Comments on: The inflationary threat to stocks

By: Rolfe Winkler

Rolfe Winkler — Wed, 28 Oct 2009 13:59:00 +0000

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%.

Why?

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.

By: Richard

Richard — Wed, 28 Oct 2009 13:24:57 +0000

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.

By: SKV

SKV — Thu, 22 Oct 2009 14:41:44 +0000

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.

-SKV

By: patrick

patrick — Wed, 21 Oct 2009 12:09:07 +0000

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.

By: Pete Cann

Pete Cann — Wed, 21 Oct 2009 11:20:23 +0000

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.

By: Bill

Bill — Wed, 21 Oct 2009 10:21:58 +0000

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).

By: Casper

Casper — Tue, 20 Oct 2009 21:44:17 +0000

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.

By: DP

DP — Tue, 20 Oct 2009 20:16:44 +0000

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.