Hacker News recently posted the chart below, stating that “the inflation-adjusted SP500 has never recovered from its 2000 peak”.
This is extremely wrong and silly for reasons we’ll get to in a bit, but it’s worth noting that Hacker News is owned and run by Y Combinator, one of the most successful and powerful venture capital firms on Earth. How can an investment firm so successful in funding startup companies make such a bad financial mistake?
The answer is quite simple: success in investing in startups does not depend so much on financial literacy as it does on identifying good tech and future market demands for technology–things that simply have little to do with concepts such as financial returns, monetary theory, or equity valuation.
But let’s get back to the error, and why it’s so interesting–the chart is measuring S&P 500 returns relative to the money supply, as measured by M3, which includes money in circulation, money market funds, short-term repurchase agreements, and other highly liquid forms of money. The belief behind this chart is that this is somehow a measurement of inflation.
But it is not. Inflation is defined as an increase in the general price level, and can be measured in a variety of ways (the CPI and PCE are the two most commonly used measurements). Any financial analyst who tried to use M3 or another money supply measurement as a measurement of inflation would be laughed out of a room; even if CPI and PCE are imperfect as indexed samplings of the underlying concept, they are nonetheless measurements of inflation. Money supply, however, is just one part of the calculation; if one does not compare that to an economy’s ability to produce goods and services, one is measuring the wrong thing. It’s like trying to figure out how fast someone traveled 500 miles without knowing how long they were traveling.
Yet this isn’t an error unique to Paul Graham’s news outlet–it’s commonly found, and commonly mixed with political arguments about why a particular person, party, or group is doing the wrong thing. It’s also often used to make the argument that a particular alternative investment, nowadays most often cryptocurrency, is a good thing (at the bottom of the chart above on the website it was taken from is the polemical and emotive phrase: “Invest wisely and you can maintain or increase your standard of life. Invest poorly and the road to serfdom is real. Invest in crypto”).
Thus we can begin to cleave misunderstandings of inflation into different camps; there are those who do not accurately understand inflation and have thus come to faulty conclusions, and there are those who are leveraging inaccurate arguments towards their own political, ideological, or financial ends. And these do not have to be separate people; one can easily do both at the same time, and perhaps many people are doing precisely that.
This is why, sadly, misunderstandings of inflation will likely propagate and continue over time–and be leveraged towards various personal interests. It is not as boring as, say, the dividend discount model, a now-defunct method of calculating a stock’s fair price (P = D1/r-g is the formula, where P = price, D1 = value of next year’s dividend, r = constant cost of equity capital, and g = constant growth rate in perpetuity). Bad ideas, if exciting or useful towards personal goals, will last longer than bad ideas that have no utility.
Ultimately, misunderstandings of the price level will continue in popularity for as long as someone can use those misunderstandings towards a particular end–and for that reason, we can expect a lot of market inefficiencies hinging upon people making bad errors of judgment due to misunderstanding inflation.