The thing that is top of mind for investors at the moment is inflation. It seems that on a daily basis, the yield on the 10-year Treasury Note rises as the congress talks about another round of stimulus for the economy. This talk of stimulus has investors worried that it is more than needed, and that worry is leading to the fear of inflation moving materially above 2%.
We all know that as inflation rises, bond yields rise as well because investors require ever higher yields to compensate for the lost purchasing power of the dollar due to inflation. This, of consequence, sends the value of the bonds people already own down and they slow losses in their bonds portfolio holdings.
So, inflation up = bonds lose money. It’s a very standard bit of knowledge that investors possess.
However, inflation’s impact on the stock market is less well understood. We all believe that when inflation goes up, stock prices come down, and the graph below from Ally Invest confirms that since 1990, or over the last 30 years, at least for the first twelve months we see reduced stock market returns when inflation is reported above 2% compared to when it is reported below 2%.
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So why is this? Stock market returns may be adversely affected by inflation because those inflationary pressures may threaten future corporate profits. As investors value stocks for investment purposes, nominal discount rates used to value future corporate profits rise under inflationary pressures, reducing current value of those future profits and thus the value of the stock market.
Our job, then, as investment managers is to position portfolios so that they are defensive against the impact of inflation by including stocks of companies that will benefit from inflation or that have pricing power to raise prices of their goods and services as inflation rises.
What are these companies? The easy ones to identify are precious metals miners, agriculture related companies, energy companies, real estate, or any other company in a commodity business. All of these companies act as insurance for your portfolio during times inflation is rising or at a high level.
The more difficult ones to identify are the ones that are not commodity producers. A rule of thumb for investment managers is that Value Stocks out-perform the market during times of rising or high inflation and Growth Stocks out-perform the market during times of falling or low inflation. We have seen this over the past several years as growth stocks have outperformed value stocks in the post 2008 stock market crash era.
So why would Value Stocks out-perform? Value Stocks in general have material amounts of current cash flows and dividends, and many have pricing power for their products and services. As inflation rises, their current cash flows rise and dividend increases tend to follow as the prices for their output rise with inflation. As valuations for these companies are calculated, during the initial phase of rising inflation, the cash flows are rising faster than the increase in the rate at which investors discount those cash flows.
Unfortunately, there is level of inflation above which the discount rate rises faster than the companies can increase prices, thereby leading to a slowing of cash flow growth rates. From the studies I’ve read, as inflation rises to 3% above then current inflation levels, cash flow growth will increase as companies can raise the prices for their goods and services without a material impact on demand.
In fact, the height of the out-performance of Value Stocks over Growth Stocks is when the rate of inflation has risen to between 2% and 3% above then current levels as this is where the price increases have been maximized and demand has not been impeded. When inflation increases greater than 3% above the then current levels, demand begins to fall along with wider economic conditions.
From the period when inflation rises greater than 3% above then current levels until it tops out is a really bad time for the stock market because all values are discounted at rates greater than companies can increase cash flows. This is when you have to watch for stock prices to bottom, generally ahead of the ultimate top in inflation, and watch for Growth Stocks to begin to out-perform the market once again.
So here is your roadmap to investing during an inflationary period: based upon an analysis of the history of inflation and stock prices, when inflation starts to rise the initial 12 months shows pressure on the broader stock market as investors begin to adjust to the new reality. During this time, Value Stocks begin to out-perform the wider stock market and expand their outperformance as the rate of inflation increase to a level of 3% above current. Beyond a 3% rise, both Value Stocks and Growth stocks perform poorly until investors being to anticipate a top in inflation, then Growth Stocks begin their period of out-performance as inflation falls.
Please note that this road map imples just buying Apple, Google, Facebook, Amazon, Netflix and Tesla will lead to you outperforming the stock market. Nor can you rely on your index funds as we are entering a period where stock picking will be key to the health of your savings and investment. If you do not want to try your hand at picking stocks that will outperform the market during an inflationary time, use a professional who understands the implications of inflation and proper portfolio management. If I can help, please let me know.