The debate over whether stocks rise or fall in reaction to inflation continues. But studies indicate what many investors have suspected all along: The market is inconsistent.
Editor’s Note: The “throwback” article was written in early 1986.
The U.S. economy is experiencing the lowest inflation rates in almost two decades. The stock market is at an all-time high (as of this writing). But many economists warn that inflation may not have permanently abated. Would a resurgence of inflation imply bad news for the stock market?
The traditional view held that if an investor expected high rates of inflation, he should buy real assets and sell assets that are fixed in nominal dollars. Under this view, real assets include such items as buildings and machinery, since they increase in value with inflation, and also common stocks, since they represent ownership claims to real assets. Fixed assets denominated in nominal dollars include bonds, since their dollar value remains constant; their value decreases as the dollar value decreases with inflation.
The traditional view of the relationship between inflation and the stock market was questioned in the late 1960s and 1970s. During that period, inflation soared, yet stock prices plummeted, contradicting the traditional view. Several researchers attempted to reconcile the traditional view and the contrary behavior of the market. Nobel Prize-winning economist Franco Modigliani and Richard Cohn argued that the stock market was simply wrong. In their view, investors were committing two serious errors in valuing common stocks. The first error, they said, was that investors were using nominal rates of return rather than real interest rates (rates adjusted for inflation) in their stock valuation models. In determining the fair value for a stock, expected future cash flows are incorporated into the stock price model by discounting those flows to the present. The larger the discount rate assumption, the lower the resulting stock price will be. The use of nominal rates for the discount rate, the economists argued, incorrectly put too low a valuation on stock prices.
The second error, the two said, was that investors failed to recognize the gains accruing to the corporation through decreases in the real value of corporate debt as a result of inflation. Since corporations were heavy borrowers, their liabilities were actually decreasing as a result of inflation, they argued.
The result of these errors, according to research studies conducted by Modigliani and Cohn, was that in the 1970s, investors had undervalued common stocks by about one-half.
Several other researchers disagreed with Modigliani and Cohn’s conclusions. They maintained that inflation had an adverse effect on corporate income. Former chairman of the Council of Economic Advisors Martin Feldstein argued that corporate taxes adversely affected firms during inflationary periods. The primary culprits, he said, were historical cost depreciation and the taxation of nominal capital gains. The depreciation of assets is computed on the basis of historical costs rather than replacement value. Taxes are based on nominal rather than real income. As a result, the firm’s tax liability will increase with inflation even though there is no real increase in economic value. The implication of these arguments is that inflation has an adverse impact on stock prices.
The debate over the effects of inflation on the stock market thus boils down to this: Is the stock market a hedge against inflation (the traditional view) or does inflation result in falling share prices? Clearly, which of these views is correct is of primary importance to investors in formulating their investment strategy.
How the Market Has Reacted
We examined stock market investors’ reactions to inflation over the period 1926 to 1978. The advantage of examining a long time period is that the results will less likely be dominated by effects peculiar to a particular period. For example, the ’60s and ’70s were dominated first by a costly war and then by an unprecedented increase in energy prices. Only by examining the relationship between inflation and the stock market over a long period of time are we likely to isolate the effect of inflation alone.
Surprisingly, we found no consistent relationship between inflation and stock prices. In other words, an investor’s stock portfolio has a 50/50 chance of increasing or decreasing in value as a result of an increase in inflation. Our study hypothesizes that a major explanation of this result is that investors may be anticipating government anti-inflationary policies.
How did we reach this conclusion? In conducting our study, we attempted to isolate any consistent reaction by the market to inflation. In order to do this, we first developed a stock valuation model that predicted stock prices on the basis of dividend history for normal (noninflationary) times. In other words, it provided us with an approximation of what stock prices would have been had there been no inflation; this removes the effects of inflation on stock prices—primarily the impact on dividends—so that we can look instead at investors’ reactions to inflation. Other factors that may affect stock prices at a particular point in time are also ignored by the model, and so the predicted price will not be the same as the actual price. For example, wars, revolutions, technological breakthroughs and changes in investors’ expectations will all have an impact on stock prices that are not accounted for by our model.
