Saturday, March 19, 2005

Why Inflation Shouldn't Spook the Market

With oil prices rising, a common headline recently has been "Stocks fall on inflation worries." The basic idea is: As energy prices rise, manufacturing costs increase, thereby depressing corporate profit margins and earnings.

But, pursuing this economic logic a few steps futher, I would say: Manufacturers will raise the price of their finished goods to maintain profitability, and consumers will continue to buy at the higher prices because they will soon be receiving higher wages to compensate for the inflation. Sure, there may be short-term time lags of one sort or another, but the basic long-run effect should be that ALL prices--commodity prices, producer prices, consumer prices, wages, and stock prices--rise with inflation.

To see what the relationship between inflation and stock prices has been historically, I downloaded data from 1821 to 2004 (source: Here's what I found:

Period: 1821 to 2004
Average annual inflation rate: 2.0%
Average annual change in S&P 500: 5.0%
Correlation between inflation and stocks: 0.03

Quartiles: I, II, III, IV (sorted by inflation, from high to low)
Average annual inflation rate: 9.0%, 2.8%, 0.8%, -4.5%
Average annual change in S&P 500: 4.7%, 5.8%, 5.2%, 4.0%
Correlation between inflation and stocks: -0.12, -0.04, 0.22, 0.28

For this 184-year period (as far back as the data go), stocks on average performed better in mild inflationary environments, with returns tapering off slightly in both severe inflationary and deflationary environments. However, since the correlation between inflation and stock prices is very low, it is difficult to draw any reliable cause-effect relationship.

Considering that the "modern" economy may be intrinsically different from the pre-1925 economy, I also restricted the analysis to just the most recent 80 years are re-ran the numbers:

Period: 1925 to 2004
Average annual inflation rate: 3.1%
Average annual change in S&P 500: 8.0%
Correlation between inflation and stocks: -0.02

Quartiles: I, II, III, IV (sorted by inflation, from high to low)
Average annual inflation rate: 8.4%, 3.4%, 2.1%, -1.4%
Average annual change in S&P 500: 3.0%, 11.0%, 10.8%, 7.4%
Correlation between inflation and stocks: -0.33, -0.03, -0.09, 0.49

Here the tapering-off of returns in high inflationary and deflationary environments is more evident. However, when the high inflation quartile (Quartile I) is divided into halves, we have:

Quartile I: Upper half, lower half
Average annual inflation rate: 11.0%, 5.8%
Average annual change in S&P 500: -3.5%, 9.5%
Correlation between inflation and stocks: 0.0, -0.25

This shows that historically the impact of high inflation has not really kicked in until inflation rises beyond 6% annually, which is more than twice the current inflation rate (CPI rose 2.7% in 2004). However, again, since the correlation is so low, it really is not very meaningful to place much confidence in the notion that inflation causes lower stock returns.

A quick look at the years with the highest inflation bears out the "scatter" in the data:

Year: Inflation Rate, S&P 500 Return
1864: 21.8%, 6.4%
1918: 20.4%, 16.4%
1946: 18.1%, -11.9%
1917: 18.1%, -30.6%
1835: 17.6%, 3.1%
1851: 17.6%, -3.2%
1919: 14.5%, 14.0%
1836: 13.3%, -11.7%
1979: 13.3%, 12.3%
1863: 13.0%, 38.0%
1916: 12.6%, 3.4%
1980: 12.5%, 25.8%
1974: 12.3%, -29.7%

In these high inflationary years, stock returns have been as high as 38% in 1863 and as low as -30.6% in 1917. In more recent history, the two occasions with double-digit inflation, 1974 and 1980, showed strikingly different stock returns, -29.7% and 25.8%, respectively.

Conclusion: Historically, inflation has been a lousy indicator of stock market performance, i.e., inflation does not "cause" the stock market to fall. While inflation fears might "spook" investors, history shows that inflation is less of a monster than investors imagine it to be.


Blogger Jim Duncan said...

Very interesting post that correlates well in many respects to what is happening in our market. I appreciate your taking the time to so thoroughly analyze the market.


5:51 AM, June 10, 2005  
Blogger armyjoe said...

I'm not sure if anyone reads this stuff, but if so I'd like some advice. I'm an officer in the Armed Forces (that's all I'll say because I'm not so sure about the legality of disposing of the info I'm about to). Anyway, there has become a new standard in the way we have been required to carry information - from what I've seen the winner in all of this will be - - - We are talking a major military contract - - is this a public company? How can I cash in?

2:21 PM, June 16, 2005  
Anonymous Anonymous said...

Hey, you have a great blog here! I'm definitely going to bookmark your site!

I have a fund investing mutual
site. It pretty much covers fund investing mutual
related stuff.

Come and check it out if you get time :--)

8:55 PM, October 12, 2005  
Anonymous Anonymous said...

Nice site. Check mine out if you can. investing guide

8:34 PM, October 24, 2005  
Blogger apoorva said...

this analysis does not bode well with economic theory. Not inflation, but forecasts about inflation affects the market. So if any statistical analysis or regression analysis is to be done between inflation and stock market data, one needs to use lagged values of stock market (once sub challenge is to find out apporpriate time lag which depends upon how much future expectations about inflation have been discounted in to the stock prices) and not the current data about stock prices. It is no surpirse thay there is no systematic relationship between current inflation and current stock market prices.

7:25 AM, March 31, 2010  
Anonymous stock tips said...

Thanks so much for this! I haven't been this moved by a blog for a long time! You’ve got it, whatever that means in blogging. Anyway, You are definitely someone that has something to say that people need to hear. Keep up the good work. Keep on inspiring the people!
Stock Tips

11:22 PM, June 03, 2011  
Anonymous Learn Stock Market said...

Pretty interesting info is visible in this blog and the very good articles are display in this blog. This info is very helpful for me with my project time and thanks you very much for using the valuable info in this blog.

4:03 AM, April 25, 2013  

Post a Comment

<< Home