it seemed to suggest a “tail wind” existed that allowed the stock market to perform better. 

Let’s talk about what it means by a challenging market.  Ed found that during these challenging periods (i.e. bear markets) the average up year was 21% while the average down year was 18%.  These are very volatile swings.  Ed believes these periods are more challenging because, “when inflation rises, the return that investors want from stocks increases because they wish to be compensated for the rise in inflation.”  “As a result, stock prices decline to a lower level where they can [hopefully] provide high future returns.” This is a stark difference compared to the bull market where the average up year was 19% versus the average down year of only 5%. 

While buy and hold strategies might work well during the bull markets, they may prove challenging during the bear markets.  Sometimes it can take a while to recover from an 18% drop, or more, in your portfolio.  This begs the question, what type of strategies may work well during bear market periods?  Since we do not have the “tail wind” of inflation trending downward, investors might consider ways to manage downside risk.  Plus, it may be important to establish exit strategies that help lock in some profits.   Ed calls this “rowing.”  This is because if you were in a sailboat and the tail wind stopped blowing, you still need to get to your destination.  So, you must row your boat.  Because, if you wait for the wind to come back you may wait for a while.

If you would like to see how we “row” at Anchor Wealth Management, click "Rowing" button below.

*All performance referenced is historical and is no guarantee of future results.  All the indices are unmanaged and may not be invested into directly.

Niall Ferguson does an excellent job in his account of financial history.  Starting in ancient Mesopotamia with the use of clay tokens all the way through our modern era, he walks the reader through the organic evolution of financial progress.

In the beginning, Mr. Ferguson shows how money “crystalized the relationship between the debtor and creditor,” which led to the origin of banks.  From there, he guides you through the following financial chronology:

1.       Thirteenth Century: Government bonds were introduced which created the securitization of streams of interest payments along with the creation of secondary markets.

2.       Seventeenth Century: Equity in corporations (stocks) were introduced and could be bought and sold similarly to Government Bonds.

3.       Eighteenth Century: Insurance funds and then pension funds were created which exploited economies of scale and the laws of averages to provide financial protection against “Calculable Risk.”

4.       Nineteenth Century: Futures and options were introduced which offered more specialization and sophisticated instruments (the first derivatives) for hedging and risk management.

5.       Twentieth Century: Households were encouraged to increase leverage and skew their portfolios in favor of real estate.

6.       Twenty-First Century: The movement towards globalization occurred on a grand scale.

What is very fascinating, going through each level of innovative growth, was that it never occurred in a smooth risk-free fashion.  On the contrary, with each new step in financial evolution, it was a very volatile albeit growing period.  There were booms and busts along the way.  However, with each step in this journey, rules and modifications were developed that helped create a level playing field for operators in each new era. 

This is encouraging, because I feel when new developments are created or discovered, people are too quick to dismiss their effectiveness because of extreme volatility.  When the very first stock began trading back in the 1600’s, no one dreamed that they would become as mainstream as they are today. 

He summarizes, in the end, “Economies that combined all these institutional innovations, performed better over the long run than those countries who did not.  This is because financial intermediation generally permits a more efficient allocation of resources.” (page 342)  In other words, having the ability for the investor, lender and borrower to move capital freely between each other allows people to take advantage of opportunities in a timely manner.  And it helps get the needed resources into the hands of those who are prone to make good decisions.

As the world moves towards greater complexity, it requires new financial avenues to take advantage of opportunities within this new complexity.   The key, in my opinion, is that as new innovations come into existence, a great deal of research, observation and testing is required before going down that new path.  As a Wealth Advisor, part of my job is to do this extensive tire kicking.

I am always reading and absorbing books on a variety of topics, but they usually fall into two categories, finance and history.  Sometimes they are books on financial history!  For example, right now I am reading a great book called “The Ascent of Money, by Niall Ferguson.  It is a great book that walks through the history of money as a form of exchange and value and, how financial instruments have evolved through time.  The value in this book is being able to see how progress is achieved in the financial world and that helps me see what valid developments may exist in the future.