In Figure 1, the difference in actual market behavior and our model is illustrated. You can see that the model fits the data fairly well on average over a long period of time. Yet the fit could be improved if we incorporated into our model any previously ignored factor that consistently affects stock prices. For example, suppose that snowfall in New York City consistently affects stock prices in the same fashion. By incorporating this variable into our model, we should obtain a closer fit between the model and actual stock prices.
The variable we were concerned about, however, was not snowfall but inflation. And that is the basic rationale of our approach—we were looking to see if the market consistently reacted to changes in the inflation rate. If it did, and if we incorporated inflation into our model, it would cause our model to conform more closely to actual stock prices. And it would provide investors with a clue as to how stock market investors might react in future inflationary environments.
When looking at inflation, there are three possible measures that one can use: the actual inflation rate, the expected inflation rate and the unanticipated inflation rate. We looked at all three measures. For the actual inflation rate, we used the consumer price index (CPI); the expected inflation rate was derived from a standard time series model; the unanticipated inflation rate is merely the difference between the actual inflation rate and the expected inflation rate. We compared these rates to the percentage error of our model—the amount that our model differed from actual stock prices.
Statistical tests showed that there was no significant relationship between any of the inflation measures and the percentage error of the model (Figure 2 illustrates this for the actual inflation rate; similar results were obtained for the other inflation measures). Thus, no reasonable measure of inflation could move our model to a closer fit with actual stock prices. In other words, changes in the inflation rate did not consistently affect stock prices once the impact of inflation on dividends was removed, as it was in our model; the stock market did not react to changes in inflation in a consistent manner.
The Lesson for Investors
Our study indicates that the relationship between inflation and stock prices is complex. Betting on whether inflation will cause the market to go up or down is hazardous, and investors should not expect to use the market as a hedge against inflation. Conversely, the market does not always fall with inflation, so investors need not avoid the market if they expect increases in inflation. We can contrast an individual’s strategy with respect to his stock and bond portfolio. An investor expecting an increase in inflation would certainly wish to reduce his holdings of bonds, since they are likely to fall in value if expectations are realized. On the other hand, real assets such as gold or collectibles will increase with inflation. However, the odds of a stock portfolio going up or down are the same in periods of low or high inflation.
Some Words of Caution
It must be pointed out that it is possible that the inflationary episode of the late ’60s and ’70s may have affected investors’ future expectations. Since many observers attributed market declines to inflation and the rise in the market to a reduction in the inflation rate, it is possible that this could have some impact on the market in the next round of inflation. We would expect such an effect to be temporary.
It is also important to note that in formulating any investment strategy vis-a-vis inflation, what matters is not the absolute level of inflation, or even changes in inflation, but the difference between what an investor thinks inflation will be and what the market’s inflationary expectations are. Suppose that Investor Jones thinks inflation will be 6% next year, and the market thinks that inflation will be 12%. Should Jones sell bonds because he thinks inflation will occur? The answer is no. If Jones is correct and inflation is only 6%, then he should buy bonds: The market’s higher inflationary expectations will mean rates are high when Jones makes his initial purchase, but if his prediction is correct, rates will drop and thus bond prices will rise.
How should individual investors adjust their portfolios to protect themselves from inflation? If investors expect inflation to increase in the near future, then they should hold more real assets, such as real estate, because real assets tend to appreciate with inflation. If investors do not know whether inflation will increase or decrease should they avoid the stock market? Our evidence says no. The results indicate that, on average, stock investors do not react to inflation in a systematic way.
The stock market is neither a good nor a bad place for the investor to be during inflationary periods.
This article was written by Steven Mann and Thomas S. Zorn for the August 1986 issue of the AAII Journal. At the time, Zorn was an assistant professor of finance at the University of Nebraska, in Lincoln; Mann was a graduate student. This article represents technical material that was elaborated on in the May/June 1986 Financial Analysts Journal.