What is the Impact of High Inflation on Stock Returns?

Quiz!

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

1. Value stocks that are priced far above their average valuations.
2. Growth stocks.
3. Value stocks.

What is the Impact of High Inflation on Stock Returns?

We are experiencing very high inflation, last seen in the early 1980’s. What is the Impact of High Inflation on Stock Returns?

1. Negative: It hurts stocks, by reducing stock valuations (Price/Book) to reflect a lower value of future earnings. It hurts growth stocks with high valuations especially hard. Examples are S&P 500 and Nasdaq.
2. Positive: It ultimately helps stocks, because high inflation = higher prices => higher earnings for the companies.

The bigger the spike in inflation, the more stocks are likely to decline in the short run, because the negative forces can be greater than the positive ones. Once stock valuations adjust to higher inflation and higher interest rates (that are used to combat inflation), the positive impact tends to be much stronger, especially for value stocks.

Key takeaways:

1. When inflation spikes, you should be especially cautious of stocks with very high valuations. Now the largest tech stocks are priced extremely high, something familiar from past cycles. In the 1970’s, we had the nifty-fifty, also called “one-decision” stocks. Counter to expectations at the time, they crashed badly despite being the most prominent of US stocks (https://en.wikipedia.org/wiki/Nifty_Fifty). Stock returns adhere to the formula, price = book value x (price / book value). If the valuations (price / book value) are very high, even the best company in the world can see its stock price drop.
2. Value stocks (with low valuations, or price / book-value) are better positioned for high inflation, for 2 reasons: (1) Immediate: there is no big correction necessary to valuations; (2) Ongoing: more of their earnings are from the near-term, with a smaller needed discount to future earnings.
3. Even value stocks can be expensive at times. For example, US Large Value stocks are currently very expensive (but still less than the S&P 500 and Nasdaq). In stark contrast, non-US Value stocks are priced low.

Quiz Answer:

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

1. Value stocks that are priced far above their average valuations. [Correct Answer]
2. Growth stocks. [Correct Answer]
3. Value stocks.

Explanation:

1. While value stocks tend to have low Price/Book, sometimes an entire collection of stocks becomes expensive, including value stocks. A current example is US Large stocks.
2. Growth stocks tend to have earnings far into the future, that need to be discounted by high interest rates (the tool used to combat high inflation).
3. Value stocks are priced lower and have nearer-term earnings that not impacted as much by higher interest rates. The increase in income (along with inflation) can become the dominant force.

See article for more explanations.