A small yet enlightening research on the relationship between inflation and the stock market and a discussion of the stocks that will offer more protection against inflation
Inflation is rearing its ugly head. It has been at it for a while now creating a potential for a nasty economic environment of inflation and a recession combined. In may prices rose by 0.6%-0.8% (depending on the indicator), 4.2% higher than in May 2007 and amounting to a yearly inflation rate of 3.9%.
Price increases are everywhere but food prices and gasoline prices attract the most attention. We’ve all witnessed the oil prices and commodity prices skyrocket these last couple of years and now we’re getting a feel of the results.
Studying the increase in prices by expenditure categories between may and April reveals the following:
1. Energy prices increased by 4.4%.
2. Food prices increased by 0.3%.
3. Housing prices increased by 0.5%.
Ignoring food and energy prices the increase in remaining prices is a mere 0.2%.
The relationship between inflation and the stock market
Fearful of an inflationary environment I began asking myself what will happen to my stocks should prices continue to rise?
I decided to take a quick look at the relation between inflation and the stock market. I’ve examined how the S&P500 and inflation rates have evolved since 1950s and since 1987 (20 years).
Since 1950 the level of inflation is negatively correlated with stock market returns. This is understandable as high levels of inflation eventually hurt stock values as well.
The following chart depicts the Yearly inflation rate and the S&P500’s return for each month (for example in July 1999 the inflation rate since July 1988 is compared to the S&P500’s return since July 1998). A very clear and distinct negative correlation can be observed:
Another intriguing result appears when I cleared out the months at which the yearly inflation level was lower than 3% (YoY). Out of 370 months in which inflation level, YoY, was over 3% over 163 produced negative returns.
Which stocks are more defensive or offer greater protection against inflation?
Essentially, stocks are assets and as such should respond to an increase in prices by increasing in value themselves.
This general rule of thumb is usually true and stocks often provide good protection against inflation. However, it is very important to note that in times of high inflation more asset oriented stocks respond and defend their value better. The following are important things to notice when investing in stocks in times of inflation:
1. The level of liquid assets the company holds – A high level of liquidity would hurt the company’s value as prices increase and erode the value of liquid assets.
2. The level of fixed assets the company holds – In turn, the higher the level of fixed assets the more the company is protected against inflation. These assets, such as buildings, land and machinery have a value regardless of inflation (they are automatically adjusted).
3. Commodity oriented companies are more defensive – Since commodity prices adjust to inflation a commodity oriented company should be more defensive in times of inflation (think of oil companies or food companies for example).
4. The level of exposure to foreign markets – The higher the level of exposure to foreign markets the less susceptible a company will be against inflation in its home country. Furthermore, the company might benefit as its expenses might erode due to inflation (such as wages) while its income remains at previous values.commodity prices, Inflation, inflation rate, inflation rates, negative correlation, Offer, Protection, relationship, Stock, stock market returns