Sunday, July 27, 2008

Are Stocks A Good Hedge Against Inflation?

(I originally posted the following article on The DIV-Net website on July 20, 2008)

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: " 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 by John P. Hussman, Ph.D. of the Hussman Funds, he 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 the above 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 necessarily 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 stocks 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 is 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.

Inflation, Correlation, and Market Valuation
Hussman Funds
By: John P. Hussman, Ph.D.
May 29, 2007

The Impact of Inflation on ROE, Growth and Stock Prices (PDF)
Financial Services Review
Frank K. Reilly

Inflation? Stick With Stocks
The New York Times
By: Paul J. Lim
June 8, 2008

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