Volatility, The Markets & CPI
By Richard L. Kesner, President
The CommonWealth Group
August 2008
Market volatility, which actually began in June 2007 with the elimination of the uptick rule, continues to dominate the news and has created fears among many investors. We have had numerous conversations about whether this time the world is really coming to an end. WE DO NOT THINK THIS IS THE END OF THE WORLD.
However, as we have discussed with many clients, if you feel that you cannot live with the volatility, then you should move some money into more conservative investments. This may allow you to sleep at night and ease the burden of watching your investment portfolio.
I want to state publicly that I am not moving any of my assets. I have money in equities and I have money in the Ibex Funds; I am hedged. I have no assets invested in bonds or other fixed income.
For those investors who are long term and who believe that the world will survive we feel that this is a buying opportunity that may not be seen again for quite a while. Stocks are cheap and smart buyers should make a lot of money over the long term. That does not mean that there will not be more setbacks or that the volatility will abate. In fact, I still believe that the volatility is necessary to achieve superior long term returns.
Consumer Price Index
The CPI, which is the government’s measure of inflation, was designed to help businesses, individuals and the governments adjust their financial planning for the impact of inflation. For most of the 1980’s the index worked well. However, changes made by various administrations have understated inflation dramatically. These changes were made to reduce the social security entitlement benefits by almost 50% to the nation’s retirees without having to publicly disclose that the changes were being made.
We feel that inflation is understated by about 5% per year. We have seen other statistics that show that it is actually closer to 7% per year. The changes in the calculations began in the Reagan Administration. However, additional changes were made during both the Carter and Clinton Administrations. If these changes had not been made social security checks would have been about double. In addition, anyone who relies on receiving payments adjusted for the CPI has been similarly damaged. On the other side, if you are making the payments based on CPI (like the federal government) you are making out like a bandit.
Just for the record the CPI originated in the mid-1880’s when the Bureau of Labor Statistics was asked by Congress to measure the impact of new tariffs on prices. The current CPI came into broad acceptance after WW II when it was included in auto union contracts as a cost-of-living adjustment for wages.
In the early 1990s it was originally thought that the CPI was overstating inflation. It was argued that if the CPI rate could be reduced, then entitlements, such as social security, would not increase as much each year, and that would help to reduce the budge deficit. Two luminaries, Michael Boskin, chief economist to the first Bush Administration, and Alan Greenspan came up with a plan to alter the way the CPI was calculated. However, it was not until the Clinton Administration that calculations were adopted.
The changes were to change from an arithmetic weighting of the CPI components to a Geometric weighting. The benefit of this weighting was that it automatically gave a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price.
The point is to warn investors that any fixed income type of investment cannot keep pace with inflation. The problem with equities is what we have been experiencing the last 12 months, volatility. As stated previously if the volatility is too great for you to handle, then you must make changes in the investment strategy, however understand that you will be losing purchasing power for every dollar that is invested in these conservative non volatile investments.
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