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Stocks As An Inflation Hedge

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

The talking heads have gone into overdrive: Inflation is the next big peril! These are the same bright guys that warned us of deflation last year, which should tell you something.

You will detect a recurring theme in this hysteria: Inflation is bad for the stock market. You have to do something now to prevent your equity portfolio from being ravaged. The line of reasoning is pretty straight forward. It sounds great when you hear it. Like much other conventional wisdom, however, the conclusion isn’t justified by the facts.

Here is the reasoning: Inflation is linked to higher interest rates. These higher interest rates will make bonds look more attractive relative to stocks. Higher interest rates, coupled with higher raw material and labor costs will reduce corporate profits. Investors will withdraw funds from stocks to purchase more bonds. Other investors may flee to the protection of “hard assets” such as gold, real estate or even fine art. Prices of stocks will sink as a result.

The basic premise that portfolios should be adjusted for inflation is just ludicrous, even if you could accurately predict it. It turns out that stocks behave pretty well during inflation. Owning an asset that can adjust reasonably quickly to inflation is an ideal hedge. Successful companies pretty soon figure out how to deal with inflation (or any other prevailing economic problems) to protect their real profits. As they do, the value of their stock increases.

Looking at large company stock returns since 1926 we find an annualized return of 10.02% return vs. inflation at 3.04. A seven percent real return is a pretty impressive inflation hedge. So, stocks look good for the long term.

What about the shorter term. Do stocks sink when inflation spikes? The data just doesn’t support that conclusion. The monthly and annual correlations are indistinguishable from zero (-0.011 and 0.001). Stocks move randomly, inflation moves randomly, and you can’t tell anything about one by looking at the other.

 

Here is a year by year graph. If you can see a pattern, either you are smarter than my Excel Spreadsheet, or you are smoking something questionable.

As a rule of thumb ignore the talking heads. They don’t know any more than you and I. And even professional economists have a dismal record of forecasting inflation and interest rates. As often as not they are dead wrong on the direction, let alone the magnitude of these changes. But, they can’t fill air time by telling you they don’t have a clue about the prospects for inflation.

I freely admit that don’t know if we are about to have a round of inflation, which will forever disqualify to be a talking head. I can live with it. The good news is that we can build efficient portfolios without making predictions about either inflation or stock price movements.

Building or changing your portfolio based on all idle chatter and groundless speculation is the height of folly. Inflation predictions are just as useless as stock market predictions. No one does it consistently. Even if they could accurately forecast inflation, it would tell you nothing about how to adjust your equity portfolio. Determine what your ideal asset allocation should be to meet your unique long term goals, and stick with it.