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Thursday, December 2, 2010

Stocks and Inflation

Just a real quick point about stocks and inflation because I saw an article yesterday about how you don't want to own stocks during periods of high inflation.

First off, inflation still is not anywhere on the horizon. Until there is wage inflation, there can't be any real outbreak of inflation. Anything else that occurs will be transitory. Second, stocks are priced in nominal dollars because their earnings are based on nominal dollars. This means that, all other things being constant, stocks should actually rise as a result of inflation in the long run. However, because all things are not constant, interest rates rise in the short run, which compresses the multiple that stocks can command. This is what happened during the 1970s. Corporate earnings grew quite a bit, actually, but interest rates nearly tripled during the decade.

Once the inflation subsides and interest rates drop, stocks' multiples expand on a larger earnings base. This is, to a large extent, why the 1980s were so good for stocks, particularly in the first two years of the rally. Stocks had gotten ridiculously cheap and the decline in interest rates starting in 1982 helped to provide for a robust multiple expansion.

The upshot of this is that in the long run, stocks are as much an inflation hedge as any other asset can possibly be. In the short run, however, they can take a hit due to interest rate surges. Still, this is purely an academic discussion since inflation is not a threat. Incidentally, yes, deflation is uniformly bad for stock prices.

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