Are Stocks a Good Hedge Against Inflation?

Much has been written about inflation and its impact on stock prices. A common question that arises is whether or not stocks are a good hedge against inflation. The accurate question that should be asked is whether inflation expectations impact stock prices.

A recent New York Times article, Inflation? Stick With Stocks, began with the question: "...is inflation bad for stocks?" Then answered the question: "The simple answer is, not necessarily." The research notes the real question should be more specific and centered around the anticipated future direction of inflation.

In a strategy article, John P. Hussman, Ph.D. of the Hussman Funds notes:

In short, looking at the historical data, we do observe that low trailing inflation rates have been associated with high P/E ratios, and that high trailing inflation rates have been associated with low P/E ratios. But – and this is crucial – we still find that those P/E ratios led to exactly the long-term consequences you would expect. High P/E ratios were associated with poor long-term returns, while low P/E ratios were associated with elevated long-term returns (emphsis added)...

What's really going on is that when inflation rates have been low, investors have had a historical tendency to overprice stocks on the basis of excessive optimism. When inflation rates have been high, investors have had a tendency underprice stocks on the basis of excessive pessimism.

If this “mispricing” interpretation is true, we would expect to find that high one-year rates of inflation have actually been related to high subsequent long-term rates of return, and low rates of year-over-year inflation have actually been related to poor subsequent long-term rates of return.

Dr. Hussman notes in his article that the relationship did prove to be true. What he found was high inflation periods were usually followed by high returns but lower inflation. And, low inflation periods were generally followed by poor returns but somewhat higher inflation.

Additional support was found in an article by Frank Reilly, The Impact of Inflation on ROE, Growth and Stock Prices (.pdf). A key summary of the Reilly article was the importance of investors to focus on inflation expectations. I would recommend investors read both the Hussman article and the Reilly article given the level of current inflation. The Reilly article ties his analysis in with the Dividend Discount Model and the Dupont formula. The Reilly article does conclude:

...the negative impact of inflation of the implied growth rate is confirmed, which helps explain why investigators find consistent empirical results that common stocks are poor inflation hedges.

Just because the rate of inflation is high does not necesarily indicate future stock price returns will be negative. On the contrary, it is the direction of future inflation that has an impact on stock price returns. Consequently, if the trend in future inflation is down (i.e., the second derivative is negative) then stock prices could move higher. The New York Times article notes:

According to Ibbotson Associates, in 1980, the Consumer Price Index rose by more than 12 percent, but stoocks still gained more than 32 percent. Why? Perhaps because in 1979 inflation was even higher, at more than 13 percent.

In conclusion, in these tough times in the market, stock price returns will be impacted by events happening in the future and not by those that have already occurred. From an emotional standpoint, it easy to let ones feelings for future stock expectations get clouded by past events. Being able to overcome these past influences is important in achieving positive investment returns.

Source:
Inflation, Correlation, and Market Valuation
Hussman Funds
By: John P. Hussman, Ph.D.
May 29, 2007
http://hussmanfunds.com/wmc/wmc070529.htm

The Impact of Inflation on ROE, Growth and Stock Prices (.pdf)
Financial Services Review
Frank K. Reilly
1997
http://www.rmi.gsu.edu/FSR/abstracts/Vol6_1/v6-1a1.pdf

Inflation? Stick With Stocks
The New York Times
By: Paul J. Lim
June 8, 2008
http://www.nytimes.com/2008/06/08/business/yourmoney/08fund.html?ref=yourmoney

 

Comments

[mixter:]

I used to think stock market investors were intelligent. Now, I think they are like sheep, the lead ram takes off in one direction, and the rest of the flock runs to follow the leader.

Just what in the hell is the leader going to do if "Islam" Obama, and the "dim-wit-O-craps" take total control of what is left of "our" government?

Perhaps 17% interest rates will be common, and we can invest in CD's, just like the Carter disaster years!

