Post by Bozur on Jun 8, 2008 14:40:55 GMT -5
Inflation? Stick With Stocks
By PAUL J. LIMWhile inflation devalues corporate earnings, a major driver of stock prices, it is usually much harder on bonds.
----------
Fundamentally
Inflation? Stick With Stocks
Article Tools Sponsored By
By PAUL J. LIM
Published: June 8, 2008
WITH inflation running higher than it was a year ago, investors are faced with a host of uncertainties. First and foremost, is inflation bad for stocks?
The simple answer is, not necessarily.
To be sure, inflation devalues corporate earnings, a major driver of stock prices. But the mere presence of inflation also suggests that many companies are successfully passing along price increases to customers, said Alan F. Skrainka, chief market strategist at Edward Jones, the brokerage firm based in St. Louis. And that’s good for profits.
Moreover, while periods of high inflation typically reduce stock returns, they have been much harder on bonds. In the 23 calendar years between 1926 and 2007 when inflation measured more than 4 percent, stocks returned 6.9 percent on average, versus just 2.8 percent for long-term government bonds, according to Ibbotson Associates.
A separate analysis by Merrill Lynch, meanwhile, found that in inflationary periods — as measured from troughs to peaks — going back to August 1972, some 6 of the 10 market sectors in the Standard & Poor’s 500-stock index actually gained ground, on average.
This explains why stocks — even though they’re hurt by rising prices in the short term — may be an investor’s best long-term hedge against inflation.
Of course, this isn’t to say that high inflation is welcome. The mere fact that inflation can cut into returns, sometimes significantly so, is enough for investors to be worried.
So stock investors may want to consider several factors in the coming weeks and months:
THE 4 PERCENT THRESHOLD Is inflation running at 4 percent or more? “That seems to be the line in the sand,” said Sam Stovall, chief investment strategist at Standard & Poor’s Equity Research.
Mr. Stovall studied past periods of inflation going back to 1960, using the overall — or “headline” — Consumer Price Index as a gauge. He found that when the C.P.I. was rising at no more than a 4 percent annual pace, the S.& P. 500 gained about 1 percent a month, on average.
But when the price index grew 4 to 6 percent annually, stocks lost an average of 0.3 percent a month. Stocks fared even worse at higher rates of inflation.
According to the Labor Department’s most recent assessment of consumer prices, based on April data, the price index was growing at a 3.9 percent clip. That’s just under the 4 percent threshold and still within what Mr. Stovall calls the sweet spot for inflation: the 2 to 4 percent range.
A MATTER OF DIRECTION Which way is inflation headed? “There’s a big difference in the level of inflation and the direction of inflation,” said Jeffrey N. Kleintop, chief market strategist for LPL Financial in Boston. For example, when inflation is painfully high but falling, stocks can do quite well, Mr. Kleintop said.
In 1980, the Consumer Price Index rose by more than 12 percent, but stocks still gained more than 32 percent, according to Ibbotson Associates. Why? Perhaps because in 1979, inflation was even higher, at more than 13 percent.
And while the average rate of inflation throughout the 1980s was an uncomfortable 5.6 percent, it still turned out to be a great decade for stocks: the S.& P. 500 rose by an average of 12.6 percent a year. The key may have been that inflation was declining throughout the decade.
In periods of low-but-rising inflation, stocks can feel a pinch. Ned Davis Research of Venice, Fla., recently studied the performance of stocks between the first quarter of 1926 and the first quarter of 2008. In periods when inflation accelerated, stocks gained less than 0.5 percent a year, on average, Ned Davis found.
By comparison, in periods when the inflation rate fell, stocks soared by an average of nearly 10 percent.
THE CORE RATE A big complaint these days is that economists don’t understand how painful inflation is to the average family, because they tend to focus on core inflation, which strips out the volatile prices of food and energy.
But in measuring the macro economy, said Mr. Skrainka at Edward Jones, core inflation is a “better indicator of long-term trends because it tells us if higher energy and food costs are feeding through to the rest of the economy.”
Investors also need to pay attention to core inflation because the Federal Reserve Board does. And “if inflation pressures remain high or rise to the point where the Fed is forced to raise interest rates, then you’ll see a direct negative impact on stocks,” said James B. Stack, editor of the InvesTech Market Analyst, a newsletter.
There’s another reason to be mindful of core inflation.
“There’s a perfect inverse relationship” between core inflation and stock market valuations, said Liz Ann Sonders, chief investment strategist at Charles Schwab.
Ms. Sonders has discovered that since 1960, whenever core inflation has hovered between 2 and 3 percent, the average price-to-earnings ratio of the S.& P. 500 has been 19.7, based on trailing 12-month earnings. But when core inflation jumps to between 4 and 5 percent, the average P/E falls to 14.8.
Where is core inflation now? The government says it’s running at an annual pace of about 2.3 percent. That’s the good news — at least so far.
www.nytimes.com/