Stockmarket rallies are said to climb a “Wall of Worry” as the stockmarket climbs higher in spite of the various problems that already exist or may be about to happen.  There will always be many Cassandras and Perma-Bears out there highlighting the many reasons why the stockmarket is too high and is riding for a fall.  The vast majority of the time they are wrong but they have their day in the sun when the market does indeed fall (often after having risen substantially since the bears originally started shouting about their worries).

The reality is that stockmarkets broadly follow the economic cycle as GDP expands during times of economic growth (which happens most of the time) and as GDP contracts during recessions (which rarely last long but do cause sharp and painful falls in stockmarkets in the order of 30% to 50%).  When a recession ends the problems of the downturn are still fresh in people’s minds and it is these worries that the stockmarket’s rally overcomes.

They have been called the four most dangerous words in investing.  Beware whenever you see the words “its going to be different this time” used to justify why it is worthwhile to join in the latest investment mania.  The mania will probably last longer than you think it will but it always ends in the same way – by not being different this time.

Professional traders who are very disciplined and accustomed to using stop-losses are the ones who truly profit from speculative bubbles & manias because they are the ones who hang onto their winnings and do not end up by giving all their winnings back again cometh the downturn.  The true professionals follow the trend up, get out & then switch to the bear tack and profit on the way back down too.

From a practical investing standpoint and no matter how compelling the argument du jour used to justify why it is going to be different this time, just don’t fall for it.  The market may sustain the latest investment mania for longer than speculators betting against it can stay solvent but, rest assured, it won’t be different this time.  As an investor you don’t have to bet against the mania, you can simply choose to protect your capital by not participating in it.

Money (notes & coins in circulation) can be thought of as the longest duration, lowest coupon government debt which can ever be issued. The central bank does not pay interest on the notes it prints (although it is possible to pay interest on commercial bank reserves held at the central bank) and the central bank never has to redeem them. That legend on the ten pound note in your pocket that says “The Bank of England promises to pay the Bearer on demand the sum of Ten Pounds” will only result in the BoE giving you another, newer, crisper, ten pound note in payment for the one you attempt to redeem.

Most people think of inflation as a rise in the price of goods and services.  The published measures of inflation (RPI and CPI) measure the rise in the price of a basket of goods and services.

However economists define inflation as an increase in the amount of money in circulation (literally inflating the stock of notes & coins in circulation).  Some people deny there is a link between an increase in the money supply and RPI/CPI.  The Bundesbank firmly believe that a link exists and have passed this belief on to the ECB which manages its policy by keeping one eye on the growth in the money supply.

A simple explanation of why the money supply does in fact affect the price of goods & services runs as follows:

Strictly inflation is defined as an increase in the money supply. Assume that increasing the money supply (by printing money) does not cause cause a rise in the price of goods & services. Then a government could print as much money as it likes and use the money to acquire ever-increasing amounts of goods, services & assets. Plainly this could not last for ever and therefore there is a tipping point beyond which printing more money will cause the price of goods & services to rise.

The problem for central banks is that nobody knows precisely where the tipping point is – which is part of the reason why central banks have such a tricky job in meeting their inflation targets.