Do stocks track inflation?

January 24, 2007 4:59 PM

Do stocks naturally track inflation?

My idea is that over time, if inflation continues, you can expect stocks to go up at least as fast as inflation on average. The basis for me thinking this is that as inflation goes up, consumers pay higher prices for everything. That means businesses are pulling in higher revenues.

At the point businesses are making more per year, the stock for that company should go up (wild assumption, probably accurate for market as a whole).

So basically the question is why should I be concerned about inflation's effects on investments, since even if it gets higher, stocks will just rise to match.

NOTE: This post ignores most crazy situations like hyper inflation, or having the US taken over by the North Koreans or whatever.

posted by cschneid to Work & Money (9 answers total)

Best answer: You may find that stock prices are fairly strongly correlated with inflation. But your theory for why this might be is flawed.

as inflation goes up, consumers pay higher prices for everything. That means businesses are pulling in higher revenues

First, saying inflation causes consumers to pay higher prices is looking at it backwards. Inflation is a measure of the increase in prices consumers are paying, not a cause (though there are feedback mechanisms like wage-price spirals).

Second, businesses' revenues may increase due to inflation, but there's no general reason to think their costs won't increase as well. I don't think periods of high inflation correspond to periods of strong profits. You may find in high-growth periods that profits are strong and inflation is above average. But you wouldn't expect inflation to cause high profits (in the economy as a whole).
posted by matthewr at 5:23 PM on January 24, 2007

Stocks have historically beaten inflation, so in a sense yes stocks 'track' inflation. Of course, the lower inflation is, the meaningful gain of stocks goes up. Thus 10% stock gain with 2% inflation rate is better than 10% stock gain with 5% inflation. So in this sense no, stocks don't gain value as much when there is inflation. However, even if the stocks gain enough to offset the inflation gain, you still pay taxes on the total 'gain'.
So using simplified math, if a stock went up 15% and inflation was at 5%, you made 10% but you pay taxes on 15%. Here is a recent story on this.
So yes, inflation does hurt stock investments.
posted by Osmanthus at 5:38 PM on January 24, 2007

Equity is a real asset - so, yes, it "tracks" inflation. However, concern over inflation is more about what policy guys do to fight inflation in the short term, like raising key rates - which will adversely impact firms.
posted by milkrate at 5:52 PM on January 24, 2007

There is no easy or simple answer to this question. In the event of inflation, you want to hold the inflating asset. If the dollar loses purchasing power due to high energy prices, owning stocks isn't going to help you. If regulations or demographics increase labor costs, inflation could result, returns on capital could suffer, and equities won't keep pace.

Also, remember that inflation and higher interest rates go hand in hand, and as Marty Leibowitz has shown, stocks typically have a duration of 6-8, meaning that for every one percent increase in rates, stocks typically fall 8-10%.
posted by Kwantsar at 6:04 PM on January 24, 2007

6-8%. My mistake.
posted by Kwantsar at 6:04 PM on January 24, 2007

Kwantsar, you're right, but if you own XOM or COP or an index that weights them heavily, you own a lot of the inflating asset in your hypothetical case.

In general, stocks are priced in dollars, so if you hold equities, all else being equal the stock price will remain stable (measured against benchmark X) as the dollar's value falls (against benchmark X).

If I'm not mistaken, Kwantsar's points are that all else is never equal, and that what benchmark X is actually matters, in relation to the way the underlying company conducts business.

The more I learn about the economy, the worse the concept of "inflation" - as some mysterious, easily quantifiable force that evenly devalues dollars across all markets - appears to me. It's just not that simple and trying to make it that simple leads to errors in thinking.
posted by ikkyu2 at 6:18 PM on January 24, 2007

Here is an inflation chart versus the Dow Jones Industrial Average for approximately the same time period. A couple quick points of interest:

--Inflation from the late 1920's up to 1997 has increased the dollar's 'value' somewhere around 700% (it looks like this chart starts it at 70-ish cents and stops at $5.00). The DJIA in that same time period starts around 200-400 and jumps to around 4,000-5,000; which gives us something like a 200-400% increase. Not exactly tracking. In fact the DJIA never gets to a 700% increase, even today.

--The 'value' of a dollar really starts to climb around 1980. The DJIA doesn't kick into gear until around 1990. Its hard to attribute a 10 year lag to inflation tracking.
posted by iurodivii at 4:53 AM on January 25, 2007

"--Inflation from the late 1920's up to 1997 has increased the dollar's 'value' somewhere around 700% (it looks like this chart starts it at 70-ish cents and stops at $5.00). The DJIA in that same time period starts around 200-400 and jumps to around 4,000-5,000; which gives us something like a 200-400% increase. Not exactly tracking. In fact the DJIA never gets to a 700% increase, even today."

Even ignoring that, during that period, all kinds of stocks have come in and out of the DJIA, there is something seriously wrong with your math.
posted by jcwagner at 8:31 AM on January 25, 2007

What's wrong with the DJIA math is that the DJIA returns dividends. If you consider dividends reinvested, which the index ignores, it spanks the pants off of dollars. Even if you don't consider dividends reinvested, your equity ownership leaves you with a huge pile of dollars at the end of those 70 years.

The way the DJIA is price weighted as opposed to cap weighted also makes it a poor candidate for the kind of comparison that's being proposed.
posted by ikkyu2 at 12:53 AM on February 1, 2007