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Lynch’s thoughts on inflation

As I’m writing this people are concerned about inflation. Inflation is that event that makes everything more expensive. Businesses don’t like inflation because it chews into their ability to make money. Investors don’t like it for the same reason. It’s been awhile since 1970’s but that was the last time inflation was on everyone’s mind.

The seventies are considered one of the worst decades to have been an investor. At it’s peak in 1979, inflation pushed its way up to 11%. It culminated in the early 80’s when the Federal Reserve Bank under Paul Volcker decreased the money supply sending the 10-year Treasury rate up over 15%. This extinguished the flame of inflation. Until now.

The Dow Jones Industrial Average from 1970 – 1983. Over 10 years of poor returns.

Without digging into why inflation is happening I’ll say it appears we’re now facing a similar future to what was 1970’s America. Just Google “inflation” and you’ll see a bevy of links that explain why were facing this inflation dilemma. For this article I simply want to discuss Peter Lynch’s thoughts on inflation.

For Lynch inflation was another one of those events that he considered out of his control so he didn’t waste a lot of time thinking about it. He was primarily interested in individual businesses and less interested in macroeconomics. To him it was pointless to try to predict what would happen with interest rates or the stock market in general.

Lynch kept it simple. He knew that the stock market would sometimes go up and sometimes go down. Trying to predict when was a foolish pursuit. He only focused on the long term since over the long term the stock market went up.

Since the stock market is in some way related to the general economy, one way that people try to outguess the market is to predict inflation and recessions, booms and busts, and the direction of interest rates. True, there is a wonderful correlation between interest rates and the stock market, but who can foretell interest rates with any bankable regularity? There are 60,000 economists in the U.S., many of them employed full-time trying to forecast recessions and interest rates, and if they could do it successfully twice in a row, they’d all be millionaires by now.

Peter Lynch, One Up on Wall Street

For investors it’s sometimes difficult to remember but you’re investing in businesses, not stocks. The more you know about the business the more likely you are to succeed at investing. There can be a stock market correction where the price of a stock can fall by 50% or more. However, at those times if you know that the business is still strong, that it’s making money then you won’t be intimidated by the price decline.

One important metric to remember when evaluating the health of a business is its earnings. Lynch says its earnings that ultimately decide the price of a stock. When the earnings decline, so does the price. When the earnings improve so does the price.

During the last decade we’ve seen recessions and inflation, oil prices going up and oil prices going down, and all along, these stocks have followed earnings. Look at the chart of Dow Chemical. When earnings are up the stock is up. That’s what happened during the period from 1971 to 1975 and again from 1985 through 1988. In between, from 1975 through 1985, earnings were erratic and so was the stock price.

Peter Lynch, One Up on Wall Street

Lynch’s emphasis on individual businesses, their earnings and having a long-term time horizon are key lessons for anyone wanting to be a successful investor.

Despite the spectre of inflation there is money to be made for investors. Although I’m not Peter Lynch I would say that some businesses are better than others within this type of economy. I realize that goes against Lynch’s advice of ignoring the macroeconomic picture. However, Lynch himself suggests that success with Cyclical stocks partially depends on knowing what’s happening with the general economy.

When discussing investing in the auto industry, Lynch says

Lately we’ve had five years of good car sales, so I know we are in the middle, and perhaps somewhere close to the end, of a prosperous cycle. But it’s much easier to predict an upturn in a cyclical industry than it is to predict a downturn.

Peter Lynch, One Up on Wall Street

Lynch’s track record proves that long-term investing in individual businesses is a strategy for overcoming inflation.

A few other notable investors such as Ben Graham and Paul Tudor Jones have an interesting opinions that counter Lynch’s argument to ignore macroeconomic concerns like inflation. I won’t discuss their thoughts in this article but will include it in further writings in my subscription newsletter.