Inflation, deflation and stocks

by Mark Salzinger, editor The No-Load Fund Investor

While traditionally many investors worry about the potential effects of runaway inflation on stock prices, lately others worry more about the potential effects of deflation, a falling price level.

There’s certainly plenty of common sense behind worries that either deflation or significant inflation would be bad for equity prices. But does the history of stock prices agree?

We believe that for the next year or two, likely low demand for loans and considerable slack in employment and capacity utilization greatly limit the possibility of rapidly increasing inflation. The odds of deflation are higher, but still not high.

Though there’s certainly a possibility that the U.S. economy could slip into negative growth if the housing and jobs markets fail to recover relatively soon, global competition for goods and services is likely to maintain or slightly increase overall price levels.

Even if our job market fails to pick up, for example, increasing demand for oil from China, India and some other countries with above average growth is likely to keep pressure on oil prices, which feed into the prices of many goods in the U.S., especially gasoline.

In a period of rapid inflation, expectations of even more inflation would increase, boosting the uncertainty of future real returns and rendering contracts more difficult to agree upon.

Bond yields would rise dramatically, making fixed-income investments potentially more attractive than equities while
decreasing the present values of equity cash flows and dividends (in other words, reducing the value of future profits in today’s dollars).

People on fixed incomes would see their purchasing power erode, hurting consumer spending.

For all of these reasons, share prices for equities might have to fall to reflect their increased risk and reduced prospects for real earnings growth.

However, common sense, or even seemingly sound economic theory, doesn’t always stand up to historical analysis, using actual data.

Here, we examine how the stock market has performed since 1946 given various degrees of change in the price level: deflation; as well as inflation of between 0% and 1.4%, 1.5% to 3%, 3.1% to 4.5%, 4.6% to 6%, and above 6%.

For example, the price level actually fell in three separate years from 1946 through 2009.

On average during these three years, the main S&P index of large-cap stocks (whether the S&P500 or its antecedent index) gained an average of 25.6%.

Small-cap stocks (before 1981, the bottom 20% of NYSE stocks based on market capitalization; from 1981 onward, the Russell 2000 Index) gained an average of 22.5%.

To find a case that supports the view that deflation is bad for U.S. equities, one would have to go further back in time.

In the first three years of the 1930s, the price level decreased a total of about 20% while the stock market plummeted 60% to 70%.

So, sure, if you fear another Great Depression, with many years of huge numbers of unemployed, a contracting private economy and a plummeting price level, sell your equities. However, even in the ’30s, deflation was a result, not a cause, of the downturn.

It would be difficult to argue, however, that slightly negative inflation, by itself, would be catastrophic for equity investors.

In fact, using just the post-World War II data, the average returns of large and small caps were higher during the deflationary years than during each other range of inflation we tested.

For large caps, the post World War II data provides evidence that the lower the rate of inflation, the better they perform.

It’s important to recognize the limitations of averaging data. In this analysis, extraordinary gains and losses in various years distort the averages to some degree. So, we like to look at the data from different points of view.

For example, large caps produced losses in 15 of the years since 1945, or about 23% of the years. Small caps did so 18 times (28% of the time).

However, in five of the 13 years (38%) in which inflation was at least 6%, large caps produced a loss.

And, in the seven years when large caps lost more than 10%, the average inflation rate was about 4.5%. So, we can say that high inflation increases the odds of a bad year for large caps.

Interestingly, the data do not show that very high inflation, say \above 10%, has been any worse for equities than moderately high inflation of 6% or 7%.

In fact, equities, especially small caps, performed very well in 1979 and 1980, when the consumer price index leaped by double digits each year.

The most common annual inflation rates since 1945 have been between 1.5% and 3%, a range that was realized in 20 years during the period.

Large caps produced losses in only three of these years, two of which were 2001 and 2002, after the bursting of the technology-stock bubble. Inflation (except in equity prices) had nothing to do with that bear market.

We conclude that inflation in that range helps create a benign environment for equities. It’s certainly not sufficient to guarantee a good market, however.

In summary then: It’s natural for the government to concern itself with the price level, because it affects economic activity. As investors, however, we shouldn’t worry too much about it under likely economic scenarios.

Learn more about this financial newsletter at Mark Salzinger's The No-Load Fund Investor.