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Friday, October 28, 2011

Risks associated with equity inflation

Equity inflation is an increase in the price of stock, but a decrease in the purchasing power and actual underlying value of that stock. Like monetary inflation, equity inflation gives the impression of more money, but in actuality means lower wealth. This is a financial phenomenon also described in the Quarterly Journal of Economics as “The Money Illusion Hypothesis”.

Stock value and inflation risk
Stock exposure yields more than  investment risk

Risk #1: Currency devaluation deflates increases in stock price

According to The Money Illusion Hypothesis investors can lose track of actual purchasing power of liquid assets such as stock via corresponding financial events such as monetary inflation. In other words, for each unit rise of stock prices with corresponding increases in market values, this increase loses actual value in proportion to the value of money. This however, is just one of several explanations and risks associated with the occurrence of equity inflation.

Risk #2: Stock investing expenses rise

Another cost associated with investing that may be overlooked are commissions, fees, margin interest, option contract premiums and management expenses. With a rise in the value of equities, fund managers, brokerage firms and investing services may find it easier to justify higher brokerage account costs. Yet if these costs amount to just 1% more, added to monetary inflation the total cost could be 3-4% off the total unadjusted yield of stock not including capital gains taxes.

Risk #3: Decline in business financial fundamentals

A corresponding decline in currency value and increase in equity related costs are not the only way equity inflation can occur however. This is because worth is determined by more than just yields and the currency  in which a stock is valuated. Moreover, if a company's revenue declines 5%, but earnings increase 7%, a business has essentially shrunk in size especially if the increase in earnings is due to downsizing, accounting techniques such as mark-to-market accounting, and sales of assets. These methods are further elaborated upon by Aswath  Damadoran of the Stern School of Business

Risk #4:  Increased potential for future devaluation

Eventually, investors are believed to price in shorter-term inconsistencies in price valuation such as in an asset bubble  according to the 'Efficient Market Hypothesis' described by Burton G. Malkiel of Princeton University.  One reason for this is because equity inflation is not sustainable unless underlying growth in revenue, and/or improvements in a company's operational assets occurs. Moreover, business that have products and services with clearly defined increases in revenue, market share, and competitive positioning are more justified in valuating assets in a way that can increase equity prices, than those that do not.

Image source: Value Stream CC0 1.0-PD