stocks: inflation hedge or vedge?

I want to spend a little time thinking about what markets do when inflation hits. Common knowledge seems to believe that when inflation rears its ugly head stocks will rise in line with inflation. I think we have seen the monetary stimulus from the Fed show up in financial asset prices lately and I want to dispel this fundamental misconception of stocks as a hedge for high inflation with some market history. Note that my comments are not valid for hyperinflation. Almost anything is better than paper money during such time periods. During Brazil's high inflation of the late 1980s and early 1990s the stock market roughly held its own with domestic paper money (but looked flat to a foreign investor). If you’re like me and believe we’ll see elevated, but not catastrophic inflation in the near future it makes good sense to look at what periods of elevated (again, not hyper-) inflation have done to the stock market.

I looked back at a period of time where inflation was low, rose to quite elevated levels, and fell back again to low average levels. In other words, a period containing three "regimes": before inflation reared its ugly head, during high inflation, and back again to more stable, predictable levels. I chose the twenty-five year period from 1964 through year-end 1988 because it nicely exhibits these characteristics.

The chart to the left shows inflation (consumer price index) in red, the S&P 500 total return in green and the real return (total return minus inflation) in purple. Each is indexed to 100 at 1/1/1964. Clearly, stocks (green) did not keep up with inflation over this time period while the real return on the market over was negative. That’s a pretty poor showing over a period when inflation boosted the consumer price level to almost 4 times its starting point. If stocks were a good inflation hedge we’d expect the green line to be persistently higher than the red, and meaningfully higher at 12/31/1988 if real returns were positive. However, this does not seem to have been the case.

Why were stocks such a poor inflation hedge over this period? The answer lies in valuation. Using Shiller’s cyclically-adjusted PE ratio, which I’ve cited often, the S&P 500 traded at 21.6 times earnings in 1964. By year-end 1988, they were just 14.7, a P/E decline of 32%. The chart below shows the inverse relationship between inflation (red) and stock valuations (cyclically-adjusted PE, green). Over this time period, the correlation between the two was negative 0.956, representing an almost perfect inverse correlation. High inflation proved to be an enemy when stock valuations started high.

Why is inflation so hostile for stock valuations? It comes down to interest rates; nominal interest rates must include compensation for inflation plus a real return component. Investors ultimately compare this rate against the "coupon" available on stocks - that is, corporate returns on equity (ROE). Since ROE does not tend to fluctuate much over long periods and is more likely to fall than rise during high inflation, the yield available on stocks can only change if their prices move lower (coupon "yield" relative to book value moves higher). Maturities are also compared – bonds have a definite maturity while a stock’s maturity is infinite. I’ll defer to Warren Buffett for further clarification: “Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return – and 12 percent return on equity versus, say, 10 percent return on bonds issued by the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.”

Historical stock returns are likely to have looked much different if starting valuations were much lower than the 22 PE we see in the above illustrations. Because of these elevated levels, inflation had a demonstrably large impact on longer-term returns. While starting valuations always matter for subsequent returns, they seem to matter even more during high inflation.

Could this happen again? Well, today the cyclically-adjusted PE ratio is 23.7, so valuations are even higher than where these charts begin (1964). Even if you believe the Fed has everything under control and we won’t see high inflation anytime soon, it’s worthwhile to consider the aforementioned data when allocating your portfolio. The importance of stable prices is most noticeable when they go missing.