In past newsletters I talked a lot about valuing stocks as a combination of owning investments that have quality financials with growth opportunity coupled with a price we are willing to pay. Are the financials of the investment attractive enough to buy and are we willing to pay the price it is being sold for?
Inflation is not your typical financial input. Financial analysis is oftentimes focused on financial statements such as income statement, cash flow and balance sheet. So, why are investors worried about inflation?
Investopedia.com defines inflation as “the decline of purchasing power of a given currency over time.”This is primarily reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. In other words, a dollar today will not likely buy as much as it did 20 years ago. The Dollar Stores and Five Below are the “dime stores” of yesterday. In some cases, it might take a dollar to buy what a dime bought many years ago.
Why does this happen? There are three primary types of inflation:
- Demand-Pull Effect. This occurs when demand for a good or service is high and consumers are willing to drive up the price to get it. Exclusive sneakers are an example from Investopedia.
- Cost-Push Effect. This happens when inputs to a good or service are increasing in price and are being pushed through to consumers.
- Built-in Inflation. Employees typically expect that prices will rise over time, thus demanding wage increases to keep up with rising prices. This increase in wages can turn into a self-fulfilling prophecy with consumers willing to pay more for items because they have more in their pockets.
The most obvious area of the market where we are seeing the impact of all three of these inflationary forces is real estate.
- Demand-Pull Effect. The short supply of housing is driving those who are in the market to pay more because they are worried a desirable house will not be available again.
- Cost-Push Effect. The strong rise in lumber costs is being pushed through from the home builder to buyers.
- Built-in Inflation. Real estate is typically seen as an appreciating asset because there is a limited supply of land, and with the population rising there will always be more people looking to buy it. Low mortgage prices are fanning the flames of this urgency for people who are anxious to lock in a home.
There are many inflationary factors in the economy today, not just in real estate. Money supply has flowed into the economy through stimulus checks to businesses and individuals, Federal Reserve bond buying and low interest rates. Costs for goods and services are rising due to the rising cost of inputs as manufacturing plants were closed for part of the year and dealt with employee constraints from COVID-19. As consumers see prices rising for almost all goods or services they look to consume, buyers are buying more with the fear that prices will rise in the future.
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