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: www.globalfindata.com). 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.