Equity bulls are hoping for further monetary stimulus in order to bet on stocks to use inflation to save their returns from weakness normally created in a slowing economy. There are many problems with this thesis, but one flaw that is underlooked is that stock prices in real terms are a poor inflation hedge. In fact, the peak of an inflationary cycle historically creates a bottom in real terms for stock prices.
As seen in the chart below, the best decades for S&P 500 (SPY) (the 1920s, 1950s, and 1990s) were periods of low inflation and positive economic growth. Highly inflationary decades such as the 1910s, 1940s, and the 1970s were some of the worst decades for real stock market returns. High inflation does not promote real investment growth as investors and speculators can make an easy buck through buying gold or through carry trades versus taking the risk in investing in productive assets. It also erodes the real purchasing power of consumers and therefore depresses real corporate earnings. As a result, stocks are a poor inflation hedge.
If it is a bad idea to buy stocks on the verge on inflationary outbreak, than what should investors do to preserve purchasing power? During times of lax monetary policy and the subsequent inflation, the best decision is to buy commodities. Commodities may have a poor long run returns, but in periods of monetary debasement, they greatly outperform stocks and generate real returns above inflation.
Out of the vast world of commodities, three hard assets that stand out are oil (USO), agricultural products (DBA), and gold (GLD). Oil benefits from inflation because its dollar denomination price will rise as the value of the US dollar falls. Also, food inflation creates geopolitical instability in oil rich regions of the Middle East, which benefits oil prices. Agricultural products benefit as the current demand for food is inelastic, population growth will drive future demand, and stagflation will not stop people from eating. Gold benefits because inflation causes investors to distrust fiat currencies, and move to gold as an alternative store of value.
The market will probably have a significant pullback if not an outright crash in the short to medium term. However, in the long run (greater than one year), expect high inflation to be a long-term consequence of the Fed's current reckless money printing. However, do not default to buying stocks as a response to inflation. Go for commodities (DBC) instead. Like the real bottom of the last major bear market in the early 1980s, the peak of a highly inflationary environment is an excellent buying opportunity in stocks, not when the inflation begins.
Disclosure: I am short GLD.