Sunday, June 22, 2008

How Does Inflation Affect Stock Prices?

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.


denisjax said...

Your answer only explains situation when a stock pays dividend. If you own a non-dividend paying stock, its price will inevitably increase to reflect the decreasing purchasing power of money, and growing overall prices on the markets! So here is the other side of the coin, Johnson!

ahacme said...

I don't think your are correct denisjax. With rise in inflation, interest rates go up, so from valuation standpoint, the present value of future cash flows is reduced with higher discount rate. The P/E multiple needs to be re-adjusted downward to facilitate higher free market rate.

Saj Karsan said...

Hi Denisjax,

I agree with ahacme. Dividend or no dividend, the earnings yield will have to increase (in other words, the P/E will have to decrease) if interest rates go up.

Anonymous said...

You are terribly wrong denisjax. Might as well go back to your economics 101 class. When inflation goes up, the stocks becomes less interesting compared to fixed incomes as the future value of your investment is eroded.

whippersnapper said...

I would think that in a near continuous high inflation situation that owning a company stock would be more protective than holding onto bonds. The bond could be paid off with worthless cash, whereas the company stock, assuming it survives the debacle, would be revalued (to the new currency?) holding its own with other companies. At least you are left with a company that can sell into the market and be valued, compared to the bond that was paid off with inflated funds?

The company can continue to sell to the folks (that have the new currency, maybe backed by gold/silver?) and be valued on how well they do vs. their competitors?

Or does one just sell off the old bond and buy new bonds that have a higher interest to compete with inflation, that is why holding a bond is better that holding shares during inflation? Will bonds be available during high inflation with matching interest rates?

Hyperinflation, when folks lose confidence in the paper money...would stock in a company be better than bonds? Is not a company (stock) considered a commodity in a sense?

If no currency is backed by a commodity, just faith in a government having a lower inflation rate than others, then you hope to have the currency with the lowest inflation rate? Or are commodities like pork bellies and aluminum better to hold onto? (where am i going to store all those pork bellies?)

Deboshree said...

The answer that you have given is for time t+1 but at time t..stock prices would actually rise because when people see that their money today means nothing they would immediately run towards the stock market.
Please correct me if I am wrong.

Paul G said...

Depends on which companies your talking about- mining / agricultural shares for example might be ok as the value of their goods would potentially increase with inflation (although not definitely). Some companies input costs may outweigh the rate they can increase prices, so they would do badly.

Overall, I think reasonable inflation is ok- like between 0% and 5% but anything outside this range is likely to be bad for the economy overall.

Saj Karsan said...

Hi Deboshree,

I would agree with Paul in that the answer depends. I believe a big determinant is the source of the inflation. For example, whether the inflation comes from oil prices or labour shortages would impact which sectors rise and how the entire market ends up is anybody's guess.

The Dixter said...

I think you guys believe the market to be perhaps more rational than it is. In the end, a company that does well, even in the presence of inflation, will see market strength grow, as well as earnings per share. These companies will be easily recognized (netflix, google, ibm, apple) as they increase their market share and dominate, just as those companies that are more susceptible to inflation shall see their share dwindle, and shall be likewise easily recognized. In the end, the companies that are strong will be rewarded with higher P/E, as will the share holders owning those companies.

Sure, in a world of black and white, a lesser value for a dollar means a lower share price. But that's for weak companies that have weak business structures.

Thankfully we do not live in a boring black and white world; and the poor, pure economist reading higher inflation and staying away from the stock market, would likely see their bank account dwindle as they invest in precious-metal-bubbles and government bonds.

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