Independent Investment Advice Blog

Will inflation destroy your 401k? Independent Financial Advice

    An article in on 2-21-2012 in the Wall Street Journal “Rising Chinese Pay Toughens Fed’s Job” warned that the rising cost of labor in China will result in inflation in the U.S. I agree with this but feel that domestic deflationary pressures will overwhelm the forces of inflation. If people can’t afford to pay higher prices they will have no choice but to reduce their standard of living and buy less. Of course buying less units of an increasingly expensive good is still inflationary but a reduction in the number of units sold puts pressure on manufactures to cut prices. A consumer who has to cut back on purchases is going to make a decision to stop buying some goods altogether and this will result in some business going bankrupt and having deflationary “fire sales” at depressed prices. One possible point where consumers could break under pressure would for them to move to a smaller, cheaper home or rental apartment, resulting in a continuing of the real estate depression.

   Assuming I’m wrong and inflation returns then interest rates will rise. It was the constant lowering of interest rates in the 1990’s that was used by the bulls as justification for a massive stock market boom. In financial theory an asset’s value is determined by using a discount rate to discount the cash flow of an asset. If the discount rate (a hypothetical estimate composed of an interest rate and a risk premium) is greatly reduced then new, higher valuations may result, which is what happened in the 1990’s. But if interest rates rise as they did in the 1970’s then a rising discount rate will hurt stocks (it would hurt long term bonds even more). So if today’s low inflation and low interest rates are an artificial, temporary, phony thing then watch out because when interest rates return to “normal” then a rising discount rate will hurt stocks. If a discount rate of 2% is used to value an investment with a hundred year cash flow and then is changed to 4%, then, in theory the value of the investment would be cut to 56% of its previous value.

      Since inflation makes people poorer then corporations will sell less units of goods and corporate profits will not outrun inflation and will be reduced on a “real” inflation adjusted basis.

   I don't expect a return of inflation until several years from now. For the next few years I expect a Japan-style Soft Depression. The inflation insight of this article is an attempt to awaken readers to the idea that the stock market is overvalued in part due to an undeserved windfall from deflation's influence on interest rates which lower the discount rate for stocks. (The stock market discount rate is a hypothetical estimate which varies for each security and is not the same as the Federal Reserve's Discount rate).

     I have written an article “Three things you must know about the crash” and “Bears should not capitulate”.

     Investors should seek independent financial advice.