Inflation and Stocks

I read this article today, and it made me want to write on the topic.  This is a concept that I learned early in my investment career.  It is worth understanding, so that you can do better in investing.  Inflation is negative for stocks, but it is a small negative — for every 1% that the inflation rate goes up, stocks decline 2% on average.

That’s not very big.  So why do stock investors panic over inflation?  They panic because the Fed might respond to inflation, and raise real (inflation-adjusted) interest rates enough to quell inflation.  Rises in real interest rates are far more negative to the market — a 1% rise in real rates hurts the equity market by 10%.  Why such a big impact?

The impact is large, because when real interest rates are high, capital is scarce.  Go back to my “Fed Model” article which is very different from other “Fed Models.”  High corporate bond rates raise interest costs for corporations, reducing profits, and raising discount rates (cost of equity capital).

At present, real interst rates are negative — in nominal dollar terms, this is not a bad time to own stocks.  Think of the dividend discount model for a moment.  Inflation runs through earnings and the discount rate, so the effect is muted.  Real rates run through the discount rate only — poison.

Is there any hope in an era where inflation is rising, and where real rates may rise?  Value investing always offers some hope, but that’s not my main point here.  Inflation manifests itself differently in different eras.  Look for the areas that are in short supply.  They will be the areas where corporations will have pricing power.  Those areas will outperform the market, even if the market as a whole declines.  At present, I am looking at energy stocks, food stocks, and others.

Inflation is bad for the market, but don’t let that stand in the way of looking for what might offer relative profit in this environment.