economonkey

When people talk about ‘inflation’, they implicitly mean one of two types: price inflation or wage inflation. In simple terms, price inflation is an increase in the cost of the things people buy, such as food, furniture, fuel and so on. Wage inflation is what happens when salaries go up across the board, regardless of the type of market sector or level of job.

One type of inflation can lead into the other, with higher prices leading to demands for higher wages to compensate, then strikes, capitulation, an increase in prices to cover higher payroll costs, and around again, in what’s termed a wage-price spiral, a type of positive feedback loop.

There are various indices that measure price inflation. The UK government used to target RPI (the Retail Prices Index), aiming to keep it below 2.5%: at the time of writing it’s a whisker over 4%. But in more recent times the target has been CPI (the Consumer Prices Index), also known as the Cheap Plastic Index or Chinese Products Index by cynics, because it excludes housing costs and places quite a high emphasis on consumer electronics. Some people complain that ‘real’ price inflation is anywhere between 5% and 10%, depending on who you are and what you buy: you can check your own at www.statistics.gov.uk/pic/

If you can keep your head while all around you are losing theirs, you’d probably make a good investor.

Times of turbulence on stock markets can be times of opportunity for the savvy investor. Picture the scene last week. City traders losing X billion pounds a day and having to cancel the order for that third gold-plated Porsche. Pension fund managers taking one look at their huge losses and… shrugging because it’s not their money. Uninformed media sources proclaiming the end of the world. Meanwhile, you could have been quietly sitting at your computer, raking in the cash.

Most people are aware that to be successful at investing you should buy low and sell high. What fewer people know is that you don’t have to do it in that order.

Buying low and selling high means that you are ‘long’ a particular entity. For example, if you buy shares in Skullcrusher’s Friendly Bailiff Debt Grabbers Plc at a price of 10p, in the expectation that they’ll reach 50p on the back of increasing debt defaults, you are long that trade.

But you could also sell high and buy low. If you think Skullcrusher doesn’t have much of a future because there’s no money left to collect, you could short the trade; borrowing the shares, selling them at 10p and hoping to buy them back at 2p, for example. In this case you would be short Skullcrusher Plc.

(as found in everything from your common or garden mortgage to major investment bank funds)

“Give me a place to stand and a lever long enough and I will move the world”, said Archimedes.

And he was right. Although the Earth would have to be orbitally stationary relative to his position, and it would have to stop rotating, and he’d have to be in a spacesuit, and the lever would have to be made from something immensely more light and strong than even carbon nanotubes, and the pivot would have to be frictionless, and wherever he was standing would have to have sufficient mass to counteract his exertions, and…

In fact the whole thing’s daft, really.

But you can see what he meant: little movements can have a big effect if you have the right leverage. And, just as you can shift a heavy boulder with the aid of a small rock and a big stick, so you can shift a lot of money on the back of geared loans secured upon bricks and mortar.

Because that’s what a mortgage is; a form of leverage. Most people can’t afford to buy their house outright, so they put down a deposit (usually) and take out a loan for the rest. For the sake of argument, let’s say that Mr and Mrs Average put down £20,000 on a £200,000 house, borrowing the remaining £180,000. They now have a leveraged ‘investment’ - sometimes rather quaintly known as a ‘home’ - with a gearing factor of 10.

Prices only go up, don’t they?

The title of this article combines comments by Alan Greenspan about the stock market boom of the 1990s (”irrational exuberance”) and the title of a book by Charles Mackay. The book, “Extraordinary Popular Delusions and the Madness of Crowds”, is a short but interesting one, covering those aspects of human psychology, sociology and politics that lead to what are known as bubbles. A bubble is loosely defined as what happens when the price of a particular class of item breaks away from fundamentals and, in effect, goes up because everyone expects it to go up.

We’ll rewind a bit here and take a look at the way markets usually work; all markets, not just financial ones. Company A produces a product; it could be a car, a toaster, a cake or a life insurance policy. In order to sell its product, Company A must price it at a realistic point. Too low and it will lose money on each product it sells. Too high and nobody will buy it except the rich and the insane (often the same demographic).

Note that to keep it simple here I’m excluding things like loss-leader promotions, where products are deliberately sold below cost to stimulate demand for related items.

Anyway, in a stable market the price is set at the margins, where the ability and willingness of the buyer to buy is matched by the ability and willingness of the seller to sell. This is a nice little negative feedback loop that keeps prices competitive, assuming competition is permitted within this particular market sector. Shortages of supply - whether real or deliberately created by withholding stock - can lead to increases in price, but higher prices will only be met if the demand is present and if Company A isn’t undercut by Company B.

And, most crucially of all, demand is moderated by the ability to pay. As the old example goes, the demand for Ferraris among 12-year-old boys is pretty much infinite, but that doesn’t have any effect on the market (at least until they grow up) because they have no ability to pay.

As I’ve discussed in previous articles, the two most significant negative emotions for investors are greed and fear. Either one on its own can lead to people losing money, but more often than not they are combined in an elegant double-whammy that hits some amateur investors so hard that they leave the market with their […]

Fear. We’ve all felt it at some point. The ominous sound of footsteps padding along behind you as you walk back from the pub in a provincial town at 2am on a Saturday night. The realisation that your evil mother-in-law is coming to dinner and you’ve forgotten the steak (not to mention the garlic and […]

“Working nine to five, what a way to make a living”, sang Dolly Parton. She was right, too, although today it’s more like “Working nine to six with a twenty minute lunch break, plus the commute, and probably an hour’s unpaid overtime on top and I never get any thanks and my blood pressure’s too […]

It’s been said that there are two types of people in the world: those who understand compound interest and those who are doomed to pay it. In this article we’ll investigate what that means and whether or not it’s actually true.
First, we need a definition of compounding and compound interest. When your interest is compounded […]

Ah, gold. So beloved of microchip manufacturers, Bond villains and high-maintenance women. This shiny, ductile, (almost) chemically inert metal has powers of heat insulation and electrical conductivity and so is often used - albeit in small quantities - in industry. It looks nice on your wedding finger too. But gold is much more than an […]

Those of you watching recent events in the financial markets might have seen the terms ‘carry trade’, ‘Yen carry trade’ and ‘YCT’ crop up a few times. This is often explained in the press as the process of borrowing money in a low-interest currency and investing it in high-interest one. Which is true, but there’s rather more […]