The answer is all around you
original article by Avner Mandelman (December 1, 2007)
Good investors check things out for themselves as Ronald Reagan recommended when he dealt with the Soviets: "Trust, but verify."
For example, if a company says it is close to getting a contract from customer A, you pick up the phone and call customer A. He may not talk to you - but then again, he might. And if he does, you may learn what the market doesn't know yet.
Yet the mindset of checking-things-out-for-yourself isn't just for individual stocks. It is also good - especially good - for larger questions.
To take a concrete example: What do you think is the level of inflation? This is critically important, both if you invest, and if you plan for your retirement. In the case of investing, the rule of thumb is that the proper market price-to-earnings multiple is 20 less the inflation rate. So if inflation is 3 per cent, a PE of 17 times is reasonable. On the other hand, if inflation is 10 per cent, as it was in the late '70s and early '80s, then even a PE of 11 or 12 would be too high. As for retirement, no need to elaborate on the need to figure just how far your dollars would go in your golden years.
So, how do you find what inflation is?
Most investors would go to the Internet and Google the word, then look up sources. For example, many would seek the government of Canada's statistics - Statistics Canada produces lots of figures, including some that relate to inflation. So, you may ask, what's wrong with taking Statscan's consumer price index figure? That number usually ranges between 2 per cent and 3.5 per cent. But is this the real inflation figure? No it isn't. In fact, the government says so specifically - although in very small print: The CPI is merely a measure for indexing civil service employees' pensions. (I am indebted to fund manager Tom Stanley - another skeptic - who dug out this info.)
So what is the real inflation level, and how to find out? Why, by keeping track of how much you paid for things a year ago, five years ago, and 10 years ago, then comparing it to how much you are paying today. Simple.
But which things? Well, the things that you and your family need and buy. Here are a few anecdotal pieces of evidence, then a conclusion of sorts.
Seymour Schulich, in his wonderful book Get Smarter: Life and Business Lessons, says that in his experience, money loses 90 per cent of its value every 30 years. For example, a La-Z-Boy chair for the TV that costs today $2,000, had cost $200 about 30 years ago. A house that had cost $50,000 30 years ago, would cost today $500,000, and so on. A growth of 10 times in 30 years comes out to about 8 per cent a year. Far higher than Statscan's 3 per cent, which might mean that the market's proper PE should be not 17 times, but 12 times. But is this inflation figure typical?
Let's look at prices of other items. How about airline tickets?
The airline ticket to Paris I had bought in the '80s was 3.5 times cheaper than today. That's about 6.5 per cent a year. The lunch I had at Simpson's in the Strand in 1982 cost $8 for two. Today it would be about $50, or 7.6-per-cent inflation a year. Again close to 8 per cent.
Now, this 8 per cent a year is a very high inflation number - but is still not derived from critical items: You don't have to buy a fancy recliner, and you don't have to fly to Paris. But you do need to eat. Therefore, the best indicator for food inflation I have found is the price of yogurt. Yes, that simple, plain food item that - unless you buy it flavoured - is about the same everywhere. Since I have a good memory for prices, I know that eight years ago my family paid 29 cents for one of those little plastic containers of yogurt. Today we pay 79 cents. (You'd probably pay $1.29, but I am a value buyer.) This comes to 2.7 times the price in eight years, or a growth rate of 13.2 per cent a year! And before I get irate letters from yogurt makers, let me say that this applies to the yogurt that I and my kids eat, but I do believe it is fairly typical.
Back to the 13-per-cent figure: You may not realize just how shockingly high this inflation rate is. But in the early '80s, when inflation levels rose above 10 per cent a year, it caused then-Federal Reserve chairman Paul Volker to raise interest rates above 20 per cent, which sank the economy into a deep recession - Bay Street had restaurants boarded with plywood - just to get inflation levels down to mid-single digits. It eventually did - but at a horrendous cost to many.
So once again: How high is real inflation today? It is certainly not 3 per cent a year. Even if it is "only" 6 per cent, the market's PE is too high. But if inflation is really 8 to 10 per cent a year, then the market next year may see some reckoning, because its PE is way too high.
But is inflation today really close to 10 per cent a year? Maybe not - many items made in China drive down prices, so my guess is that 6 to 8 per cent is probably the range.
So why does everyone figure on inflation of 3 per cent a year, 3.5 per cent, tops? Because, as you probably realize by now, few people bother to check things out for themselves. Most rely on printed numbers and stats, instead of opening their eyes to physical reality. If you, on the other hand, start checking things for yourself, very soon you might know what no one else does - and could take advantage of it by acting on what few others see.