2008 Jul 27 08:32 AM

[FWallace:]

The Repub's have done such a terrible, terrible, terrible job the past 8 years.... it's time for change, and change is what we'll get !!!


When the Dem's take full control of our Government, you may want to relocate elsewhere, because things are about to change drastically around here, the majority might find themselves out, and it's about time !!!

2008 Jul 27 09:11 AM

[Joyful Alte...:]

Whoever's in charge, there will be tough economic times ahead, as we try to fix the debt structure before the Chinese government decides to cancel our national credit card. McCain and his lobbyist advisors aren't capable of taking us anywhere but further down the Bush path to oblivion; I hope Obama can straighten out the crony capitalism and shore up our foundations in the next four years and get us headed upwards in the following four years, but it will be a very tough job.

And supposedly the stock market does better under Democratic presidents, even though the "investor class" votes Republican.

2008 Jul 27 11:03 AM

[najdorf:]

It's pretty funny that all 3 responses to an economics post are about politics and terribly reasoned.

Tell me one concrete way that your life has changed due to the Democratic takeover of Congress in 2006. Political parties simply don't have that much power to effective big, quick changes, especially when the nation is as divided as it is now. You don't have to worry that the next president/congress will ruin everything, but I wouldn't hold out a lot of hope for them vastly raising the quality of our nation either. Most of the major aspects of our current path aren't subject to real debate or modification.

Why would China stop lending us money? We always pay the interest, we have an enormous economy, and we buy a ton of their products without putting any significant political pressure on their leadership. Who would want to make a change in that relationship? If the dollar continues to decline they'll just take some of their assets denominated in other currencies and start buying our assets. You'll have to invest a greater percentage of your portfolio in the Chinese markets and we'll go on with our lives.

We haven't had enough presidents, the economy is too complex, and presidents don't control the economy enough for you to draw any valid conclusions about correlations between presidential party and stock market returns (and you know that, hence "supposedly" - what's your source?). What the president can do is push a tax agenda through Congress, and Republicans have taken care of the investor class very nicely in this regard (Reagan cut max income tax bracket massively, Bush cut capital gains and dividend taxes). Lower taxes lead directly to money in the pockets of investors. The other aspects of economic policy that a president can influence are hard to quantify and we don't really know what effect they have on stock prices.

Nice job on the original post. Since I don't see a good way for us to predict future inflation, I'll just stay in stocks for the long-term and figure that most of the gyrations will equal out in the long run. If we go the route of Weimar Germany or Zimbabwe then I'll be more worried about how to afford food than yearly real returns.

2008 Jul 27 12:14 PM

[fran:]

are you serious?

are stocks priced in fiat currency? what happens to fiat currency values with on going inflation? are earnings the primary driver of stock price? are earnings priced in fiat currency? they both inflate. maybe you hedge if your money/stock is in a stable fiat, but name one.

look at history. have fiats[paper/digits in computer] ever hedged? if you wish to hedge inflation, you'd best own "things"--objects that hurt when dropped on foot.

the trick will be to choose your "things" properly. those that the market place wants

2008 Jul 27 01:46 PM

[bearfund:]

Inflation kills growth, which kills stocks. The stock market's function is to price risk. What is risk? The variability of future returns. The thesis here seems to be that the rate at which the currency in which a stock is priced is losing purchasing power, or is expected to be losing purchasing power, is positively correlated with the price of stocks. But even if this is true, remember that what matters is not the paper value of future returns but the purchasing power of those returns. When the value of the currency in which those returns will be paid is highly uncertain, so is the value of the returns themselves. That translates to higher risk which, all else being equal, means lower prices. And in fact this is exactly what we see when we look at the price of stocks in terms of purchasing power (i.e., in terms of gold).

Price expansion is killer for growth; it drains away money that might have been invested and directs it instead to assets that are not investments, like cash, gold, silver, food, and oil. Do not be misled by paper gains. Even if the government's CPI lies to you, the market will not. Price your stocks and their prospective future returns in gold to evaluate their true worth. When your home currency once again becomes a reliable store of value, if it ever does, its value against gold will stabilise and you can once again look at traditional paper-denominated charts. Until then, they are useless.

