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How do Inflation Levels Affect Stock Market Returns? by Joon Choi

How do Inflation Levels Affect Stock Market Returns? by Joon Choi

The Consumer Price Index (CPI) is a broadly used measure of inflation in the U.S. which is published by the U.S. Bureau of Labor Statistics on a monthly basis.  This figure is calculated by measuring the monthly price change of a predetermined basket of goods, such as food and medical care.  Investors focus on the CPI figures because the Federal Reserve Bank uses the information to implement restrictive or expansionary monetary policies.

Theoretically, a high inflation environment generally leads to restrictive monetary and fiscal policies which cuts off economic activities and lowers stock market valuation.  The opposite is true for low inflation environment.  The average rate of inflation during 1956 to 2011 span was 3.83% and the average annual performance for the S&P 500 Index total return for the low inflation years was 12.1%, which was higher than the average of 8.7% for high inflation years (Table 1).The inflation is considered high if the annual CPI is greater than the average and low if it was below.

Table 1: High vs. Low Inflation

Inflation Level

Average Annual S&P 500 Index Total Return

High (above 3.83%)

8.7%

Low (below 3.83%)

12.1%

Further evidence of inflation’s impact on the stock market.

The results in Table 1 suggest that the level of inflation has had an effect on stock market performance.  However, further analysis reveals that a change in the direction of inflation has had an even greater impact on the stock market than the level of inflation itself.  Table 2 shows that the S&P 500 Index rose at an average rate of 17.1% per year when CPI was falling and 4.4% when rising.  These results seem to support the notion that investors favor falling inflation.

Table 2: Rising vs. Falling Inflation

Inflation Direction (from prior year)

Average Annual S&P 500 Index Total Return

Rising

4.4%

Falling

17.1%

Combining the two studies above, Table 3 displays the stock returns during four inflation climates. The best performance of 20.1% average return was achieved during years when the inflation level was high but turning down.  Next best climate for the stock market was low and falling inflation with 16.1% average return.  Low but rising inflation years averaged 6.3%, and high and rising inflation was the worst climate for the stock market with 2.1% average performance.

Table 3: Stock Market

Returns for  Four Different Inflation Environments

Inflation Direction

Inflation Level

Average Annual S&P 500 Index Total Return

Up

High

2.1%

Down

High

20.1%

Up

Low

6.3%

Down

Low

16.1%

How has inflation affected the stock market returns in recent years? So, if rising inflation had not been good for the stock market, why does the Fed seem less worried about further accelerating the inflation rate with a very accommodating interest rate environment?  The most obvious reason is that the Fed is faced with slow economic recovery, especially the labor market, since the financial crisis in 2008 and it wants to stimulate the economy.

Another possible reason might be that the level or the direction of inflation has not affected stock valuations in recent years.  In order to analyze the hypothesis above, the 56 year study period was divided into 4 sub-periods.  During the first 3 sub-periods, falling inflation years, for the most part, led to higher stock market returns than rising years.  (A lone exception was the return of 22.6% for stocks in 1983, a year when inflation was below average but rising.)  In contrast, during the most recent 14-year period ended in 2011, there has been no clear bias between the different inflation environments. It almost seems like inflation expectations are no longer driving the stock market the way they did previously.

Conclusion

A popular saying in investment lore was “Don’t fight the Fed”.  However, since 1998, it appears that the stock market appears to have disengaged from Federal Reserve policy.  Investors have been paying the price, as Fed policy for most of the past ten years has been very stimulative.  In years past that would have triggered a bull market rather than the stagnation that stocks overall have experienced.  The good news for investors is that even if the Federal Reserve succeeds in further stoking inflation, which is already up to 3%/year despite high unemployment, stocks will likely not suffer the way they did during the 1970s.

Joon Choi is a Portfolio Manager at Signalert Asset Management, LLC and has been with the company since 2002.  He formerly held a Portfolio Administrator position at The Vanguard  Group.  Mr. Choi received his B.S. from Colgate University in Economics and also earned his MBA from New York University.

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