The inflationary threat to stocks

October 20, 2009

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.

(Click chart to enlarge in new window)


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.

Historically, according to Howard Silverblatt of Standard & Poor’s, investors have valued stocks of the S&P 500 at about 17 times earnings. If a company stands to earn a dollar per share in a given year then investors will tend to pay $17 for a share of its stock.

But if you add inflation to the mix, future earnings lose their purchasing power, which means investors won’t pay as much for them.

Einhorn, at the Value Investing Congress on Monday, said that if we wind up with significant inflation, distant earnings will be discounted at higher rates, meaning “P/E ratios will collapse.”

We see this relationship in action if we compare the average P/E multiple of the S&P 500 with inflation as measured by the Consumer Price Index. In the 1960s, when inflation was low, P/E multiples were high. In the 1970s, when inflation was high, P/E multiples were low. After Paul Volcker beat back inflation in the early 1980s, P/E multiples began a two-decade expansion.

To be sure, investors use expected inflation rates when discounting future earnings. That said, when building their models they tend to extrapolate the future based on the present.

Depending on its relative impact on revenues and costs, inflation may or may not be good for company earnings, but it will certainly shrink the multiple investors are willing to pay for them.


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I have also wondered about the oft-repeated argument that stocks perform well in periods of high inflation. Warren Buffett has even made the argument on numous occasions. I have never seen a real study on it, but I found something that said stocks returned barely more than treasury bills, 7.3% annualized versus 7.1%, during the inflationary period of 1966-1982. And of course to get that tiny bit of extra returns, equity investors had to endure volatility that was many times greater than it was for treasury bills, 5-6X the volatility if my memory is correct.

Posted by DP | Report as abusive

You are getting better by the day, Rolf.

P/E multiple one way of valuations, I like the discounted cash flows concept, also (aggregate) positive project NPV’s within the entities. The dividend growth models are also valid, i.e. dividend cover.

That brings us back to nominal and the dreaded real returns.

A plot of the PPI against the Dow Jones Industrial could also be revealing. I always add 5-10% to published statistics for good measure.

Posted by Casper | Report as abusive

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Posted by Goud en goudmijnaandelen: de bearmarket voorbij – Page 818 – Forum | Report as abusive

Not quite right. Distant earnings will be discounted at higher rates but will be compounded with the rate of inflation. So it’s a question of real rates (rates minus inflation).

Posted by Bill | Report as abusive

Good point, but pretty obvious, I think. I always grouse about the use of the P/E ratio at all. Some blue-blood must have had an aversion to math on real numbers between 0 and 1. The obvious figure to use is E/P, the multiplicative inverse of P/E. You can compare it directly to inflation and interest rates, and it tells you how much of your investment, every year, is going to increase capital or pay dividends, which is exactly what you care about. E/P must compete with other investments, particularly debt, particularly treasurys, so rates go up, E/P goes up, E is given, P goes down. The intuition with equities in inflation is that you own stuff, so if money is cheaper stuff that’s worth something should be worth more money. I think you may be just a hair wide of the mark, actually. Inflation isn’t relevant to E/P. Rates of return are relevant to E/P. When inflation is high, yes people are really antsy for higher rates of return (e.g. debt interest rates), but they may or may not get them, and if they don’t, they’ll pay more for equities.

Posted by Pete Cann | Report as abusive

that’s just stupid. all money is affected by inflation. if future earnings are in inflated dollars, then so is the future price of the stock in inflated dollars – so you’re paying less even though the price is up. what should we do – buy a 1.5% CD? Besides, with 10% unemployment, I’m not too worried about inflation. You want a measure of inflation – put your house or your car up for sale.

Posted by patrick | Report as abusive

Thank you Rolf, for raising interesting topic!
I just wish that you go into more detail.
It is way too general.
We should highlight at lest few most affected industries.

Almost for sure that gold mines stocks and basic materials should benefit from inflation while manufacturing stock should suffer.


Posted by SKV | Report as abusive

You are suffering from inflation illusion. Sure, higher inflation means higher discount rates, but it also means higher earnings growth rates. The two cancel out.

Consider the basic DDM: P = D/(r-g). Both r and g increase by the same rate of inflation.

It is possible that inflation serves as a proxy for a real economic effect that depresses earnings, but pure inflation should have no effect on stock prices.

Posted by Richard | Report as abusive

A fine theory Richard, but the increase in the discount rate of future earnings more than offsets any increase in earnings during inflationary periods.

What’s interesting to note is that during the ’70s, the earnings of the S&P 500 actually outpaced inflation, increasing from $1.80 at the beginning of 1972 to $4.06 at the beginning of 1982, when inflation finally moderated.

But what happened to stock prices during that time? They were flat. The S&P was at 102 on 12/31/71. It was at $122 on 12/31/81. So despite earnings that more than doubled, stocks were actually up only 20%.


Because the average P/E multiple for the index declined from 18 to 8.

Oh, and when Volcker moved to kill inflation, it hammered earnings by 25%. But the market saw inflation was declining and the P/E multiple again increased, so despite the fall in earnings, stocks were UP in 1982.

Posted by Rolfe Winkler | Report as abusive