Equity Returns and Inflation

By: Michael Ashton | Sat, Jun 8, 2013
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There has been a lot written in the academic literature about why equity returns and inflation seem to be inversely related. What is amazing to me is that Wall Street seems to still try to propagate the myth that equities are a good hedge for inflation (sometimes "in the long run" is added without irony), when virtually all of the academic work since 1980 revolves around explaining the fact that equity returns are bad in inflationary times - especially early in inflationary times. There is almost no debate any longer about whether equity returns are bad in inflationary times. About the strongest statement that is ever made against this hypothesis is something like Ahmed and Cardinale made in a Journal of Asset Management article in 2005,[1] that "For a long-term investor such as a pension fund, the key implication of these results is that short-term dynamics cannot be completely ignored in the belief that the stock market will turn out to be a perfect inflation hedge in the long run." For someone looking for a refutation of the hypothesis, that is pretty small beer.

And yet, it is amazing how often I am called to defend this observation! So, since it seems I have never fully documented my view in one place, I want to refer to a handful of articles and concepts that have shaped my view about why you really don't want to own equities when inflation is getting under way.

I will repeat a key point from above: this is not news. In the mid-1970s, several authors tackled the question about stocks and inflation, and all found essentially the same thing. My favorite summing up comes from the conclusion of an article by Zvi Bodie in the Journal of Finance:[2]

"The regression results obtained in deriving the estimates seem to indicate that, contrary to a commonly held belief among economists, the real return on equity is negatively related to both anticipated and unanticipated inflation, at least in the short run. This negative correlation leads to the surprising and somewhat disturbing conclusion that to use common stocks as a hedge against inflation one must sell them short."

By the early 1980s this concept was fairly well accepted (something about deeply negative real returns over the course of a decade-plus probably helped with the acceptance). In a seminal work in 1981,[3] Eugene Fama suggested that the negative relationship between equity returns an inflation is actually proxying for a positive relationship between real activity and equity returns (which makes sense), but since real activity tends to be inversely related to inflation rates, this shows up as a coincidental relationship between bad equity returns and inflation. But I am not here to argue the nature of the causality. The point is that since about 1980, the main argument has been about why this happens, not whether it happens.

The reason it happens is this: while a business, in inflationary times, sees both revenues and expenses rise, and therefore reasonably expects that nominal profits should rise over time with the price level (and overall, it generally does), the indirect owner of shares in a business cares about how those earnings are discounted in the marketplace. And, over a very long history of data, we can see strong evidence that equity multiples tend to be highest when inflation is low and stable, and much lower when there is either inflation or deflation. The chart and table below represent an update I did for a presentation a couple of years ago (it doesn't make much sense to update a table using 120 years of data, every year) illustrating this fact. The data is from Robert Shiller's site at http://www.econ.yale.edu/~shiller/data/ie_data.xls but I first saw the associated chart (shown below it) in Ed Easterling's excellent (and highly-recommended) book, Unexpected Returns: Understanding Secular Stock Market Cycles. The x-axis on the chart is the market P/E; the y-axis is annual inflation with each point representing one year.

CPI Range1881-2010

Now, it should be noted Modigliani and Cohn in 1979 argued that equity investors are making a grievous error by discounting equities differently in high-inflation and low-inflation environments. They argue that since equities are real assets, investors should be reflecting higher future earnings when they are discounting by higher nominal rates, so that the multiple of nominal earnings should not change due to inflation except for various things like tax inefficiencies and the like whose net effect is not entirely clear. Be that as it may, it has been a very consistent error, and it seems best to assume the market will be consistent in its irrationality rather than inconsistent by suddenly becoming rational.

So, if inflation picks up, then so do earnings - but only slowly. And in the meantime, a large change in the multiple attached to those (current) earnings implies that the current equity price should decline substantially when the adjustment is made to discount higher inflation. After that sharp adjustment, it may be that equity prices become decent hedges against inflation. And in fact, if multiples were particularly low now then I might argue that they had already discounted the potential inflation. But they are not - 10-year P/Es are very high right now.

In short, there is almost no evidence supporting the view that equities are a decent hedge for inflation in the short run, and some careful studies don't even find an effect in the long run. In a thorough white paper produced by Wood Creek Capital Management,[4] George Martin breaks down equity correlations by industry and time period, and only finds a small positive correlation between Energy-related equities and inflation - and that is likely due to the fact that energy provides most of the volatility of CPI in the short-run. Among many meaningful conclusions about different asset classes, Dr. Martin concludes that equities do not offer a good short-term inflation hedge, nor a good long-term inflation hedge.

In fact, I think (especially given the current pricing of equities) the case is worse than that: equities are, as Dr. Bodie originally said in 1976, likely to hedge inflation only if you short them.

 


[1] "Does inflation matter for equity returns?", Journal of Asset Management, vol 6, 4, pp. 259-273, 2005.
[2] "Common Stocks as a Hedge Against Inflation", The Journal of Finance, Vol. 31, No. 2, Papers and Proceedings of the Thirty-Fourth Annual Meeting of the American Finance Association Dallas, Texas December 28-30, 1975 (May, 1976), pp. 459-470, Wiley, Article Stable URL: http://www.jstor.org/stable/2326617
[3] "Stock Returns, Real Activity, Inflation, and Money", The American Economic Review, Vol. 71, No. 4 (Sep., 1981), pp. 545-565, American Economic Association, Stable URL: http://www.jstor.org/stable/1806180
[4] "The Long Horizon Benefits of Traditional and New Real Assets in the Institutional Portfolio," Wood Creek Capital Management, February 2010. Available at http://www.babsoncapital.com/BabsonCapital/http/bcstaticfiles/Invested/WCCM_Real_Assets_White_Paper_Final.pdf.

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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
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Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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