Jack Dorsey Has A Point

Jack Dorsey Has A Point
Reda Farran, CFA

over 2 years ago6 mins

  • Non-oil commodities haven’t been the greatest stores of value, and even oil’s becoming less reliable on that front as the world gradually weans off oil for its energy needs.

  • Gold’s worked quite well as a store of value, but it’s very volatile and is impossible to value, so you never know if you’re paying too much for inflation protection.

  • But stocks are some of the best long-term stores of value as they represent real assets: actual businesses with cash flows that should keep up with or beat inflation.

Non-oil commodities haven’t been the greatest stores of value, and even oil’s becoming less reliable on that front as the world gradually weans off oil for its energy needs.

Gold’s worked quite well as a store of value, but it’s very volatile and is impossible to value, so you never know if you’re paying too much for inflation protection.

But stocks are some of the best long-term stores of value as they represent real assets: actual businesses with cash flows that should keep up with or beat inflation.

Mentioned in story

In a tweet that received a lot of – arguably too much – investor attention, Twitter CEO Jack Dorsey speculated that we’re headed into a period of hyperinflation. That’s an extreme view, for sure, but there’s no denying that inflation does look like it’ll be high for a while. And if that’s the case, simple short-term hedges might not be enough to protect your portfolio: instead, you’ll want to seek out long-term stores of value…

What’s the difference between a hedge and a long-term store of value?

Hedging against inflation risk involves buying a financial instrument that closely tracks the short-term fluctuations in inflation – like an inflation-indexed bond, whose principal and interest payments rise and fall with the rate of inflation. That means it can help offset inflation-induced losses in other parts of your portfolio.

Long-term stores of value are those assets that maintain or even increase their real purchasing power – that is, the amount of goods and services that can be purchased with one unit of the asset, adjusted for inflation – over time. Let’s say the price of a bar of gold was $1,000 a decade ago. Then let’s say that over the last 10 years, the prices of goods and services in the economy have doubled, and so has the price of gold to $2,000. In that case, gold has maintained its real purchasing power because a single bar of gold can buy the same amount of goods and services today as it could 10 years ago.

It’s important to note that long-term stores keep up with or outperform inflation in the long term, but aren’t necessarily correlated with inflation in the short term. The latter are financial instruments often used to hedge inflation risk.

Why’s it more sensible to invest in long-term stores of value?

To be clear, when I say more sensible, I’m taking the perspective of a long-term investor. That’s because short-term investors are usually more concerned about hedging short-term inflation risks, whereas long-term investors are often more interested in building robust portfolios that can withstand different macroeconomic environments. Hedging’s more short-term nature makes timing the decisions of when to enter and exit the hedge tricky too.

What’s more, hedging is a form of insurance. And just like any insurance, it has a cost. For example, a five-year inflation-indexed government bond in the US currently trades at a -1.8% yield to maturity. So if you buy this bond and hold it to maturity (five years from now), you’re guaranteed to make an annualized loss of 1.8%. That’s the price you have to pay to hedge against inflation over the next five years.

The yield to maturity on five-year Treasury Inflation-Protected Securities (TIPS). Source: Bloomberg
The yield to maturity on five-year Treasury Inflation-Protected Securities (TIPS). Source: Bloomberg

Are commodities a good long-term store of value?

A focus on long-term stores of value naturally leads us to search for real assets, and the first that come to mind are commodities. But despite conventional wisdom, commodities generally haven’t been the greatest stores of value. The graph below shows the real prices – that is, the inflation-adjusted prices – of oil and a basket of all other major commodities (proxied by the CRB spot commodity price index).

Real commodity prices from 1951-2021. Source: GMO
Real commodity prices from 1951-2021. Source: GMO

With a real annual return of -1.6% over the past 70 years, non-oil commodities haven’t acted as a store of value. Oil has, however, just about managed to with a real annual return of 1.2% over the past 70 years (notwithstanding the huge volatility).

But one of the main reasons oil’s kept up with inflation is because it has a direct influence on energy and materials prices, which, in turn, have a big influence on inflation rates. But here’s something very important: as the world gradually weans off oil for its energy needs, this relationship between oil prices and inflation is only expected to get weaker going forward.

There’s also another problem with investing in commodities as long-term stores of value. See, investors tend to buy into commodities via futures contracts, either directly or indirectly (investing in a commodity ETF that holds futures, say). But the return investors make from investing in futures is influenced not only by how the prices of physical commodities move, but also by other factors like collateral yield and roll return. The latter, for example, can be negative and flip your total return into a loss even if the price of the physical commodity kept up with inflation.

And what about gold?

From the graph below, you can see that the yellow metal’s worked quite well as a store of value. But it comes with a lot of volatility and big drawdowns, not to mention the fact that it’s impossible to value it. That means you never know if you’re paying a high or low price for inflation protection.

Real gold price in USD. Source: GMO
Real gold price in USD. Source: GMO

So what is the best long-term store of value?

Here’s something that might surprise you: it’s stocks.

Stocks, after all, represent real assets: actual businesses with cash flows that should keep up with or beat inflation, given that they can often pass on inflation-driven higher costs to their customers in the form of price hikes. If costs and prices are evenly matched, a company’s cash flows can maintain their real purchasing power over time and therefore act as a long-term store of value. And if a company can increase its prices faster than its costs, the real purchasing power of its cash flows will increase over time – making the stock an even better long-term store of value.

To test this, let’s look at some historical data. The table below ranks the calendar years with the highest rates of inflation and shows the corresponding stock market returns. The average returns for the S&P 500 in these years were 9.4% – basically the long-term average over the past 90 or so years. The average real returns were around 0.7%, implying stocks managed to act as a store of value even during the worst years of inflation.

How stocks performed during the years with the highest inflation rates. Source: A Wealth of Common Sense
How stocks performed during the years with the highest inflation rates. Source: A Wealth of Common Sense

Notice that many of the high-inflation years were during the 1970s. The graph below shows how US stocks fared relative to inflation during this decade, as well as how value stocks – i.e. stocks that look cheap relative to the market – performed.

Performance comparison of inflation (CPI), US stocks, and US value stocks during the high inflation era. Source: GMO
Performance comparison of inflation (CPI), US stocks, and US value stocks during the high inflation era. Source: GMO

Value stocks fared even better than regular stocks as long-term stores of value during the 1970s. Why? I have two theories.

First, if buying stocks is buying real assets (actual businesses), then buying value stocks is basically buying cheap real assets whose real purchasing power should increase over time. And second, central banks tend to increase interest rates during periods of high inflation in an effort to cool down the economy. And value stocks tend to outperform the overall market when interest rates rise.

So regardless of whether you think Jack Dorsey's right about hyperinflation or not, it's not a bad idea to build a robust portfolio that can withstand different macroeconomic environments. And you'd be wise to stick to stocks – or, even better, value stocks – as your long-term stores of value.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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