How Inflation Affects the Stock Market

How does inflation affect the stock market?  Inflation is probably the last thing on people’s minds right now.  While gas and food prices were soaring a couple of years ago, gas has settled into a higher but relatively stable price and talk of deflation is all around.  The cost-of-living increase for Social Security was even set at 0% for this year since there was no inflation last year. 

The Federal Reserve, however, has been flooding the economy with dollars to try to prevent deflation and they indicated recently that they would be willing to start causing inflation to get things moving, perhaps as much as 2% per year.  Flooding the economy with lots of dollars that no one wants, however, may spark off a fire storm that they are not expecting (the economy is like the Titantic and the Fed has a dramatically undersized rudder – it does not turn on a dime).  I keep thinking that things are looking a lot more like the 1970’s than the 1930’s, so maybe the 15% inflation of the early 1980’s is just around the corner.  The price of gold certainly seems to indicate so.

So what happens when one has a basket of stocks and inflation occurs?  To understand what will happen, one needs to understand stock pricing in general.  Like any other investment, the price of a stock is determined by 1) the rate of return, relative to other investments, 2) the amount of risk, both in getting that return and in losing money, once again in relationship to other investments, and 3) the underlying value of assets of the company (because they could be sold off and the money given to the investors – the owners).

The first element, the rate of return, over the long-term depends on earnings growth .  When inflation occurs companies can generally increase prices to offset the effects (since everyone will also be getting paid more).    Earnings will therefore tend to grow with inflation, as will the amount paid out in dividends, so the price of a stock will tend to grow due to earnings growth with inflation and the company business growth in general.

Over the short-term, however, inflation tends to cause stock prices to go down.  The first reason is because the effective rate of return from current dividends and earnings must increase for investors to be interested since part of the return is now being eaten up by inflation.  The way the effective yield (percentage paid out) increases, since the stock is paying a fixed amount for a dividend, is for the price to go down. 

For example, if a stock is paying a 5% dividend (or has earnings that would allow them to do so in the future) and inflation spikes to 10%, the effective dividend would be -5% if the stock price remained the same and the company did not increase the amount paid out for the dividend.  Investors would do better by buying gold or another fixed-price asset.  The price of the stock would therefore decrease until the rate of return was at least 15%, from which the effective rate of return would be 5% after inflation was taken out,  meaning the price would drop by about 60%.  As stated above, however, earnings and dividends would increase over time as the company was paid more, less valuable dollars for their goods and services.  The stock would therefore not necessarily drop by the full 60%. 

The second issue, risk, is not affected by inflation for most companies.  The only exception is multinational companies that do a lot of importing.  If inflation occurs the cost of buying goods from overseas may increase which may affect earnings.  Again, this can be offset somewhat if the company can raise the price on goods sold enough, but this is not always the case.  If the company exports a lot, however, they may be able to undercut the prices of goods manufactured in other companies and come out ahead.  The exchange rates in converting from foreign currencies into US dollars might also be a benefit.

The third factor, the value of assets, will generally increase with inflation.  The value of machinery and especially real estate will increase, causing the value of the company to increase (again while staying stable in real-dollar terms).    

So, initially the effect of inflation on stocks is to cause stocks to decrease in price since the rate of return will need to increase for new people to be interested in buying the stock.  After a time period however, as companies are able to pass on costs to customers and exports increase since dollars are inexpensive relative to other currencies, earnings will increase.  Assets of the company will also increase in value (in dollar terms).  Stocks will therefore tend to increase with inflation over the long-term.  Stocks are therefore a good hedge against inflation provided they are held for a sufficient period of time.

To ask a question, email or leave the question in a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Comments appreciated! What are your thoughts? Questions?

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