How Does Inflation Impact Stocks?

 |  Includes: DIA, QQQ, SPY
by: Eddy Elfenbein

Since the market is digesting yesterday's troubling inflation report, I wanted to look at how inflation impacts the market. I took the inflation-adjusted monthly market returns from 1925 to 2005 (thanks to my Ibbotson Yearbook), resorted them by inflation rate and look at the cumulative return by rate of inflation.

As you might expect, high inflation is bad for equity prices. In fact, the only thing worse for stocks is deflation, which is really, really bad for stocks. Here’s my chart:

Stock returns do very poorly when deflation runs over 5.6% (data points 0 to 68). After that, stocks do quite well up to an inflation rate of 3.1% (data point 490). They then slow down a bit but still climb up to an inflation rate of 5% (data point 698).

Now the trouble starts. Above 5%, stocks flat line up to an inflation rate of 12% (remember, I’m looking at the inflation-adjusted returns). After 12%, things get very ugly and stock returns plunge.

So inflation isn’t good for stocks, but the troubling numbers we’re seeing are still a long way from being a major problem.