With inflation, the prices of things generally increase. You would therefore expect the prices of stocks to rise as well. This is true during the latter stages of inflation, but initially equity prices may actually fall. Here’s why:
The price of a stock includes a “discount” to its fair value due to the perceived risk involved. For example, say that a stock normally trades for about ten times its earnings (its price-earnings ratio, PE, is 10). This is the price that the market has set for the company, and like other things, the price may fluctuate a bit but over long periods of time the price will remain about the same. If earnings were expected to rise by ten percent in the next year, you might expect the stock to increase ten percent as well in expectation of the earnings increase so that the PE ratio would remain around 10. If the earnings increase were a certainty, this would happen, because ten times earnings is thought to be a fair price for the stock, assuming that everything else that could affect the stock price remained the same.
There is uncertainty, however, in whether a company will actually meet those earnings. The greater the level of uncertainty, the lower the price will be compared to the fair price – i.e. the greater the discount. The stock in our example might trade at nine times future earnings, or at a PE ratio of 9, so that if they do make earnings the people purchasing the stock now will be rewarded with an increase in price to make up for the chance they are taking that the company will fall short on earnings.
Inflation reduces the return you receive from holding a stock. If earnings increase by ten percent but the value of the dollar decreases by ten percent, there will be no reward for holding the stock. To compensate, the price people are willing to pay will need to drop so that they will be rewarded after the effects of inflation are felt. This is why stock prices may initially fall when inflation increases. After the initial fall, however, the price of equities will increase with the price of everything else. Businesses will pass the cost increases they see for materials and labor onto their customers who will pay for them with inflated dollars. The dollar value of the business will increase as the dollars become worth less, so the price of the company stock will increase.
As usual, stocks are a long-term investment. Over long periods of time, the chances of doing well with a diversified set of stocks is almost ensured. Over short periods of time, however, there are several factors, including inflation, that can result in a loss.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.