How Does Inflation Impact Stocks?

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.

Comments

[Byronm:]

Very interesting topic. I would like to more about this, however, your chart is useless without labeling the axes - what are you plotting? Please expand this article as this is a very timely and important topic. Thank you.

2008 Feb 21 08:47 AM

[LAS:]

Yes, useless chart. Unconnected with the text.

2008 Feb 21 09:48 AM

[David Lentz:]

Good question.

And when you use the term "inflation rate", exactly what do you mean? CPI, Core inflation, or something else? I know of no objective measure of inflation, as it inevitably involves some subjective components, like "value" or "worth".

But from the observations, I can see why the Fed likes to keep inflation between 2% and 3%, instead of driving it as close to zero as possible. One would want to keep some space between the economy and deflation, which is why Bernanke is continuing to pump credit into the economy to replace the credit that has imploded/is continuing to implode. My guess is that until we see evidence of inflation stronger than 6%-8%, the Fed will continue to stand on the gas pedal and pour funds into the economy, if only to try and avoid a deflationary situation.

2008 Feb 21 10:15 AM

[Eddy Elfenbein:]

I used the CPI from the government. I know there are many criticisms of this index, but it's the only one I have.

I apologize for any confusion about the chart but there's no easy way to graph it. The blue line shows the cumulative gain of the S&P 500 going by the rate of inflation (low to high being left to right).

In the deflationary period at the beginning, the market drops. Then between -5% and +5%, it rises very dramatically, Then it levels off and falls dramatically.

2008 Feb 21 10:59 AM

[bbee:]

may i know how could i create a similar graph by myself?

2008 Jun 10 02:42 AM