The stock market took a new round of beating after inflation hit the highest 8.6% in May 2022. It is the highest inflation in more than 40 years since 1981. Surging food, gas, and energy contributed to the inflation gain. Less these, the May core CPI is a 6% increase year-on-year basis compared which is much lesser than April and March.
The key message is if you are holding cash you will lose money due to inflation. Inflation is eroding away your purchasing power. At a 4% inflation rate, you lose 33% of your wealth every 10 years. You need enough cash for emergency funds (my personal gauge is 6-12 months of personal expenses) and only invest money you don’t need in the short term. Holding cash is detrimental to your net worth.
You may be thinking if I invest now, the value may drop 30-40%, might as well put it in bonds or banks. In the short term, if you hold stocks, your investment value will go down due to market volatility. However, in the long term, as long as you hold productive assets, their value will go up. The only way to beat inflation is to keep productive assets such as businesses and real estate which generate cash flow. The US stocks market outperforms real estate and gold over a period of 30 years. From the below chart, you can see that S&P500 has the highest returns, followed by real estate, and the last in the race is gold.
Why do stocks fall?
High inflation, means the cost of running businesses increases. For example, your raw material price to produce goods increases, your logistics cost increases, and overall the cost rise. If you cannot pass your cost to the consumer, your profit margins will deteriorate. High inflation will cause the FED to raise the rates faster and more aggressively to counter inflation. This means the business’ cost of borrowing increases. More cash flow from business will be used to pay off the interest. High inflation will imply lower purchasing power and decrease demand.
We should choose businesses that have pricing power with low CAPEX, high free cash flow, and low debt-to-equity ratio. We can focus on businesses that are essential to business and consumers.