Would inflation be good for stocks?
With the monetary and fiscal spigots open wide, some investors say equities are a good place to be. But David Einhorn of Greenlight Capital has warned that inflation could compress price-to-earnings multiples. A look back to history suggests his fears are warranted.
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The Federal Reserve has lowered rates to virtually zero and expanded its balance sheet significantly, stuffing banks with excess reserves that are available to lend. If the market picks up, banks will find themselves surrounded by creditworthy borrowers again and excess reserves could quickly flow into the real economy, increasing inflation.
In the meantime, many analysts argue that the government is likely to keep printing money to finance runaway fiscal deficits and large unfunded obligations for Medicare and Social Security, increasing inflation.
The Fed will tell you that deflation is the primary risk facing the economy as the private sector continues to de-lever. And inflation is hardly guaranteed. There's still time for the Obama administration to get America's fiscal house in order and the Fed can choose to tighten monetary policy. Highly unlikely both, but nevertheless possible.
If inflation is in the cards, why might that be bad for stocks? One reason is that investors will pay less for future earnings.
