Stocks and Inflation: Who's Winning the Race?

Looks like fund investors have had it with this market. As my colleague Karen Dolan detailed in a recent article, mutual fund outflows recorded their biggest monthly drains in September and October since Morningstar Market Intelligence data started tracking redemptions in January 2000. If past patterns of behavior are any indication, then there's a good chance investors are bailing at the worst possible time. Yet, one must say the angst is understandable. Since equities hit a new peak last October, a steady decline has turned into a rout the last couple of months. The sell-off is now deep enough to test the conviction of even the hardiest buy-and-hold investors. Even those who have been in stocks for a considerably long time now find their savings haven't kept pace with inflation.

This is a difficult time indeed to keep faith in stocks as an effective hedge against inflation. However, there is more to the relationship between stock returns and inflation than what we're seeing now. Let's look at the range of academic opinion on this subject, and evaluate the case for holding on to stocks for the long run from the standpoint of inflation.

The Lost Decade?
It's not over yet, but thus far the first decade of this century has proved very lean for stocks. As the following table shows, the Morningstar U.S. Market Index, which is a broad benchmark of domestic stocks, has declined at a 2% annualized clip since the start of 2000 through Nov. 3, 2008. Meanwhile, inflation, as tracked by the U.S. consumer price index (CPI), has paced a bit more than 3% annually in this decade. Forget about keeping up, stock investors have steadily lost ground to inflation. By comparison, competing asset classes such as bonds in general, inflation-protected Treasuries, and especially commodities have proved far superior. What happened? Weren't stocks supposed to be among the best stores of value in the long run?

Asset Class Returns during This Decade
Index	Annualized Return Jan. 1, 2000 to Nov. 3, 2008	Year-to-Date Return (as of Nov. 3, 2008)
DJ AIG Commodity Index	7.37	-27.94
LB US Agg Bond Index	5.72	-1.36
LB US Treasury US TIPS Index	6.81	-7.15
Morningstar Large Cap Index	-3.90	-32.27
Morningstar Mid Cap Index	1.91	-37.00
Morningstar Small Cap Index	3.54	-31.09
Morningstar US Market Index	-2.25	-33.12

Theoretically, stock returns should keep pace with inflation. Ultimately, returns are tied to a company's ability to generate profits. If prices rise, companies should ideally be able to pass their higher costs on to their customers, and thus preserve their profit margins. Also, the debt in a company's books erodes with inflation because the firm pays back money it borrowed yesterday with today's devalued dollars (in other words, the fixed interest rate bonds earn is worth less in real terms after inflation). Thus, other things being constant, inflation alone shouldn't affect profit margins or stock returns.

Things get complicated in practice, however. Many empirical studies have shown a negative correlation between stock returns and inflation; in other words, stocks tend to do poorly when inflation is rising or is expected to be high. The academic explanation for this observation splits a couple of different ways. For one, an accelerating rate of inflation does make profits uncertain because it becomes trickier for companies to manage their costs and price their products. This causes stock investors to demand a bigger margin of safety, which depresses equity valuations. Another reason is that even if a company were to keep its profits intact, investors discount those future cash flows more steeply because of the perceived erosion in buying power of tomorrow's dollars. This line of reasoning implies that while stocks do poorly when inflation spikes, they are undervalued.

The 1970s serve as the classic example. Inflation ranged well over 7% in that decade, and stocks fared very poorly. When the inflation surge was tamed in the early 1980s, it laid the groundwork for a long bull market in equities. Although the average 3% inflation rate this decade is benign compared with that of the '70s, things have gotten quite costly in recent years due to soaring agricultural and industrial materials prices. Commodity prices have fallen off a cliff in recent months due to fears of a global economic slowdown, but as recently as this summer, the inflation rate stood close to 6%. No wonder it feels like bell bottoms should be back in fashion (for some they never went out of fashion) when you look at the stock market these days.

Well, sure, the global financial meltdown has something to do with the slump in stocks. But the key observation here is that the negative correlation between inflation and stock returns found by many academic studies has again held true in the 2000s.

But Money Still Grows on Stocks
There's more to this story, however, which is why stocks are still the best place to be over the long haul. The positive relationship between inflation and stock returns that classical economic theory predicts is a long-term equilibrium. The relationship can deviate in the short and medium term, as we have seen. But some new studies that use long-term data and appropriate statistical techniques have effectively shown that in the very long run, stocks tend to provide an effective inflation hedge. Given enough time, firms can raise prices to match higher costs due to inflation, and the uncertainty surrounding their profits also dies down. What also allows stocks to be good inflation hedges in the long run is that inflation shocks--which usually drive stock prices down into deep discount territory--tend to have temporary effects. When the underpricing corrects, stocks more than make up for the short- and intermediate-term negative correlation with inflation. For example, The S&P 500 Index's 6.4% annualized rate of return since 1970 compensates for the average 4.7% annual rate of inflation during that time.

The inflation scare has all but died down in the last few months as the global slowdown has become more and more apparent. In fact, officials and policymakers worldwide are turning on all kinds of liquidity spigots and capital infusions to combat the opposite problem, which is deflation. Some time in the future, however, the loose monetary and fiscal measures being taken now could have inflationary consequences. In any case, the opportunity to buy a cheap inflation hedge is now. And arguably, stocks make the strongest valuation case among the alternatives. Some of our favorite fund managers and many prominent market commentators are saying stocks are very attractively priced. And as is evident from the table presented earlier in this article, large-cap stocks have an especially battered record in this decade. Morningstar's list of  Fund Analyst Picks is a great place to look for vehicles best equipped to take advantage of the bargains available in various equity categories.

Stocks have no doubt disappointed over the past decade. But looking at the market's performance through the lens of inflation data helps explain the result and also offers long-term hope.