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Investing During Inflation (Part One)

In my last blog post, I provided some details on why prices are on the rise and inflation is becoming an issue. Since then, I’ve been doing some research on which investments perform positively and which perform negatively during inflation.

Below will be a series of graphs I put together that compare the historic performance of various asset classes to the levels of inflation at that time. I’ve have added a linear regression that will help you see the positive or negative relationship between the level of the Consumer Price Index and the returns on that asset class. Please understand that these graphs do not present the data in chronological order.

S&P 500 Index (Large Cap Stocks)

Below are a series of graphs that analyze the correlation between Large Cap Stocks (as represented by the S&P 500 Index) and the Consumer Price Index. The first graph covers the period for which all data is available, 1926 to today:

I know this graph is difficult to read if you are not used to looking at statistical correlations, so let me walk you through it. (1) Qn the left side, you will note that the Y Axis is the return for the S&P 500, going from -50% to +75%. (2) On the bottom, you will note that the X Axis is the level of inflation for various years and ranges from -10% to + 20%. (3) For each annual inflation reading, there is a blue dot that shows the return of the S&P 500 at that level of inflation. (4) The red line through the dots is a linear regression best fit line that helps us visually define whether there is a positive or negative correlation between inflation and stock market returns.

Looking at the red line, you can sort of make out that there is a slightly negative relationship here, meaning that inflation has a slightly negative impact on stock prices over the long term. To confirm this visual analysis, I also calculated the statistical Correlation at -0.00787, so it is definitely a very slight negative correlation.

This is all well and good, but that doesn’t really get to the heart of how stocks perform during periods of significant inflation. To examine that, I isolated the time period of 1965 to 1986, a 21 year span that saw inflation move from 0.97% in 1964 to high of 13.29% in 1979 ( along with other double digit years during this time span) and back to 1.1% in 1986.

Visually, this is a lot easier to conclude that a period of rising and then falling inflation has a negative impact on large cap stock returns. To confirm that, I calculated the statistical Correlation to be -0.260998, a materially larger number than the Correlation of the 1926 to present day calculation.

The above analysis looks at an entire inflationary cycle. Since we are just at the beginning of a new cycle, lets refine the data further and just examine the period of time from 1965 to 1978, where inflation was building prior to its peak.

As we might guess, the visual examination shows the impact is even greater negative as inflation is building. The calculated correlation is even more revealing at -0.560582.

S&P 600 Index (Small Cap Stocks)

From the above, we see that rising inflation has a negative impact on the returns of Large Cap Stocks. However will it have the same impact on Small Cap Stocks. To determine that, I performed the same analysis on the S&P 600 Index. Unfortunately, there is not the same amount of data available for this index as there is for the much wider known S&P 500. Our data starts in 1975 for this analysis, so it doesn’t make sense to analyze the data prior to the 1979 peak in inflation, so we will examine the 1975 to 1986 period, comparable to the second graph above.

We again see the negative correlation between stock market returns and inflation. The calculated Correlation is -0.217613.

Implications

Based upon this analysis, the broad stock market is a bad place to be during times of inflation. Given the dominance of index funds and passive investing over the past decade or so and their dominant percentage of investment vehicles in the stock market – over half of all stock market investment is now through index funds – any negative impact on the broad market will have an oversized impact on individual investors.

The beta side of the stock market potentially is in trouble so we, as investment managers, need to rely on alpha to provide acceptable stock market returns and to reduce the risk of loss for clients. Beta is emblematic of the saying “a rising tide lifts all boats.” Many stocks have moved higher over the past decade because they were included in an index, and as money came into index funds, their stock prices went up whether they were a desirable investment or not. That is because the index funds have to mimic the make-up of the index so they have to buy the bad with the good.

Over coming days, I will show you various other analyses of markets, sectors, industries, and investment styles that illustrate which benefit from inflation and which do not. We are at the leading edge of this economic change so I want you all to understand what we are doing and to know how to manage your investments that you do not have with us.

Next up, we will look at the proxies for the growth and value styles of investing, the NASDAQ and the Dow Jones Industrial Average. Until then, keep this fact in mind so that you are sure to read the next post: today the 3-year breakeven inflation rate is 2.82%, the highest level in 15 years while the 10-year breakeven inflation rate is the highest in eight years. The breakeven inflation rate is a signal given by the bond market and has proven to be exceptionally accurate over the years.

Inflation is here, we now need to prepare our investment portfolios accordingly.

—Mark

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