As we discussed here, despite the fact that price increases should shield corporations from the effects of inflation, they actually end up eating up much of the profits in asset requirements. But this cash requirement of the business is hidden from investors, who continue to see rising earnings. Therefore, what happens to stock prices during inflationary times? Do they continue to rise along with earnings? The answer is no.
They key to understanding the argument below is to recognize that as inflation increases, central banks increase interest rates to reduce the money supply and slow inflation down: When interest rates are high, people find it expensive to borrow, and therefore there is less money floating around. With interest rates are high, people require higher returns on stocks. Well, its not so easy to just increase earnings for a stock, so its price has to adjust downward.
Consider a stock that sells at $10 with earnings of $1, a 10% return. When government bonds pay 5%, an investor may be willing to buy this stock for the extra 5% return. However, if interest rates were to rise, to say 15%, who would pay for this 10% return, when they could get 15% risk-free by buying the bonds? Therefore, the stock may drop to $5. With earnings of $1, this now generates a 20% return and is once again at a price where an investor might be willing to take the risk on this stock for the extra 5%.
As we can see, inflation compresses P/E values, which can be a painful adjustment for anyone holding stocks.