2008 Jul 27 02:04 PM

[donaldj:]

You forgot to mention that China's 70 year plan of male children only is only to build a billion man army the willl be able to walk on water and march up Pennsylvania ave. proudly goose stepping their way to the Red House. The only thing we have to offer them is a palter .o5 percent interest on U.S. Gov Bonds. How tragic will that be?

2008 Jul 27 02:16 PM

[Did U Think...:]

I love the concept that others will loan us money forever simply because they always have and without any analysis of why they do this.

In short, they are playing the vendor financing game. You have over capacity and nobody with enough productivity to trade with. So you take their worthless IOU and claim you are making "sales".

At some point the entity receiving the stuff either simply will not take anymore OR they default on their promises to pay for the stuff and the one manufacturing and sending the stuff over stops.

When Chinese manufacture stuff and send it to the USA, they really want something else of value in return. Since we have chased much of our production offshore, we have little to trade back with. So instead we send our dollars as IOUs. The Chinese do not want our dollars, they want stuff that the dollars represents and they hope to be able to trade those dollars back to us later for goods and services. But it has been many years of us sending IOUs and now the lack of domestic US production, which has been masked by fake production of financial services, is causing Americans to be unable to buy as much imported crap as before. Soon this will become a trend and once that is in place, the vendor finance game will end. China will want us to take our dollars back in return for production but they will find we have left them holding an empty bag.

China and Japan and others will not buy our debt forever. They will throw our worthless dollars into the marketplace to buy anything that anyone is dumb enough to give them for the paper. This is why commodities are so sky high. The wealth is looking for places to hide from the collapsing US dollar.

At some point people will realize that inflation is moving up faster than any gains in stocks and bonds which are valuated in USD. The stock markets will crash as everyone attempts to extract their wealth while there is anything left to be able to extract.

None of this is rocket science. Ron Paul, Peter Schiff and other smart people have been warning you about this for years, but you all believe that the system is some sort of bottomless pit of wealth and value which can never dry up. While nobody knows how long it will actually take to collapse, collapse it must, and it will come as a major shock to most people in the world. Remember that the USSR, once thought of as a super power, default on all of its public debt only a few short years ago. All fiat currency based systems suffer the same fate eventually. The process of breakdown tends to be exponential which means it moves ever faster into the crash. This is why so many people are taken by surprise. Nobody can give you a final year or month, but the certainty is there nonetheless.

Now, go ahead back to your pointless dem vs gop arguments, sheeple, even though we no longer have a true 2 party system. It's now the uniparty and their goal is to extract your wealth from you while appearing to represent and support you. The Central Leviathan Party is alive and well. Go ask them for your daily bread or your right to live because that is just where this is taking a sleeping America.

2008 Jul 27 06:52 PM

[hrant:]

a good question but unfortunately the article did NOT answer the question !
waste of my electricity.

2008 Jul 27 08:22 PM

[youngolf:]

No matter what congress we get, the power to move this country in a direction still belongs to the President-and IMH-unpolitical-O, Bush/Cheney have done a terrible job.

Almost every federal office we fund, including immigration, emergencies, housing, money, and the waste in Iraq....has been mishandled or abused. The FHA, Fed, even the SEC...all have sat on their so-called 'educated' hands and here we are now, in a real mess.

Nothing substantial has been done about national healthcare...and so now companies are rolling the 55+ age worker, not only to cut salaries, but because they drive their health insurance costs up. Oh, they do extend paid coverage for 6 months...then its famous COBRA for up to 18mos.......then they get to go out there and seek quotes for themselves at 57 years old!!!

It is badder than we know.

The President is a key (like FDR, Lincoln, Washington) in getting us outa this mess.

2008 Jul 28 08:05 AM